It's session number 13 , and we’re going to be talking about Pensions. It’s a misunderstood subject, so as ever, I hope to shed some light on it for you.
But before we get into that…
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OK, pensions. If there is one aspect of financial planning which has a sense of mystery attached to it, it’s pensions. I don’t know why this is, because in fact, pensions are actually pretty simple for 99% of people. For relatively few people, there may be some complexities in pension plans you’ve picked up along the way, but for most of us, this side of retirement at least, a pension is – ready for this? – a tax-efficient savings plan. That’s it.
Let’s define retirement for the purposes of this session right here. When I use the word retirement, I’m talking about taking benefits from your pensions. It has nothing to do with stopping working or taking long holidays. It’s just about taking money out of your pension plans, rather than putting money into them.
The problem with pensions is that not only do they have a bit of mystique about them, they are also shrouded in controversy. There have been countless headlines about workers’ pensions being worthless after 40 years of faithful service. And let’s not forget a certain Mr Maxwell who raided his company’s pension scheme and then jumped off a yacht – allegedly.
So we need to get the truth out about pensions and get rid of the mystery.
Everything you need to KNOW
1 – A pension is imply a tax-efficient savings plan
This side of retirement, you might as well forget about what form your retirement income will take. To some extent you can even forget about how much it’s going to be, you just want it to be as much as possible. All you’re doing is building up a pot of money, that’s all.
Pensions are tax-efficient for two reasons:
- You get free money from the government for paying in. Yes, you heard that right. The government gives you money for paying into a pension. This is called tax relief. If you’re a basic rate tax payer and you ay £80 into your pension, the government will make it up to £100. That’s an overnight 20% return. Not too shabby. If you’re a higher rate tax payer, you can get a further 18% off your pension contribution through your tax return. So £100 pension payment will only cost you £60. You don’t get this kind of benefit anywhere else, unless you’re into fairly complex tax mitigation schemes.
- The money in a pension grows free of capital gains tax and largely free of income tax. Basically it’s like an ISA in the way that it grows
What’s the catch?
- You can’t get at your money until age 55 – wouldn’t be surprised if this increases
- You can only get at one quarter of the fund then, the rest has to buy you an income in some form
That’s it, seriously.
2 – Understand the difference between workplace pensions and personal pensions
Pensions can be divided into two main types: workplace pensions and personal pensions.
In the old days, you worked for a company for 40 years, and when you retired, they gave you a carriage clock and an income for life. That doesn’t happen any more. Those kind of workplace pensions, more properly called occupational pensions are dying out, unfortunately.
For the purposes of this session, a workplace pension is simply a pension which your employer pays into for you. Pretty soon this is going to be mandatory for all employers. A personal pension is one which you set up yourself, that’s all.
Many employers now have schemes called group personal pensions, which is a bit of both. The employer pays into it while you work for them, but if you leave you can take it with you, detaching your pension from the others in the scheme and taking it to your new employer, or just pay into it yourself
3 – A pension is a wrapper
Listen to Session 11 for more detail on what that means. Put simply, a wrapper is a box you hold investments inside. Usually, a pension will hold funds. It is the choice of fund which will determine how your pension performs to a large extent. Other factors too, like how much you put in!
There are some different types, which you’ll need to look out for:
Stakeholder Pensions – launched in 2001, these were the Labour government’s attempt to get the nation saving for their own retirement. They are cheap and cheerful, the Aldi or Lidl of the pension world. They have caps on their charges, which keeps things cheap, and in return for being cheap, you normally get a somewhat limited range of funds to choose from.
Personal Pensions – as above, but without the charging cap, though in reality pensions have tended towards stakeholder pricing in recent years.
Self-Invested Personal Pensions, or SIPPs – These are more full-featured. There are a wide range of permitted investments for SIPPs, including the ability to hold commercial property like office buildings. These are more costly as a result, and you need a decent size fund to justify the costs or benefit from the added investment choice.
On the workplace pensions side, apart from Group Personal Pensions which I’ve already mentioned, there are two types:
Money Purchase pensions – where the benefits at the end depend on how much gets paid in and the investment returns you get.
Final Salary pensions – where the income you get in retirement is entirely dependent on how long you’ve worked there, your final salary, and the accrual rate, which is usually expressed as a fraction, for example a 60th scheme.
e.g. 60ths scheme, 30 year service, and final salary of £100,000pa = pension of £50,000 per year, or a lower pension and a lump sum
These are the gold-edged kind of pensions. There is no risk to you the employee, it’s all on the shoulders of the employer who is guaranteeing to pay you a certain amount in future. The employer has to pay enough into the scheme (so do you) and invest it well enough to make sure there is enough in the pot to pay all the pensioners. This risk has become unsustainable for many companies, which is why most of these schemes are closing to new members.
4 – Pensions should form part, but not all of your long-term financial planning
Every client I have, has saved up a large proportion of their wealth in pensions. They understood that getting free money from the government was worth having. Unless you’re in a final salary pension scheme, what you get at the end, when you retire and start to take money out of your pension, is entirely dependent on:
- Value of the fund, so invest well and put in as much as you can.
- Prevailing rates for converting that fund into an income at the time.
It is therefore difficult to predict what you’re likely to get out of a pension if you’re more than, say, 10 years away from retiring. That’s why I say to forget about it and concentrate on putting in as much as you can.
Also, remember that there are other ways of saving for the future, e.g. ISAs, and that the best policy is to have both, if you can.
So, here are the things you need to know:
- A pension is a tax-efficient savings plan
- Understand the difference between workplace and personal pensions
- A pension is a wrapper – we talked about the different types
- Pension should form part, but not all of your long term financial planning
Everything you need to DO
So, armed with that knowledge, let's look at what you need to DO
1 – If there’s a pension available at work, join it.
This is a no-brainer. If your boss is willing to give you more money, you should take it. Who cares if you won’t see it until much later, it’s free money, so suck it up and join the pension
2 – If there isn’t a pension scheme, or if you’re self-employed, get a stakeholder pension
For those starting out with pensions, Stakeholders are a great place to start. They’re cheap and cheerful, but with all the benefits of pensions that we’ve talked about. You can upgrade to a SIPP in a few years’ time, but for now, keep your costs down and concentrate on getting as much into it as possible.
3 – Sort out your emergency fund and short-term savings first
Listen back to Session 5 about balancing long and short-term savings. In short, don’t pay into a pension if you have a credit card debt – pay that off first. If you’re already in a company pension though, stick with it. Once you’re clear of debt, you can pile money into pensions to your heart’s content (Well, up to a maximum of £50,000 a year in 13/14), but there’s no sense in paying interest to a credit card company any longer than you have to.
4 – If you’re within 10 years of retirement, go see a financial planner
And I mean a financial planner – listen to Session 8 for how to find a good one. You don’t necessarily need to be sold anything here, you just need to work out your current position and see where you’re going to be in 10 years’ time. A good planner will help you to collate everything and give you an accurate picture of your financial health, and how likely you are to meet you goals for your retirement years.
5 – Invest for the long term
I’m 38, which means if I retire at 68, I have 30 years to go. This timescale means my money is going to be invested for a long time. So what do I care if the stock market tanks for six months, or for three years? I can afford to be aggressive with my investments inside my pension because they’re going to be invested for a very long time. Again, a good adviser can help you identify your tolerance for risk, and explain the different risks to you. Whatever pension you’re going to save into, take a look at the fund options and take advice as to which suits you best.
Hopefully you can see that pensions are actually pretty simple for most of us. It’s just a case of starting one and putting money into it. You will get friends down the pub telling you that pension are a con and not worth putting money into. The only people who say this, are those that haven’t put enough in, or were on such low incomes, they arguably should have been saving in other ways rather than pensions.
That's it for this session of the MM podcast; I hope that was helpful. Did I miss anything? I’ve been intentionally simplistic, here but everything I’ve talked about will be all that the vast majority of ordinary people will need to know.
Any questions? Please leave any comments or questions in the comments section below.
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I hope you enjoyed this session. Next time we'll be talking about the other end of pensions – what happens when you get to retirement?
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