In the last month or so, we’ve been getting questions about Pensions quite a lot. What are they? Do I need a pension? How do I get one? So here’s a brief outline on what they are and why you might just want one.
What is a Pension?
Strictly speaking, a pension is just a tax wrapper. What that means is that it is a product or somewhere that you hold certain assets, which has special tax privileges. The purpose of a pension is to provide for when you have retired by putting money away that you earn today. Not everyone will use a pension to provide for their retirement, but it is definitely one of the most tax efficient ways to provide for your future.
What are the features of a pension?
There are two main types of a pension. A defined contribution pension (DC) and a defined benefit (DB) pension.
90% of us will be in a defined contribution pension. This is where you contribute, your employer should contribute too, and the money sits in a pension account. It should be invested to grow for you, and then when you come to retire you can provide an income for yourself. The more you have in the fund, the greater income you will be able to fund. Equally, the earlier you start, the longer it has to grow, and the bigger the fund should be!
You’ll be in a defined benefit pension if you’re a doctor, teacher, civil servant or in the public service sector. When you retire you are guaranteed an income for life, depending on your working salary and how many years you work. These are the gold standard of pensions and so very few private companies still offer them because they are so expensive for the company.
The downside is you can’t access anything in your pension until a certain age – currently age 55 – but this is going to increase in line with state pension age. It will be 10 years before state pension age, so for me, I can’t get at mine until age 58 (according to current pension rules).
What are the tax privileges?
On the way in, you get tax relief on your contributions up to a certain level (your earnings or £40,000 – whichever is lower). The tax relief is 20% for Basic Rate Taxpayers and 40% for Higher Rate Taxpayers. Once in, everything inside of a pension grows tax free. Then on the way out you get 25% of your pension tax free, and pay tax at your own marginal rate on the remainder.
Why would you want one?
Out of Necessity:
Lots of people I speak to don’t have any intention of paying into a pension. Some older business people who don’t have pensions simply tell me “I don’t like pensions.” Younger people have heard their parents moaning about them, or they’ve seen the many complaints about them in the media, or they don’t want to put money somewhere they can’t get at it because we need it today. These people might just kick themselves when they get towards retirement age and start to wonder how they are going to afford their lifestyle.
Think about it, you were in Education from age 5 – 16, maybe 18 or maybe even mid 20s if you went to university. Your parents and possibly state benefits or a student loan provided for you during this time. Then you work until maybe 68 and you live off what you earn. If you’ve put nothing away and simply lived from pay cheque to pay cheque, when you retire, you could have 20 years or more left to live. Who is going to provide for you?
You may well receive a State Pension, but right now, that’s worth £159 per week. I personally would struggle to live off that every day, and still go on holidays and buy Christmas presents. The only way to boost this is to provide for yourself!
Yes, I did say free money. If your employer offers a pension scheme (and if you’re employed, every employer does or will do by April 2018) then if you pay in, they will too. It might only be 1% now, but that’s due to go up to 2% and will eventually be a 3% employer contribution. So if you take it up, you’ve just earned a non-negotiable 3% pay rise!
You get tax relief on your personal contributions. So higher rate tax payers get 40% relief, and basic rate taxpayers get 20%. (You’ll also pay back slightly less student loan!!)
If you run your own company, they are a great way of getting cash out of the company into your name, tax free, and it also comes off the tax bill for the company too!
There’s other reasons too, but I think these are the most important three.
What if I die?
We always get asked what happens if….? This is arguably one of the biggest concerns people have.
If you are in a defined contribution pension, it can go wherever you like. You will need to have completed a pension death benefit nomination for this to happen. If you die before age 75, this money goes where you wanted it to go completely free of tax. If it’s after 75, the people benefiting from it will pay tax at their own rate.
In a defined benefit (final salary) pension scheme, the pension will have a set of scheme rules. Normally they will pay your widow a percentage of your pension, either 33% or 50%. On their death, the money is completely gone – one of the major disadvantages of a DB scheme.
This is a very brief outline of pensions, there are so many more features of pensions which could be talked about. It’s much easier if we know your specific situation. As I say in the Seven Steps to Financial Success talk that I do as Destination, I could do a full day talk on pensions, easy.
The bottom line is, get involved, get involved early, and pay in as much as you can to give yourself options when you come to think about retiring!
*Pension rules are always changing so it is important to keep on top of them.
**Speak to us individually if you have any questions about pensions as everyone’s situation will be different