A short guide to pensions before retirement
Updated: Apr 14
This is the first in a short series of blog posts this week which will explore the often confusing world of pensions in a bit more depth.
Whether you are 18 and just starting out, or whether you are beginning to think about life after the alarm clock, saving for retirement is known as the ‘accumulation’ stage, or more simply the stage when you are putting money into a pension rather than taking money out.
You have different options when saving towards your retirement. The option, or options, that will be suitable for you will depend on a range of factors specific to you.
One universal truth is that it is important to ensure you have a full state pension at retirement. Based on current legislation, this will provide you with guaranteed income for life, generously indexed to keep pace with inflation and wage growth.
However, the state pension alone won’t allow you to maintain a reasonable standard of life in your later years, and – with increases to life expectancy and a dwindling National Insurance pot – how much you get and how long you get it for may change. For this reason, it is important to also save for your future throughout your working life.
Start saving before it’s too late
When you begin your working life, retirement feels a long way away – and, of course, with student debt and the costs of buying your first home, servicing a large mortgage, or starting a family, the age at which people generally begin planning for retirement is increasing. However, the sooner you start, the less you will have to save each month – and the greater your pension pot is likely to be when you do retire.
This is because, with most pensions, the income you will receive at retirement depends on the total value of your pension pot when you reach your chosen age of retirement. Put simply, your pension pot is invested and, over the long term, should generate substantial returns. The investment decisions you make today will directly affect your retirement income – and the longer your money is invested, the greater the growth that should be achieved.
By contrast, the later you start, the more you will need to put away each month. A shorter term to save over also carries greater risk of a fall in the markets reducing your savings, as there is less time for your money to recover. This could result in you having to work longer than you want to, or leave you with less income in your later years when you need it most.
The State Pension is an important part of most people’s retirement income. This is because it provides guaranteed income for life, regardless of how long you live.
Your State Pension is also revalued annually, using the ‘triple lock’ guarantee, which, based on current legislation, means your State Pension income will grow by at least 2.5% each year – so your State Pension income will keep pace with inflation. For 2020/21, your State Pension should provide annual income of around £9,100.
However, this assumes you have made sufficient National Insurance Contributions prior to reaching your State Pension age. Contributions are made through paid employment, through entitlement to certain qualifying benefits, or through voluntary contributions. It is always worth obtaining a State Pension forecast, so that you can see your contribution history to date. You can request a free forecast online at https://www.gov.uk/check-state-pension.
Although the State Pension is an important part of most people’s retirement income, it is unlikely to be enough to provide a reasonable standard of life without other income.
In addition, the age at which we can take our State Pension is rising. Both men and women are currently entitled to their State Pension when they reach age 66, although the Government is planning further increases, to raise the State Pension age from 66 to 67 between 2026 and 2028, and to age 68 between 2044 and 2046.
With increases to life expectancy and a National Insurance pot close to exhaustion, it would be reckless to rule out further increases, or further detrimental changes such as the end of the ‘triple lock’ guarantee, in the future.
You should therefore ensure that you have other income in retirement. Workplace or personal pensions can help, as well as using your annual allowance for ISAs, so that you can retire when you want to and live comfortably when you do.
Workplace, or occupational, pensions are provided by or through your employer. However, this could cover a range of different pensions and, crucially, a workplace pension could be either ‘defined contribution’ or ‘defined benefit’.
Put simply, defined contribution means the contributions you and your employer make are invested, and the income you will receive in retirement depends on how much this pot is worth when you retire. This means there is investment risk, as your future income depends on investment performance.
By contrast, defined benefit pensions, such as final salary arrangements, instead provide income based on your length of service with the employer and your final or average salary.
The income you will receive from a defined benefit pension does not depend on investment performance, the income you are entitled to is guaranteed for life, and your entitlement is usually increased each year both before and in retirement to keep pace with inflation.
Given this, defined benefit pensions are valuable, and these pension rights should not be given up lightly.
While defined benefit pensions are valuable, outside of the public sector they are not typical today. Most workplace pensions are defined contribution, which means your future income will depend on how much you and your employer contribute and how your money performs when invested.
There are various different types of workplace defined contribution pensions, such as Group Personal Pensions, Group Stakeholder Pensions, or ‘auto-enrolment’ pensions.
While these pensions differ slightly, the principle remains the same – both you and your employer contribute, and these contributions plus the tax relief applied by HMRC are invested for your future. In addition, employers are now obliged to provide a workplace pension to the vast majority of employees, although employees can choose to ‘opt out’.
If you are entitled to a workplace pension, it is almost always a good idea to ensure you are opted in. This is because, while you will have to contribute, so will your employer. If you choose to opt out, your employer will not have to contribute. In effect, you will have voluntarily taken a pay cut.
Tax relief is also applied to your contribution, which means that, as well as your employer paying into your pension, so does the taxman.
You are eligible for a workplace pension if you:
are aged between 22 and State Pension age; and
earn at least £10,000 per year; and
usually (‘ordinarily’) work in the UK.
If you are under 22 but earn at least £10,000 per year then your employer is not required to opt you in automatically – but you can still choose to opt in.
Under current rules, the minimum total contribution that must be made to a workplace pension is 8% of your qualifying earnings. You pay in 4% from your net income, HMRC applies tax relief of 1%, and your employer contributes a further 3% in addition to your earnings. So, for every £1 you lose in net pay, you gain £2 in your pension pot. However, this is only the minimum pension requirements that apply to employers. Your employer may offer a more generous workplace pension.
Personal Pensions are pensions which you can set up yourself to save money for your retirement, independent of an employer. You can then pay into your Personal Pension, either as a lump sum or by making regular payments, for instance each month.
The money you pay into your pension is eligible for tax relief at the highest rate of income tax you pay. This means if you are a Basic Rate taxpayer, your pension pot will grow by £125 for every £100 you pay in. If you pay Higher Rate and Additional Rate income tax, you can claim further tax relief, usually when you file your self-assessment tax return.
Your income at retirement will depend on how much you’ve paid into your pension, and the returns generated by your pension savings. You will also pay charges for the costs of managing your pension, and the investments within your pension.
Stakeholder Pensions are similar to Personal Pensions. As with Personal Pensions, you simply pay into your pension, either as a lump sum or a regular contribution. Tax relief is applied at the highest income tax rate you pay, and the money available to you in retirement will depend on how much you pay in and the returns generated by your pension.
Stakeholder Pensions were introduced to encourage people with low to moderate income to save more for retirement, and a number of conditions were applied to Stakeholder Pension providers by the Government.
This means providers must accept contributions of as little as £20, and the charges that providers can apply for the management of the pension is capped at 1.5% per year for the first ten years and 1% thereafter.
However, while Stakeholder Pensions are unable to charge more than this, charges for Personal Pensions have fallen substantially in recent years – which means Stakeholder Pensions are not always cheaper.
In addition, Stakeholder Pensions typically have a smaller and more limited choice of investment options than Personal Pensions.
A SIPP, or a Self-Invested Personal Pension, is simply a form of Personal Pension which you control yourself.
What makes SIPPs different is that they also allow you greater flexibility in your investments, as you can choose and manage the specific investments you want or place your existing investments within your pension. It is this greater flexibility that has earned SIPPs the title of the ‘Do It Yourself’ pension.
However, SIPPs typically have greater charges and costs than Personal or Stakeholder pensions. Unless you want greater control over your investment choices, you may be paying a premium for features you do not need or use.
Why use pensions at all?
Well, tax. But let me expand.
Pensions are only one option for saving for your retirement, and may not always be the right option. For instance, some people choose to invest in property, which offers the prospect of rental income and capital growth, as house prices generally rise over time – although the potential tax savings are not as generous as they once were.
You may also choose to save into Individual Savings Accounts (ISA), which, like pensions, offer tax efficiency. However, while ISAs do offer tax efficiency, the tax efficiency is provided on the way out, while pensions offer tax efficiency on the way in.
For most of us, our income in retirement will be lower than during our working lives – and therefore any tax savings are greater on the way in than the way out. This means it is usually better to take the tax relief now, by saving into a pension, than it is later, using an ISA.
To explain this further, if you save £1,000 into an ISA today, then you will have £1,000 in your ISA. When you then choose to take money from your ISA, you will not pay tax on your withdrawals. By contrast, when paying into your pension, you receive tax relief on any money you pay in when the contribution is made. This is at the highest rate of income tax that you pay, subject to your annual contributions not exceeding your annual earnings or the annual allowance.
This means that, if you save £1,000 into a pension today, then the sum you will have in your pension will be £1,000 plus tax relief at the highest rate you pay.
For Basic Rate tax payers, this means you will have £1,250 in your pension. If you pay income tax at Higher Rate or Additional Rate, you can claim further tax relief when you complete your self-assessment tax return.
As the basic rate tax relief is added to the money you save into a pension at the beginning, this means your money should grow quicker, as any returns generated will be on a larger sum.
Put simply, if you save £1,000 into an ISA and achieve 5% growth over the year, your ISA will be worth £1,050 after one year. By contrast, if you achieve 5% growth on £1,000 saved into a pension, the growth will be on the ‘grossed up’ sum. So, if you are a Basic Rate taxpayer, your pension will be worth £1,312.50 after one year.
In addition, while pensions offer tax relief on the way in, they do also offer some tax efficiency on the way out too, as you can take up to 25% of your pension pot tax-free at retirement, subject to not exceeding the Lifetime Allowance.
For these reasons, saving for your retirement using a pension is typically better than using an ISA.
When might an ISA be suitable for retirement planning?
While pensions offer potentially greater tax efficiency, there are disadvantages to using a pension too – and there are good reasons for using an ISA instead. For instance, you cannot generally access your money in a pension until you are at least 55, while ISAs allow you to access your money whenever you wish to. Pension savings are also subject to allowances, both annually and over your lifetime. These allowances are known as the Annual Allowance and the Lifetime Allowance.
High earners may also be subject to the ‘Tapered Allowance’ as well, which reduces the amount you can save into a pension tax efficiently by £1 for every £2 you earn over and above £240,000 each year.
By contrast, while you can only place £20,000 each year in ISAs, there is no limit to the amount of wealth that you can hold in ISAs tax efficiently. If you require greater flexibility in when you can access your money, or if you are in danger of exceeding any of the applicable pension allowances, using an ISA to save for your retirement can be appropriate.
This blog post is not financial advice and is not specific to any individual. This article is intended as generic guidance and comment only, and does not constitute any form of financial or investment advice or recommendation, which is always specific to individual needs. You should not take any actions on the basis of this article, and should take appropriate professional advice instead.
This post was published in April 2020. Legislation and policy may change over time.
All blog posts are written by Dylan Roberts in a personal capacity and do not necessarily reflect the views of Lighthouse Financial Advice Ltd, Lighthouse Group, Quilter Financial Planning, or Quilter plc.