Pensions: What You Need to Know and Consider
Pensions are an important part of your financial journey, so it's crucial that you understand what they are and how they work. Read on to learn everything you need to know about pensions.
Chances are that sorting out your pension is not top of your priority list. Not only might it seem complicated, but your retirement may feel like it's a long way off.
However, get under the skin of pensions and you will discover there are some compelling reasons to start saving for your retirement.
You will get tax relief, employer contributions (if you’re currently employed), and something called compound interest means even a little money saved today can multiply over the decades, with minimal effort on your part.
What is a pension?
A pension is simply a pot of money that you save up over the years. The aim is that the money you pay in each month grows until you can use it to support yourself once you retire.
With a pension your money is invested in the stock markets, which over the long term are likely to grow faster than your money would in a savings account.
Usually this is done through funds, which are investment products in which you pool your money with other investors to buy a wide range of shares in companies. This may sound complex, but depending on the type of pension you have, you could choose the default fund option, or choose your own funds.
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What are the benefits of a pension?
Unlike a conventional investment or savings account, there are extra incentives to save into a pension.
The biggy is tax relief, which is effectively the government repaying the tax you pay on your earnings and putting it into your pension. This means it costs a basic-rate taxpayer only £80 to invest £100 into their pension, while a higher-rate taxpayer will only need to pay £60, and an additional-rate taxpayer just £55 to invest the same amount.
If you have a workplace pension — which you more than likely will if you’re employed — your employer will make contributions into your pension on your behalf. The amount will vary according to the generosity of your employer, but as a minimum it will be 3% of your ‘qualifying’ earnings. In the 2020/21 tax year this was the band of earnings between £6,240 and £50,000.
In addition to tax relief to top up your pension, all the money in your pot will be sheltered from tax as it grows. However, once you start withdrawing money you may need to pay tax on that income.
How to approach pension planning
The good news is that if you are 22 or over, employed and earning more than £10,000 a year, chances are you are already paying into a workplace pension (unless you have opted out). Also whether you are in work or claiming certain state benefits, you will be building up entitlement to the state pension.
However, if you are paying only the minimum amount into your retirement savings, you could still end up strapped for cash in retirement even with the state pension. This is why it’s vital to engage with your pension as early as possible and to have a plan.
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Even a small amount of regular saving early on makes a big difference later. In contrast, if you wait till much later in life, you’ll have to save much more to make up the lost time, and there’s no guarantee you’ll end up with enough money to pay for the lifestyle you want in retirement.
Check the rules on your workplace scheme to ensure you’re maximising any benefits you could get, such as matched contributions from your employer.
Consider taking financial advice to help with the pension planning, ideally from an independent financial adviser. If you can’t stretch to that, there is plenty of free information available online from reputable sources such as the government-backed Pensions Advisory Service. Many pension providers also offer lots of help and advice on their sites with tools and calculators to help you formulate a plan.
Once you have your pension set up, schedule an annual review to ensure you’re still comfortable with the pension approach you’re taking. This gets more important the closer you are to retirement.
What are the different types of pension schemes?
- Defined contribution pensions. These can be workplace pensions organised by your employer, or a personal pension you set up yourself. When you retire the money you have depends on how much you paid into it, and how the investment has performed over the years.
- Defined benefit pensions (also known as a final salary pension). This scheme means you will get an agreed sum of money from your employer for the years after you retire.
- State pension. This is the government pension you should receive once you get to the state pension age. You won’t automatically receive this; you'll need to apply for yours via gov.uk.
How much pension savings do I need?
It will depend on how long you live, whether you’re likely to be mortgage-free when you retire, and what kind of lifestyle you will have (will you run a car, travel, do a lot of hobbies, eat out, take the grandkids on day trips?).
Try a pension calculator to get an idea of what size savings pot you might need to live well in retirement. Some calculators will also show you how much you need to save each month to hit that target.
Alternatively consider talking to an Independent Financial Adviser (IFA), who can help work out what you will need in retirement and put a tailored plan in place for you.
'My property is my pension'
You’ll hear some people who are distrustful of the stock market say their property is their pension, and that may help if it’s a rental that generates income, but often they mean the house they live in.
Although many older homeowners have seen the price of their properties soar, they may not want to sell up in retirement (where will the grandchildren sleep?), or they might struggle to sell and get the money they need if house prices drop.
Even if you have one or more rental properties, it may not be as reliable as a pension. Taxes on landlords have increased in recent years, while both the government and your employer will pay into your pension. Those are two perks that are difficult to ignore.
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Hannah is an award-winning journalist with a background in the trade press. She writes about finance, asset management and business for Shares, Citywire, FE Trustnet, and interactive investor. Read more