A lot of people hear ‘pension’ and think pipe, slippers and old age. While people do often access their pension in old age, they are much more than the first image that pops into our heads. They are the UK’s best tax vehicle. Before I extoll their virtues it’s important to understand the different pension schemes.
Pensions with guaranteed income
Firstly, there are pensions that pay out a guaranteed income, once started this income cannot be varied, is usually inflation-linked, and pays out for the life of the pensioner.
The most common type of guaranteed pension is the UK state pension. Currently, the state pension kicks in at age 66 and is £9,628 per year. However, the state pension age is increasing to 68 for those born from 1978. The state pension age is different from a retirement age, though you may hear these used interchangeably. Retirement age is purely dependent on your circumstances. Many people stop working before state pension age as they have enough money, and the state pension tops up their income. Others choose to continue working beyond state pension age as they enjoy what they do, or they can’t live off the state pension. According to Age UK the average pensioner in the UK gets more than half of their income from the state pension, quite a modest income.
A defined benefit pension is another type of guaranteed pension. Very few private sector employers offer these anymore, but many of them used to. Most of the public sector (council workers, civil servants, NHS, etc.) is entitled to a defined benefit pension. The amount payable is affected by a variety of factors; length of service, average earnings, and retirement age are the key drivers.
If you think you are eligible for one of these pensions its worth finding out the details. Even if it’s on the low end, a few thousand pounds a year for life from age 60 or 65 can make a huge difference. You can transfer these pensions to a defined contribution scheme. This topic is contentious, and a slew of articles have already been written on it. Any decision to transfer a defined benefit pension shouldn’t be taken lightly, and you should seek advice.
Pensions without guaranteed income
A defined contribution pension is very different from the types of pensions above. Unlike a defined benefit pension where the income is guaranteed, a defined contribution pension offers no guarantees but flexibility.
Most defined contribution pensions are workplace pensions. Auto-enrolment has made virtually all employees in the UK pension members. It’s likely you have one or more defined contribution pensions.
The employee (the member) and their employer contribute monthly to a workplace pension. There are auto-enrollment minimums that must be met, but you or your employer may pay in more than the minimum too. The member can choose how the money is invested, and when to take an income and how much. When the member moves to a new job or retires, they don’t lose the pension. They can move their workplace pension to a new scheme or leave it. This defined contribution pension will grow over time, and with a bit of care and attention can become your biggest asset.
Contributions to a pension through your employer are typically made before tax through a process called salary sacrifice, so you save on income tax and national insurance. As an example, a higher rate taxpayer (40%) who is sacrificing £500 per month to their pension will only have to give up £290 in after tax income. Their employer may also choose to add in the NIC saved, taking the total monthly contribution £575, essentially double the amount of salary given up.
Once the money is in the pension all the growth is tax-free, as is the income inside the pension. A pension can hold a variety of investments in it, but usually the most effective approach is to choose funds that track market indices. Over time markets will reward the patient pension member who doesn’t react to short-term blips.
Private pensions are possible too and may be suitable when the workplace scheme offers limited investment options, or when someone is self-employed or a company director. The tax benefits are essentially the same, but with a slight difference on how tax relief is claimed.
There are limits on annual pension contributions, and a lifetime allowance tax when the value of your pension benefits exceed £1,073,100. Careful planning can mitigate the effects.
Defined contribution pensions cannot be accessed until 55, and this is due to increase to 57 in 2028. Pensions can provide tax-free lump sums, or income which is then taxable at your marginal rate. A common approach now is to avoid taking your pension for as long as you can as it sits outside your estate for inheritance tax purposes. This means your beneficiaries could benefit tax-free from your pension, if there is some left on your death. See my previous article, for more information about inheritance tax.
Most people are aware they have a pension through work, but they don’t realise the importance it plays in their lives. The earlier you engage with your pension, the better. I’ve calculated the figures below based on a level annual return of 7.2%, the magic number that doubles your money every 10 years.
Take for example, a 45-year-old who through their employer contributes £1,000 per month for 20 years. At 65 they would have saved about £540,000 in that pension. However, a 35-year-old saving the same amount for 30 years would have saved £1,260,000.
That sort of difference can open up a world of possibilities; a far more comfortable life after work, stopping work early, changing your career focus if you saved enough early, and so on.
It’s worth assessing how your pension is invested, how much you are saving into it, and whether your employer will match increased pension contributions.
Pensions offer tax relief on contributions, tax-free growth, a range of investment options, and the earlier you start the more you benefit from compound growth. When you come to take your pension, you’ll usually benefit from a lower rate of tax. And finally, if you do pass this on to your beneficiaries the pension is outside your estate and not subject to inheritance tax. This isn’t an exhaustive list of pension benefits, but it does give you a flavour for why they are so good. If you have any questions about your pension, I’d be happy to have a conversation.
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