If you want to retire in comfort, you’re going to have to make some important decisions yourself. Faith Glasgow explains what to consider when you’re thinking down the decades to retirement.
Gone are the days, for most people employed in the private sector, of a lifetime of employment with the promise of a decent salary-linked pension at the end of it all.
Of course, everyone will receive the inflation-linked state pension – but at just under £204 per week (£10,600 per year) for the current tax year, that’s barely enough for most people to live on.
Moreover, state pension age is being pushed steadily back. The current legislated pathway is for the State Pension age to rise to 67 between 2026 and 2028, and to 68 between 2044 and 2046.
So the onus is on each of us to make provision for our own later years, and the easiest, most tax-efficient way to do that is to save into an investment-based occupational pension plan.
All employers now have to offer a workplace pension plan by law. Most employees will automatically be enrolled into it and must proactively opt out if they don’t want to take that route.
But for most people there are good reasons to stick with it – and ways to enhance the growth of your pension further too. Here are eight considerations to bear in mind when you’re thinking down the decades to retirement.
1. Pension tax treatment is the best
Of all the savings options open to you, pensions, whether workplace schemes or personal plans (such as SIPPs), are most specifically designed for long-term saving.
Full tax relief on contributions is the main incentive, with 20% added by HMRC to your pension pot and a further 20% or 25% reclaimable through your tax return for higher and additional rate taxpayers.
That means the whole gross sum is invested from the outset and grows over the decades. In addition, all capital growth and income generated within the pension is free of tax. Those tax breaks can make a huge difference to the value of your pot.
2. Start early
To borrow from the old adage, it’s time in the market that makes all the difference for investment returns, and that absolutely applies to pension saving.
Retirement may be the last thing you want to think about in your first or second job – but if you are automatically enrolled in your early 20s, even if you’re not paying in much money, that investment has perhaps 40 years to grow.
Keeping the calculations as simple as possible, let’s say £50 a month is paid into an investment growing at 5% a year for 40 years. Disregarding inflation and all other things being equal, after 40 years that pot will be worth almost £75,000.
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Crucially, if you invested £50 a month for only 20 years, you’d have just over £20,000 at the end of the period. To ensure a £75,000 pot in that length of time, you’d need to bolster contributions to £184 a month.
In effect, the earlier you start and the longer you’re invested for, the more heavy lifting is done simply by investment returns and the power of compounding (as those reinvested returns themselves generate returns), rather than by adding money to the pot.
3. Gain from employers’ contributions
If you have the option of a workplace pension, it’s a no-brainer. That’s because employers are also obliged to pay into your plan. As an employee enrolled in a workplace pension, you’ll contribute at least 5% of your qualifying earnings, and on top of that your employer must pay at least 3%.
To put that into perspective: the Money Helper calculator shows that for a 23-year-old on a £20,000 salary, £57.33 will be automatically deducted from their gross salary each month, and that will be topped with a further £34.40 from the employer, so a total £91.73 goes into the pension pot. Over 40 years, growing at 5% a year, that could be worth £136,500 - a big boost.
Some employers are much more generous and will match your contributions up to a certain level (perhaps 10% or 15% of salary), which is clearly a huge potential benefit.
4. Avoid the default fund
Pension plans offer a range of funds for investors to choose from, but unless you make an active choice your pension contributions will be paid into what’s known as the default fund. This is basically the ‘safe option’ and comprises a mix of equities and lower risk bonds, but at the price of a lower long-term return.
However, if you’re in your 20s, 30s or even 40s, investing with a long-term perspective of up to 40 years, you can afford to take more risk by increasing your exposure to equities. That’s because although shares tend to be more volatile over the short to medium term, they also tend to outperform other asset classes over the very long term.
Depending on the flexibility offered by your pension plan and your own appetite for risk, you might be able to opt for a fund with exposure to smaller companies and international markets; there may also be a range of socially responsible choices.
Even a small move up the risk/return spectrum can make a huge difference to returns over the decades. If we invest our monthly contributions of £91.73 at a growth rate of 7% a year instead of 5%, the pot is worth £228,000 after 40 years – a 67% uplift.
5. Increase contributions
Of course, if you’re paying a set percentage of your salary into your pension, then when you get a pay rise the amount you contribute will go up too. But there is more you can do, and it won’t leave you feeling out of pocket.
Whenever you receive a salary increase, it’s a great opportunity to nudge up the percentage of salary you pay into your pension, even if only by a fraction of your pay rise. Your take home pay will still have risen – just not by quite as much.
You may find your employer is willing to match that increase in contributions, in which case it’s a double win.
6. Salary sacrifice
As you get older and earn more, you may well be in a stronger position to increase your regular contributions, and also to channel bonuses into your pension fund.
In this context, consider taking advantage of your employer’s salary or bonus sacrifice scheme, if it offers that option.
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Salary sacrifice allows employees to ‘give up’ a portion of their existing earnings (or a pay rise or annual bonus) and therefore not to pay tax or national insurance on that chunk. Instead, it is effectively redirected into their pension and treated as an additional employer contribution.
It can be particularly valuable if your pay rise would otherwise have tipped you into a higher tax bracket.
7. Maximise contributions
The April Budget brought good news for those on generous salaries. First, the lifetime allowance has been done away with. That means that with effect from the new tax year on 6 April there are no longer tax penalties of up to 55% on withdrawals if your pension pot grows beyond a certain value (previously the cap stood at just over £1 million).
Second, the annual limit on total contributions has risen, so you can now pay in up to £60,000 a year (previously £40,000), though you cannot contribute more than you earn in a year. However, the annual limit is progressively reduced down to a minimum £10,000 once your ‘adjusted income’ is above £260,000 a year.
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You can also utilise any unused allowance from the past three tax years - a process known as ‘carry forward’ – if you have a particularly large sum to allocate to your pension. Using carry forward, you could contribute as much as £180,000 this year (£60,000 plus 3 x £40,000 for the past three years).
The upshot is that if your earnings increase significantly, you now have more leeway to boost your retirement savings.
8. Resist the urge to dip in
Pensions cannot normally be accessed until you reach age 55, and that minimum age will rise to 57 in April 2028. That rules out dipping into your long-term savings for casual purposes or emergencies.
Even once you are able to access your pension, if you’re still working and able to pay into it, it makes a lot of sense to continue building it up. Your pension investment is likely to be your primary source of income through three decades of retirement or more, so the longer you are in a position to leave it untouched, the more secure your retirement finances should be.
Apart from anything else, the process of compounding becomes exponentially more powerful over the years of investment, so the greatest potential for growth occurs in these later years.
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