Help! I’ve ignored my pension – Part 2 – Building your assets
As financial folk are fond of saying, the best time to start a pension is when you’re in your twenties. The second best time is now. Many people don’t start thinking about retirement until they reach middle age, when saving for a pension becomes a priority. In my last post, I guided you through a Pension Healthcheck to see what funds you already have available. This time, we’ll look at a few ways of building your assets.
If you’re an employee, you almost certainly have the option of joining a pension scheme. In fact, you’re probably already part of one. By law, employers are obliged to provide and pay into a pension scheme for their employees (unless they’re very low paid). Enrolment is automatic, and you have to opt out if you don’t want to be part of it. You’ll be automatically enrolled again after three years. Yes, the Government is very keen to get everyone saving for retirement.
In schemes like these, a percentage of your salary is deducted from payroll before you even see it. In return, your employer also makes a contribution – so you get free money. The Government provides tax relief, too. Here’s an illustration:
You earn a salary of £32,000; you and your employer each contribute 5% into the pension scheme. Your monthly contribution from take-home pay is £133.33, which becomes £166.66 with tax relief. Your employer also adds £133.33. So, for a £133.33 deduction in your pay packet, £300 lands in your pension pot.
As I mentioned in my last post, there are two main types of company pension:
- Defined Benefit/Final Salary – you’ll receive a guaranteed amount after the specified retirement age
- Defined Contribution/Money Purchase – the size of your eventual pension pot is based on how the underlying investments have performed
Most company pensions these days are Defined Contribution, so there’s absolutely no guaranteed income. In the worst-case scenario, you might actually receive less than you put in. When you start drawing a pension, the income you receive is subject to tax, although you can take 25% of your pension pot as a tax-free lump sum.
Notwithstanding these risks, the tax relief and employer contributions make company pensions a good wheeze for most people. The three main problems with company pensions are:
- Your money is locked away until you reach retirement. This could be either the state pension age (65,66,67 or 68, depending on how old you are now), or an age set by the company or pension scheme. Accessing it earlier means a lower income or smaller pot. This is generally a Good Thing, as it means that those funds are protected for when you’re no longer able to work. However, if you were ill or unemployed for an extended period, you would be unable to access your money. Most schemes will give you early access if you’re diagnosed with a terminal illness.
- If you switch jobs frequently, as many of us do these days, you can end up with lots of small pension pots. Some are portable, but others will be frozen. It can be difficult to keep track of multiple pots and it means remembering to update numerous companies every time you move house. The new Pensions Dashboard is supposed to make this easier, but it’s not tremendously helpful in its current form.
- If you’re in a Final Salary scheme, it might not be possible to bequeath your pension to a spouse or family member, or they could receive a much smaller amount. In return for that guaranteed income, you cede some control over your money. Given the scheme is assuming the risk and responsibility for maintaining regular payments, this is an understandable compromise. However, some employees are unhappy with this arrangement and would rather receive a lump sum they can manage themselves. This is a big decision that could have serious implications for your retirement. A pot of £400K sounds appealing, but it’s hard to make it last unless you know three things: how long you’ll live, the future rate of inflation, and what they stock market will do.
If you’re uncomfortable with the idea of a company pension, there are some other options.
As you might expect, you get much more control with a personal pension scheme. And more responsibility. You’ll have to decide where to invest the money and what level of risk is tolerable. I’ll be discussing risk in a future blog post, but essentially the more risk you take, the higher your potential returns and the more your pot could grow. Equally, your potential for losses is greater. Opt for a cautious approach, though, and your pension pot might not grow enough. This is a difficult call and one of the biggest challenges in retirement planning.
As with company pensions, you’ll receive basic-rate tax relief on your contributions to any approved scheme.1 However, not all employers will pay into a personal pension, so you might be sacrificing those benefits. You can set up a personal pension with many financial companies. Head over to MoneySavingExpert for more information and suggestions.
You can reduce some of your pension stress by signing up with a Roboadviser. These are online investment services that manage everything for you. Over a couple of simple screens, you decide how much you want to invest and the level of risk with which you feel comfortable. The robots create a basket of investments for you and send updates on performance.
The advantages of Roboadvisers are:
- It’s simple
- You can set it and leave it
- In some cases, it’s cheaper than managing your own investments
The potential disadvantages are:
- The fees can be high, which eats into your future pension
- You don’t have any control over where your money is invested. This might be important if you’re an ethical investor or keen to invest in specific sectors or assets
- There’s little human interaction and no personalised advice
For sensible advice and a review of Roboadvisers, check out the Boring Money guide.
A SIPP is a Self-Invested Personal Pension. There’s a lot of confusion around this product, so I’ll try to keep this simple. A SIPP a pension wrapper – this means your investment is ‘wrapped’ in certain benefits. You get to decide exactly what’s included in your portfolio – index funds, shares, bonds, etc – and you can buy or sell them at any time. As with the other types of pension, you get tax relief from the Government, too. Any gains aren’t subject to tax, either. Theoretically, an employer could pay into your SIPP, but they’re unlikely to do so if they have a company scheme.
SIPPs are popular with self-employed people who run limited companies. They can make employer contributions as the company, which then reduces their corporation tax bill. If you’re an employee or a sole trader, most SIPPs will automatically apply for basic-rate tax relief on your contributions. Higher- and additional-rate taxpayers need to claim the extra through their tax return.
There is a different type of SIPP that allows you to hold commercial property and other assets. These are much more expensive and usually suitable only for very wealthy investors.
The advantages of standard SIPPs are:
- You have complete control over the investments
- They’re tax efficient if you run a limited company
- Depending on where you invest, the charges are relatively low
The disadvantages are:
- You’ll have to make a lot of decisions about how and when to invest your money
- The charges can mount up if you’re buying and selling investments frequently
- Some schemes have steep minimum contributions
The Best Buys page over at Boring Money provides ratings and reviews of SIPPs.
You don’t have to put your money in a pension scheme. Other investments are available and might be more suitable for you. Until recently, buy-to-let property has been a popular choice for some investors. However, changes to stamp duty and mortgage tax relief mean it’s unlikely to be a good choice for the average investor. Property is also vulnerable to market downturns, problem tenants, and high costs.
Stocks & Shares ISAs
The Individual Savings Account is a wrapper for savings and investments. There are currently six types of ISA, which I’ll cover in more detail in a future post, but the most popular type for retirement planning is the Stocks and Shares ISA. As with a SIPP, you can choose what investments to include and buy or sell them at any time. All your gains are also tax free. The main difference from a pension is that you won’t receive any tax relief on your contributions. A key advantage, though, is that you don’t have to wait till retirement to access your money – this makes it a good choice for medium-term goals. Also, any money you withdraw won’t be subject to income tax (unlike a pension). You can currently invest up to £20,000 in a Stocks & Shares ISA each year.
The advantages of a stocks and shares ISA are:
- Flexibility over what you invest and when you withdraw funds
- Your gains and withdrawals aren’t subject to tax
- The allowances are currently very generous
The disadvantages are:
- You don’t get tax relief or employer contributions
- The flexibility means you might be tempted to spend it before retirement
- Unlike your pension pot, ISA accounts form part of your estate and are subject to inheritance tax (and might be more vulnerable in a divorce settlement). They’re also included in means-testing for benefits.
There’s also a bewildering choice of ISA providers and potential investments. The Best Buys page over at Boring Money can help you choose.
What’s right for you will depend on your individual circumstances and how close you are to retirement. The solution might be a mix of pension and ISA investments so that you have access to funds in both the medium and long term. None of us knows what the future holds, but it’s almost certain that Future You will be grateful for a pot of money.
In the third and final part of this series, I’ll help you work out how much money you’ll need in retirement.
As a financial coach, I can guide you through the process of building your retirement assets. By explaining the options available and using forecasting tools, I support you in making an informed decision that’s suitable for your situation. I never recommend a specific product or course of action. If you require advice rather than coaching, you need to see a qualified financial advisor. They’ll either recommend products on which they receive commission, or you’ll pay a fee for independent advice. Please contact me if you’d like a free 15-minute chat about pensions or any other aspect of financial wellbeing.
- Higher- and additional-rate tax payers need to claim the exra through their tax return. [↩]