A Guide to Pensions: Products and Strategy
Of all savings and retirement investing products, pension plans are arguably the most important. They have certainly seen the most media exposure in recent years. A combination of significant reform to regulations around pension freedoms in 2015 and the introduction of auto-enrolment has generated increased awareness, as has a concerted government campaign to encourage pension savings.
Successive British governments have had a clear agenda to push private pension savings and with good reason. The state pension currently sits at £159.55 a week or £8297 annually, though there are some rules around qualifying for this, mainly based on National Insurance contributions over the years. As has been well documented, pensioners who rely solely on the state pension have a very hard time making ends meet. With a burgeoning national debt and an ageing demographic, the smart money would be on the present level of state pension provision being unlikely to improve in future years. If it will move in any direction that would be expected to be down.
After usually at least 40 years in full-time employment, often also combined with juggling raising a family, we all deserve an enjoyable period of retirement. Not fretting over meeting month-to-month living expenses and having at least a little left over to indulge in hobbies and maybe a little travel is not too much to ask. However, the fact is that we all need to take responsibility and plan ahead by contributing regularly to a pension pot if that is to be achieved.
We’ll look here at how much needs to be saved into a pension over the years to accumulate enough value that a reasonable regular income will result during retirement, tax incentives around pension savings, taxation on pension income and the main pension product choices on the UK market.
How Much Do I Need to Save?
A recent annual report by pension provider Scottish Widows comes to the conclusion that retirees require an annual income of £23,000 to be financially secure and have a good quality of life during retirement. That figure does not of course take variations in personal circumstances, such as owning a home outright, into consideration. Nonetheless, it does stack up as a reasonable average figure to put out there.
However, even with new auto-enrolment pension contributions (we’ll cover this in detail a little later) rising to 8% of salary from 2019, Scottish Widows estimates that those on an average UK salary, currently £27,600 for full time employees, will still fall short. If the average salary were earned throughout a working life, from around 25 to 65 years old, the pension provider estimates that 12% of earnings would need to be put towards a pension for the £23,000 target to be achieved.
Setting aside the average £23,000 target, everyone should make their own individual calculation on the level of income they would like to secure. The recommended way to look at this is to make a thorough calculation of current average monthly expenses such as rent, mortgage, groceries, utilities bills, car, public transport and leisure and entertainment. Spend a month tracking absolutely every expenditure to make sure this is as accurate as possible. Less regular expenses such as an annual clothing budget, holidays and home repairs etc. should then be added in. Expenses that will naturally drop off during retirement, such as travel back and forth to work, lunches during the working week, mortgage payments if it will be paid off by then, expenses related to children if applicable etc. Additional expenses such as higher home heating bills due to no longer spending the weekdays out at work and more time to spend on hobbies should also not be forgotten. This should provide a relatively accurate picture of what an ideal retirement income will look like. The government-run Money Advice Service website’s findings show that, based on this kind of retirement budget appraisal, those earning between £40,000 and £100,000 would like to have income equating to around 60% of their current salary during retirement.
For a pension pot to provide, in combination with the current state pension provision, an annual £23,000 income for an open-ended period of time, a final value of around £300,000 must be accumulated. That’s based on an average annual return of 5%. Taking compounded returns over the years into account, reaching that total would require monthly contributions of approximately £212 from the age of 25 to 65. There a several good calculators that can be easily found online that will provide a good estimate as to how much needs to be put aside each month, over a given period of time, to achieve the final value of pension pot needed to provide a desired retirement income. An average 5% return on investment is a reasonable assumption to work to. This means a pension pot with a value of £100,000 would be expected to provide an average annual income of £5000 without depleting the pot’s underlying value.
In recognition of the importance that as many people as possible save towards private and workplace pensions to supplement their state pension during retirement, there are very attractive tax incentives on pension contributions. Essentially, pension contributions are tax free in the UK. In most circumstances, an exception being salary sacrifice pension schemes which will be covered later, income tax will already have been paid on pension contributions and HMRC tops up contributions by returning that income tax.
This means that if a basic rate income tax payer makes a £1000 contribution into their pension pot this will be further boosted by a £200 top-up from the government. Making regular contributions to a pension pot is even more attractive for those in the higher and additional income tax bands of 40% and 45%. While the basic rate income tax rate will automatically be refunded on pension contributions, those on higher bands may have to claim the additional 20% or 25% via their annual tax return. Some pension providers will do this for the pension holder but this should be checked and set up if the service is provided.
Tax relief on pension contributions is up to a ceiling of £40,000 per annum and has a £1 million lifetime cap. However, if the whole allowance has not been used in any of the previous three tax years the unused part of the allowance can be rolled over. If for the previous three years contributions worth £20,000 per annum have been made, a £100,000 contribution made in year 4 would be eligible for full tax relief: £40,000 for the present year and the £20,000 unused allowance from the previous three.
As well as tax relief via refunded income tax incentivising pension savings, returns generated by investments made within a pension pot are also exempt of capital gains or income tax.
Tax on Pension Income
Once retirement is reached and a pension pot starts to be drawn down from to provide an income, there are some additional tax breaks. The first 25% of a pension pot is tax free, either if withdrawn as a one-off lump sum or in the form of regular income installments. After the initial tax-exempt 25%, income derived from a pension pot is treated in the same way as any other income and taxed accordingly.
Let’s take an example of £100,000 withdrawn from a pension pot:
The first £25,000 would be tax free. Assuming a state pension of £8297 is the pension holder’s only other income, that would leave £75,000 + £8297: £83,297. For the 2017/18 tax year everyone has an £11,500 personal income allowance before tax is applied. That leaves £71,797 in taxable income. The first £40,000 of this is charged the basic rate of 20% income tax: £8000. The remaining £31,797 would be charged at the 40% addition rate: £12,718.80.
So, on a £100,000 tax lump sum withdrawal from a pension pot, £12,718.8 would be due in tax if the holder’s only other source of income was a state pension.
Pension Products and Schemes
Pension contributions are paid into one or more pension products. There is no limit to how many pension products any one individual may hold. However, for convenience it generally makes sense to have one workplace pension and, potentially, one additional private pension product for those who wish to make higher contributions than they are obliged to via auto-enrolment and prefer to have some degree of diversification.
It is common for some individuals to have several different pension pots from different work place pensions that they have held in different jobs. However, this can make keeping track complicated. In most cases it will make sense to consolidate older pension pots from previous jobs into one pension. Pension holders can ask the provider of the pension they currently pay into to consolidate other pension pots and this is a relatively quick and easy process. Some pension providers do charge exit fees however so it is important to check what these will be. In most cases these won’t be significant but it is important to verify. In the majority of circumstances savings on management fees gained by consolidation will compensate any exit fees.
Pension products fall into two main categories of workplace and private pension products.
Workplace pension products are paid into via auto-enrolment, though additional contributions over and above auto-enrolment can also be made and can come out of a salary automatically if this is requested of the employer.
Auto-enrolment was first introduced in 2012 and will reach its full form by the 2019/20 tax year. In auto-enrolment employees have a % of their salary automatically paid into a Defined Contribution workplace pension product. This is boosted by government tax relief and the employer is also obliged to make a contribution.
At present, auto-enrolment involves a contribution of 1% of salary from the employee matched by an additional 1% contribution from the employer. From the 2018/19 tax year this rises to a 3% contribution from the employee and 2% from the employer and to 5% and 3% respectively from 2019/20.
Auto-enrolment covers everyone in the UK earning at least £10,000 per annum, though those earning less, for example through part-time employment, can still request to be included in auto-enrolment. While it is not legally obligatory to make auto-enrolment pension contributions, it is an opt-in rather than opt-out scheme. This means that the employee must specifically request to be taken out of auto-enrolment though by doing so they also forego their employer’s contributions.
Auto-enrolment pension contributions are paid into a Defined Contribution Pension product and every employer will have a chosen provider.
Salary sacrifice: some employers offer the option of pension contributions that take advantage of ‘salary sacrifice’ rules. In this case, part of a salary is ‘sacrificed’ and paid directly into a pension by the employer before income tax. This allows both the employee and employer to save on National Insurance and tax. The employer may agree to pay their part of this saving into the employee’s pension as an additional contribution above the minimum level required.
One drawback to the salary sacrifice route is it can impact eligibility for some forms of financing, such as a mortgage, due the employee’s official taxable salary being lower.
Defined Contribution Pensions are pension products whose final value is dependent upon a combination of the amount paid into them over the years and the performance of the investments the cash is placed in. The pension fund will usually be invested in a mix of equities and bonds, though sometimes alternative assets such as gold might also form a small weighting. Pension holders will have a choice of different funds with varying risk to reward ratio levels within a low to moderate risk framework.
Pension fund managers will often reallocate the fund’s investments towards more defensive, value preservation options as the holder approaches retirement age to protect against the negative impact of any potential market downturn. Earlier in the pension’s lifetime a slightly higher risk profile will look to achieve higher returns to go back into the pot as compounded returns and help build its value. If retirement is still more than several years away this allows time for markets to recover from a potential downturn.
Defined Benefit pensions are another format of workplace pension though they have become rare in recent years. A defined benefit pension guarantees the holder a guaranteed level of income in retirement, as long as the agreed contributions have been made, regardless of the performance of the pension’s investments. If the pot’s investments do not produce sufficient returns to meet the guaranteed income the employer is obliged to meet the shortfall. The burden of risk that falls upon the employer with a defined benefit pension has led to them falling out of favour in recent years. This kind of workplace pension product is usually only now offered to senior management as a perk and most companies have entirely moved away from them.
Private Pension products are usually either a Stakeholder Pension Product or SIPP (Self Invested Personal Pension).
Stakeholder Pension products have basically the same structure as workplace Defined Contribution Pensions. The holder chooses from a range of pension funds of varying risk profiles and makes regular and/or discretionary lump sum payments into the pension pot. The main reason to opt for a private Stakeholder Pension in addition to a workplace pension, or as an alternative if the employer is willing to make auto-enrolment contributions into it, is greater choice. While most pension funds are relatively generic in nature, the employee may not, for a number of reasons, be happy with their employer’s choice of provider. They may also simply want to diversify pension holdings and Stakeholder pension providers may also offer funds with a more aggressive risk profile than those available via an employer.
SIPPs are a ‘wrapper’ that are best suited to those who wish to take their own investment decisions and not rely on a fund manager or a passive fund. A SIPP simply defines the investments held within it as pension savings and means they are eligible for pension-specific tax relief.
SIPPs can hold a range of investment classes from individual company shares to funds, bonds, gilts, alternative investments and even commercial property (residential buy-to-let investment property cannot be held in a SIPP). Standard SIPP products will be able to hold shares, funds and often bonds and more specialist SIPPs can also hold alternative investments or trading accounts. More specialised SIPPs that can hold a wider range of asset classes are do however tend to charge higher annual fees.