Retirement saving is complicated, and I’m going to attempt to break it down simply.
We have a State Pension. You’ll get it when you’re nearly 70, you need to make sure you’ve got a good record of National Insurance contributions, but other than that, I’m not going to talk about it here.
Then we have your work pension, or a personal pension, the ways you try to save for an upgraded retirement. There are two flavours of these. The first one used to to be known as Final Salary pensions, they’re now called Defined Benefit pensions. Not many people get them any more, usually just public sector workers like teachers and nurses. They’re great for you, because the pension scheme takes on the risk and guarantees you a level of payout.
The other type is a Defined Contribution pension. This means you don’t have anyone making you a guarantee of the income you’ll get, instead you build up a savings pot and can then use it to either buy an “annuity” or just leave it invested and draw down some income from it regularly in retirement.
The Annuity is a product you buy from something akin to a life insurance company. If you give them your £100k pot, they’ll give you a pension of £x per month until you die. Or a version that’s index linked to rise with prices, or a version which will also pay out to your spouse after you die.
Not many people buy annuities any more, as the payout rates have been comparing badly to just continuing to invest for yourself and drawing down some of the pot for income.
Confusingly, many people say “pension” when they mean “annuity”. Strictly speaking your pension is the savings pot you’ve built up.
For the rest of this article I’m talking about Defined Contribution pensions as that’s what you’ll meet when you look at SIPPs and workplace pensions.
SIPPs are Self Invested Personal Pensions. They’re the ones you set up for yourself using an investing platform.
The great thing about pensions is that the government will add your income tax back in to match any contribution you make. So if you contribute £100, they’ll add £25.
Higher rate or additional rate taxpayers will actually have paid more in tax. The government will give you that extra money back (via your Self Assessment tax return, or if you claim it), but they won’t actually add it into your pension. If you want the extra to go in there, you have to put it in yourself and then the taxman will effectively reimburse you later.
Free Money!
This £25 top-up is what we mean when we talk about Free Money. It’s a big incentive to invest in your retirement, and it suits the government to encourage this as it gets us taking care of our own futures and makes us less of a problem for the state.
The way this actually works is, you put in £100 to your pension, and about six weeks later the £25 automatically arrives. Your pension provider will have reported the contribution to HMRC in the background, to make the claim, but you don’t have to do anything.
Your work pensions gets you even more free money. Your employer is obliged to put in 3% of your salary, and you’re obliged to put in 5%, making 8% total contribution. This is all done before tax, so your 25% bonus is already in there.
Some employers will voluntarily match you on higher contributions, and you should try to accept all of this free money that you can.
Finally there is something called Salary Sacrifice. This is a dodge which lets your employer reduce your salary and instead make an extra large contribution to your pension. This happens before National Insurance is taken, and because there are both Employer and Employee bits of NI paid, that benefits both you and the employer.
Salary Sacrifice also has some spinoff benefits. Because it’s lowering your salary, it may lower it below say the £50k higher rate tax band, and mean you qualify for child benefit and childcare costs.
What’s It Invested In?
A problem with personal pensions has been that there are rip-off companies out there who’ll burn through your contributions with high fees, if allowed. This is why we have generations of people who are jaded on the whole topic of pensions, having paid in and seen little return.
One way to justify high fees is to create complexity, and the pension industry is great at this. They’ll ask you about risk, and you’ll say no I don’t like risk; they’ll use this to justify putting you in a carefully managed (think fees here) bundle of investments designed not to make a loss. Only, that safety means that they’re often designed not to make much profit either. The combination of high fees and low performance means that if you leave pension companies to run things, they’ll end up making money and you won’t.
To fix this I have two suggestions for you.
1) Look at your work pension in terms of fees and performance. Try to switch down to lower fee funds. And try to switch to better performing funds. These are usually the same thing, as the best performance in the long-term is usually a passive global index tracking fund, and these should have lower fees than actively managed funds.
2) If your work pension has no good options, try to switch the money out of there and into somewhere with lower fees and better performance (ie with index funds available). This can be difficult. If the platform fee is high, and you need to continue with the pension as the only way to get that free money carrying on, your only recourse would be to talk to your employer and persuade them to use a different provider or to pay into your own SIPP.
Otherwise, you may be able to do a Partial Transfer, sweeping the money across to your own SIPP once a year or so. Many pension companies don’t allow this, as it’s taking away money that’s making them a profit.
My rule of thumb on fees is: more than 0.5% annual fees is getting expensive. That’s a combination of platform fee, management fee, fund fee, and perhaps you’re also suffering advisor fees. As a benchmark, Vanguard will be in the region of 0.35%.
If you are contributing your own money to a SIPP, in the same way look for low fees and good choice of investments. See my article on Platforms & Funds for my ideas on this.
When You Retire
One of the limitations of a pension is you can only get at it later in life. Think 60. It’s actually hard to me more accurate than that, because the government keeps moving the goalposts. They are currently moving the State Pension age back from 67 to 68, 69, or who knows where. And the personal pension access age is similarly in flux - they have suggested that it will track 10 years ahead of State Pension age, but even this hasn’t been set in stone.
If you’re planning on stopping work before 60ish, consider also building a bridge fund using an ISA.
When you are old enough and decide to start pulling income from your personal pension, you can have 25% of your pot tax-free and then the rest is subject to income tax.
Currently this means that you can treat this in either of two ways. You can take 25% as a tax-free lump sum, and the other 75% can be drawn in stages, where it wil be fully treated as income for income tax purposes. That means you’d get the first £12,570 each year tax-free and then be charged 20% income tax on the rest that you draw in that tax year.
The other way is to take your tax-free element as a portion of each withdrawal. That would mean you can have £16,760 tax-free each year, with any further withdrawals again paying 20% tax. And go above £50k in withdrawals and they’re taxed at 40%.
You are free in this situation to withdraw whatever you like, and if your portfolio runs dry then so be it. In reality you’d try to show restraint and use something like the 4% rule.
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