Does the word “pension” make you feel:
Much as I hope your answer might be (d), smug in the knowledge that you have salted away more cash than Scrooge McDuck could swim in, I fear it won’t be.
When most people talk to me about pensions, they usually look either confused, bored, panicked, or a mixture of all three. (I try not to take it personally).
(And yes, I have fascinating conversations here in Suffolk. That’s what comes of working as a personal finance journalist for more than 14 years – people back you into a corner to talk about pensions.)
So maybe you’re confused, because there are loads of rules about pensions, they keep changing, and few of us know where the money actually goes.
Maybe bored, because there are loads of rules about pensions, they keep changing and ‘Hey – shiny thing over there! Let’s buy stuff and sod the future! Retirement is years away when I’m old!’
Maybe panicked because ‘Woah, retirement isn’t that many years away and I’ve saved diddley squat’, with an added dose of ‘buying all the shiny things means I don’t have much spare cash to do anything about it’.
But here’s the deal: whatever your answer, pensions matter.
What is a pension?
A pension is just a way of providing money to live on when you’re old and don’t want to work any more. Despite all the rules and jargon, it’s not rocket science, just saving money now to spend later.
There are three different kinds of pension:
- state pension
- workplace pension
- private pension
Sure, there’s a state pension, based on paying National Insurance contributions, or if you’ve had National Insurance credits due to unemployment, sickness or as a parent or carer.
Currently, the new full state pension is £159.55 a week. Just to be clear – that is NOT MUCH.
I’ll do the numbers so you don’t have to. It works out at £691 a month. That’s a smidgen under £8,300 a year.
Could you live on that? Would you want to?
I know I write a frugal blog, but seriously. Maybe your costs might be lower by then – no mortgage, no commuting costs.
But living on a fraction of national average earnings means you’re more likely to be choosing between heating and eating, than heading over the horizon on a Saga cruise.
Also, the cost of providing the state pension is getting increasingly expensive. Inconveniently, people are getting older and living longer, so the the Goverment keeps pushing back the age when you can claim the state pension.
You can check how much state pension you might receive and the earliest age you can get your hands on it, but who knows exactly how the age and amount might change in future. The only sure bet is that if it changes, you’ll be waiting longer to get less money.
If you want more than the state pension provides, that’s where workplace pensions and private pensions come in.
Of course, you could fund old age in other ways – by investing, buy-to-let properties, that oh-so-likely lottery win and oh yeah by still working because you can’t afford to quit.
But the big advantage of pensions is that people give you free money.
That’s right. The Government recognises that many of us would rather buy shiny things now now now than save money for later. So they actually hand out free money if you’re willing to pay into a workplace or private pension.
Pay £80 into a pension, and the Government will top it up to £100, if you’re a basic rate taxpayer.
If you’re a higher-rate or additional-rate taxpayer, it gets even better. As a higher-rate taxpayer, put £80 into a pension, the Government will top it up to £100, and you can then claim another £20 back through your tax return. Suddenly, that £100 pension payment has only actually cost you £60. Nice for some, eh?
Even if you don’t pay any tax at all, you can still put £2,880 into a pension every tax year, and the Government will whack in the extra to boost it up to £3,600. Kerching.
The free money is a bribe, because in exchange you can’t touch your pension cash until you hit the age of at least 55.
But according to research by BlackRock, around 16 million Britons don’t know that when they contribute to a pension, the government boosts it with tax relief. So shout about the free money from the rooftops, now you’re in on the big secret.
Plus, if you’re lucky enough to have an employer, they will throw free money at you too. Nowadays, employers must offer eligible employees a pension scheme, must sign everybody up (it’s called automatic enrollment), and must make at least a minimum contribution. Leaving the workplace pension scheme is like turning down a pay rise – so don’t do it unless you really, truly, completely need the extra cash.
Workplace pensions come in two flavours. Defined benefit schemes, also known as final salary schemes, pay out a set amount for as long as you live depending on how much you earned and how long you paid into the scheme.
Meanwhile with defined contribution schemes, you pay into the scheme, but it’s anybody’s guess how much you’ll end up with, as it all depends on how stock markets move.
Defined benefit schemes are much more expensive for employers to run than defined contribution schemes, so they’re now almost extinct in the private sector, and only available for public sector workers like teachers, firefighters, the police, NHS staff and civil servants.
No employer, or just want an extra pension on top? You can set up a private pension and still get the free money from the Government. You can either get a pension company to manage the money for you, using a personal pension or stakeholder pension. Alternatively, you can choose all the investments yourself, using a self-invested personal pension (Sipp).
Why should you care?
I’ll just refer you back to the minimal amounts of money from the state pension.
In simple terms, if you don’t have any retirement savings, you won’t be able to stop working.
Think about it. If you stopped working tomorrow, how long could you last before your money ran out?
A few months after your last pay cheque? A few weeks? Might be tricky to meet the next mortgage payment? Few of us have buckets of cash sitting around waiting to be spent when we have nothing better to do.
But what are you doing right now, that would make that situation any different when you reach retirement age?
Maybe early retirement at 55 sounds great. But with average life expectancy running at over 80 years old (think how fetching you’ll look with extra wrinkles and Zimmer frame), your savings will need to last a quarter of a century, if not longer. A few tenners and some coppers in a piggybank just aren’t going to cover it.
The good news is that if you start investing early, and keep investing for long enough, the money really rolls up. The joys of compound interest – when you get paid interest on the interest payments you’ve already earned – make a massive difference.
Stash away £100 a month for 40 years in a fund growing at 5% a year, and you’ll end up with nearly £150,000, according to calculations by Seven Investment Management. Yet you’ll only have contributed £48,000 yourself.
Delay for 25 years, and you’ll need to save more than £550 a month to catch up. That means finding a total of £100,000, more than twice as much as if you’d started sooner. Basically the earlier you can start, the less painful it will be.
More choice about your pension pot
The other good news is that pensions became a lot more flexible when George “all the jobs” Osborne ripped up the pensions rule book back in 2015.
Before, you could whip out 25% of your pension pot tax-free, but most people had to use the rest to buy an annuity. An annuity is when you hand your money to an insurance company, and in exchange they dole out money to you every year for the rest of your life. The drawback is that annuity rates are shockingly low right now, and if you go under a bus after signing on the dotted line, the insurance company typically keeps all your cash.
In the brave new world of pension freedoms however, anyone except those in final salary schemes gets way more choice after reaching 55:
- grab some or all of your hard-earned cash (though do check if you’ll face a hefty tax bill on anything over the 25% tax-free amount)
- keep some or all invested to live off the proceeds
- leave the remains of your pension pot to be inherited by your children, if you haven’t whooped up the whole lot
- still use it to buy an annuity, if you want to make sure the money doesn’t run out before you do
Suddenly, the new flexibility makes pensions much more attractive when investing.
George Osborne also muddied the waters when saving for retirement, by introducing the Lifetime Isa. People under 40 can also use a Lifetime Isa to get a tax top up on their savings, but can then either use it as a deposit on their first home, or hang on to the money until they’re over 60 (rather than 55 with a pension). The main drawback with a Lifetime Isa is that you’ll miss out any contributions from your employer, which you’d have got if paying into a workplace pension. Nor will higher-rate and additional-rate taxpayers get as much tax relief.
Finding cash to save for retirement in future can be really tough, faced with a whole load of bills that need paying right now. I suppose a big part of my blog is trying to say it’s possible to live on less, freeing up money to set aside for stuff like retirement.
I started this rant because a report came out today from the City watchdog, the Financial Conduct Authority, about people using the new pension freedoms to cash in their pension pots.
Almost 40% of people who withdrew all their pension cash used the money to buy stuff or pay off debts – so zip all left to fund future years. Another third just stuck the money in cash, partly because they didn’t trust pension providers or pension rule changes. That made me want to scream, because interest rates on cash are so low right it’s no better than sticking it under your mattress. Long term – over 5 years, 10 years, 15 years – you are overwhelmingly likely to get better returns by staying invested, even if there is a risk that the value of your money could fall. OK so where people took out all their pension pot, it tended to smaller amounts, but it could still make a difference.
I don’t pretend to have all the answers, but I’m keen to find out more about investing so I don’t have to work till I drop.
Pensions may seem boring and confusing. But poverty in old age is even less fun. Short of finding a magic money tree, paying into a pension, and grabbing any free money on offer, could be a great start.
Now over to you – is your pension dismal or dreamy? A great comfort, or something that would keep you awake at night if you dared think about it?