What is a pension? (UK Edition)

What is a pension?

A pension can be defined as an income stream in retirement. Pensions are special because they save you money compared to other investments due to tax benefits and employer contributions. The money put in the pension grows over time and once you retire, you will take money out of the pot to live on.

What are the different types of pension?

The three main types of pension are; the state pension, employer sponsored pension plans and self-invested personal pensions (SIPPs).

The State Pension is a pension provided to you by the government if you have paid National Insurance contributions for 10 or more years during your career. You get paid an amount depending on how many years you have paid National Insurance Contributions. To get the full State Pension (for people men born after April 1951 and women born after April 1953) of £175.20, you need to have paid National Insurance Contributions for 35 years. The State pension is payable from age 66 currently, but is increasing to age 67 and 68 over a phased period of time. For millennials, it is unlikely to be payable until age 70. Employer sponsored pensions are pensions offered through your employer. There are two main types: defined-contribution pensions and defined-benefit pensions

• Defined-contribution pensions are where you decide how much you contribute (subject to the employer’s plan rules). You can think of a defined-contribution pension as a pot that you add contributions to over your entire career to save for your retirement. Pensions are special because they save you money compared to other investments due to tax benefits and employer contributions. The money put in the pension grows over time and once you retire, you will take money out of the pot to live on. The amount you have at retirement age depends on how much you (and your employer) have contributed over your career and how your pension fund has performed with investment returns.

• Defined-benefit pensions pay out a guaranteed income after you retire. The amount you receive often depends on how long you worked for the company and what your final salary was. These are very common if you have worked for very large companies or in the public sector. Your employer is responsible for contributing to these pensions, although you can contribute as well.

• Self-invested personal pensions allow you to choose where your money is invested instead of going with the pension plan your employer provides. You give up the benefit of employer contributions with SIPPs.

How much do you contribute to pensions?

Answering this question is a lot like answering “how long is a piece of string?” although there are some general rules of thumb that you could follow. In the US, there was a study done that showed that with a pension portfolio of 50% in stocks/shares and 50% in bonds, withdrawing 4% of your pension gave you a 95% chance of dying before your money runs out. However, in the UK, this withdrawal rate is closer to 3.5% for the same success rate. So for example, if you accumulate a pension pot worth £1,000,000 over your career, at a 3.5% withdrawal rate, your income will be £35,000 each year in retirement.

Therefore, one method of calculating how much you should contribute to your pension is looking at how much you expect your income to grow, and how much you need at retirement age to sustain the life you want, assuming you withdraw at 3.5% of your pot a year. However, consulting a fee-only financial planner would be advisable to have a professional reassure you that you are on track to achieve your retirement goals.

There are actually regulations on the minimum amount you should contribute to your pension. If you are between the age of 22 and 67 and earn more than £10,000, then you will be automatically enrolled in your employer’s pension scheme and have to contribute a minimum of 5% of your salary. The good news is that your employer has to contribute a further minimum of 3% of your salary to your pension as well. However, often this is usually between 7-14% in the private sector. Free money! It is possible to opt-out of these auto-enrolment arrangements, but discouraged.

How do pensions grow?

Pensions increase or decrease in size depending on the performance of the investments. For example, if the pension fund is invested in UK stocks and shares, the historical performance of these has been around 5% per annum. Assuming performance stays around the same, your pension fund will increase by on average 5% a year. Pension funds are often diversified across many different types of investments, providing you with a safer, more stable return.

Pros and cons of pensions:

• The main benefit of a pension is that you can benefit from tax relief on your contributions, tax free investment growth and a tax free portion of the eventual benefit. The government likes to give you tax relief as a reward for saving for your future so that they don’t have to foot the bill when you get old!

• The amount of tax relief you receive increases as you earn more, and is decided by the highest band of income tax you pay:

- If you are a basic-rate taxpayer, you will get 20% pension tax relief

- If you are a higher-rate taxpayer, you will get 40% pension tax relief

- If you are an additional-rate taxpayer, you will get 45% pension tax relief

Therefore, for example, say you are a basic-rate taxpayer who wants to add £1000 to their pension pot. To do so, it would only cost you £800 as you get £200 in tax relief. Again, free money!

However, in recent years, the government has severely limited the amount of tax relief high earners can get on their pension contributions by introducing the Lifetime Allowance and the Annual Allowance

• Compound interest is a major benefit of pension saving over a long period of time. It allows your contributions to grow and grow over the long-term, resulting in very large gains. For example, for every pound you contribute to your pension as an 18-year-old, you will have £26.50 by the time you’re 65! (assuming a 7% return). The benefit of starting to pay pension contributions early should be the main education piece / takeaway for readers.

• However, a con of pensions is that you are restricted in when you can withdraw the money (for both employer sponsored plans and SIPPs). Currently, you cannot withdraw the money before you hit age 55 without being subject to fees by your pension provider and a whopping 55% tax rate as this is seen as an “unauthorised withdrawal.” An alternative could be something like a S&S ISA, where you have much more freedom when you withdraw your money (although, of course for ISA’s, you do not get tax relief on the contributions you pay in). If you are someone who wants to retire before the age of 55, it is best to avoid pensions.