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Planning Retirement Online

 

Pension Decisions

 

Should I get a pension?

Make sure you read the section on Sources of Retirement Income before you read this section.

PensionHaving a large fund that you can use in retirement is vital to maintaining your standard of living, and pensions are one of the best ways of achieving this. Not only will they lock away your money until age 55 (meaning that temptation to withdraw the funds beforehand is not an issue), but they also currently attract generous tax advantages.

You might want to take a look at our page on Pensions v ISAs  if you are thinking of building up retirement funds outside a pension scheme.

There are various forms of tax relief available for pension schemes, most notably:-

1) on pension contributions

2) on growth within the fund and

3) on the lump sum when you take your benefits.

Personal contributions receive tax relief at the basic rate. This is one of the major advantages of pensions over ISAs because it means that for every £80 you contribute, an additional £20 is added from HMRC. Even a non-taxpayer can contribute up to £2,880 per tax year into a pension (which, with tax relief, adds up to £3,600).

Higher and additional rate taxpayers are able to personally reclaim the higher amount of tax paid through their tax returns, meaning that they get the full 40% or 45% rebate - so for them, the effective cost of putting £100 in a pension fund is £60 and £55 respectively.

Capital gains tax does not apply to investments in a pension and therefore, there is no tax to pay on investment gains within a pension. This is similar to the rules governing ISAs.

You generally start taking benefits when you retire, and, as stated above, can receive 25% of your pension fund up front as a lump sum, completely tax free. In fact since April 2015 you can take 100% as cash but not tax free.

There are limits on how much can be contributed with tax relief to a pension each year and on the total amount of pension funds you can accumulate with tax relief. The overall size of a pension fund is limited to a Lifetime Allowance which was £1.25m for 2015-2016 but has fallen to £1m from April 2016. (see the gov.uk web site). If your fund should go over this amount there could be tax charges. This is likely to change from time to time.

The amount you can put into your pension and gain tax relief is also restricted. You can pay in up to £3,600 per tax year even if you do not earn anything at all. However, there is a cap of 100% of your earnings for the tax year up to the limit of £40,000 from 2014/15. This is called the Annual Allowance. If you have not used all of your allowance in any one tax year, provided you have held a pension scheme in that tax year, you may carry forward up to 3 years of annual tax relief. More information is available from https://www.gov.uk/tax-on-your-private-pension/annual-allowance

Deciding about Workplace Pensions

The first thing you need to decide is whether you want to join the pension scheme. As we say above, the fact that your employer (as well as you) is paying towards your pension is an attractive proposition, as is the fact your contributions will be tax free. If you think it’s a good idea, then the earlier you join the better, so that you can build up a bigger pension pot.

If it’s a Defined Contribution Scheme, you need to think about how much to contribute every month (see the section below on ‘How much should I save?’).

People can opt out of the auto-enrolment scheme, so you have to decide whether to do that. If you have no other pension provision and you are tempted to do so, then you should think very carefully about it. Remember that contributions are tax-free and your employer will be contributing towards your pension.

If you are lucky enough to have a defined benefits scheme, then consider whether you want to pay extra into it by paying Additional Voluntary Contributions (AVCs). These attract tax relief and are therefore a very tax-efficient way of saving.

Deciding about Personal Pensions

If you have no workplace pension provision other than auto-enrolment, or if you choose to opt out of auto-enrolment, then a personal pension should be something that you think about. Remember that your contributions are tax deductible and you will be building up a pension pot for your retirement. As with Defined Contribution Schemes( also known as Money Purchase schemes), your pension contributions are invested into the stock market but you can usually choose what level of risk you want to take with your investment. The returns may actually be better than those from a defined benefit scheme if the stock market does really well but there is, of course, a risk. However, historically, money that is invested in the stock market over the long term usually does well, so think about starting a personal pension as soon as possible in order to give it as long as possible.

Purchased Annuity

If you should decide to build up a retirement fund outside a pension scheme, or in addition to a pension scheme then an option is to buy a Purchased Annuity. Anyone that is typically aged 55 or over, has a large lump sum (from a non-pension source) and want a guaranteed income for the rest of their life can benefit from purchased life annuities. The annuity taxation of a purchased life annuity is very favourable compared to pension annuities and it will often provide a higher income net of tax. This means that individuals on retirement that want to maximise their pension income could also  consider commuting the maximum tax free lump sum from a defined contribution scheme and using this for a purchased life annuity.

 

How does a typical pension fund work

Our section on retirement income covered the different types of Pension Scheme.

Additional options, commonly known as Pension Freedom, became available from April 2015 including full withdrawal of pension funds (subject to tax), pension drawdown, or annuities and potentially other products created by providers in the future.

It is worth at least understanding the basics of annuities and the basics of drawdown.

In the case of annuities you essentially trade in your pension fund or part of your pension fund for an optional lump. sum and a contract for a lifetime income (however long you live). You can use what is called the open market option to find the best annuity rate for your circumstances and the options you want at the time you take it.

Annuity rates vary over time depending on a range of factors including the age you take the annuity, expected lifetime, and the organisation you use  but if for example the typical annuity rate was 4% for taking the annuity rate at age 65, then for every £100,000 of your pension fund you would receive £4000 a year for life. 

 

How much should I save towards retirement?
Mind the pension Gap

As described earlier this depends at what age we hope to retire and the level of income we hope to have.

However, to get a decent personal pension when we retire there is traditionally a rough rule of thumb, which makes a useful starting point, when thinking about how much to pay into it. We should divide our age by two and the answer is the percentage of our salary that we should pay when we start the pension. So, if we start our pension at age 20, we should pay 10% of our salary. If we delay until we are 30, we should contribute 15% and so on. So the earlier we start the more of our salary we will have left for other things!

If you are in a workplace pension scheme then in some cases you may be able to vary how much you pay in to the scheme. In some cases your employer will also pay in a fixed percentage of your salary, in others they will even match what you pay in, up to a certain limit. Needless to say the more you can afford to pay in in these circumstances, given your other commitments, the more you can take advantage of what is in effect ‘free money’. Your pension contributions are also tax free and increase your fund by the basic rate of tax. Higher and additional rate taxpayers are able to personally reclaim the higher amount of tax paid through their tax returns.

In simple terms, you should invest as much as you can comfortably afford, as soon as you can. You should not over-stretch yourself and you should make certain that if you make a commitment to a monthly investment this will be continued for a long time.

If you want to go rather further than the above rule of thumb, In order to determine how much you need to invest, you should start with the end in mind, by considering the following questions:-

  1. What age do you want you retire at?

  2. What is your expectation of inflation (average annual figure) between now and then?

  3. How much income per year (in today's terms) do you want to retire on?

  4. What annual rate of increase do you want for your pension in payment?

  5. Do you want to provide an income for your spouse, following your death?

  6. What income (if any) will you expect to be getting from the State at that date?

  7. Subtract f) from c) - Will this be sufficient to achieve your desires?

  8. If not, the difference between g) and c) is your pension gap.
     

The actual amount you will need to invest will obviously be different for each individual and once you have arrived at your own figure it is useful to try to link that to salary. For example, if you have decided that you can afford £250 per month and you earn £30,000, a quick calculation will show this amounts to around 10% of salary.

Try to keep saving that same amount in future years, as your salary rises, but also regularly review it to consider whether you can save more or add lump sums from bonuses etc within the annual allowance.

The biggest mistake everyone makes is to under fund their retirement. As an example, if you require an income of £30,000 in retirement and annuity rates at the time are 4%, you will need a fund of £750,000 to provide the necessary income – and this ignores the effect that inflation will have on the purchasing power of your pension (i.e. £30,000 in today’s money, will only be worth £15,000.00 in real terms in 20 years’ time, assuming an inflation rate of approximately 3.6% per annum).

See our separate guide to the impact of inflation on investments and pension income.

It is very instructive to look at how pension funds can build up over time and if you haven't already seen it  you might like to look at the page on Pensions v ISAs which includes an illustration of fund growth.

However the other side of the coin is understanding what a particular pension fund can generate in income in retirement, in order to decide how much to save. Typically this has been achieved for most people by buying an Annuity which is a contract to provide an income for the rest of your life (however long that might be). There are a variety of options associated with this which determine the annual income it generates e.g. whether you want a level of inflation protection, whether you want to provide a spouse's pension after you die, whether you want a guaranteed period of payment etc. If you want to understand more about annuities and their variants go to our annuities section.

To get a rough idea you can use the table below which shows you the best annuity rates available from a panel of leading providers including Standard Life, Aviva, Legal & General as at 22nd November 2012

The rates shown below are based on a fund value of £100,000 (remaining after taking tax free cash) with payments made monthly in advance. They are also based on a number of different options.

In order to calculate the fund you will require, simply take your ‘pension gap’ figure and divide it by the relevant income figure below. The resulting factor should then be multiplied by £100,000, to give the fund figure that you will need to accumulate at retirement date.
 

  Age
  55 60 65 70 75
Single life, level, no guarantee £4,597 £5,175 £5,938 £6,899 £8,473
Single life, level, 5 year guarantee £4,586 £5,158 £5,901 £6,848 £8,346
Single life, RPI, 5 year guarantee £2,486 £2,954 £3,669 £4,710 £6,201
Single life, 3% escalation p.a., 5 year guarantee £2,986 £3,519 £4,226 £5,110 £6,610
Joint life, 50% level, no guarantee £4214 £4,660 £5,273 £6,078 £7,141
Joint life 50% level, 3% escalation, no guarantee £2,654 £3,098 £3,595 £4,409 £5,421

Where a joint life is shown this is based on a named spouse where the male is 3 years older than the female.
Rates correct as at 22 November 2012.
RPI = increased in line with Retail Prices Index
50% level indicates, spouses pension is 50% of rate

 

It is worth looking at a couple of the pension calculators available online to get a feel for all this. However be aware that they all tend to use slightly different assumptions, so make sure you understand what these are and where you can try varying the assumptions. Growth rate assumptions in particular have a significant impact.

For example try:

The Money Advice service pension Calculator

and http://www.hl.co.uk/pensions/interactive-calculators

Remember that by the time you retire our longevity may have increased further and the state pension age risen further. (Annuity rates are calculated by each Company that offers them and they use current life expectancy figures as one factor when calculating their particular rates).

It may be better to start to think in terms of how long you want retirement to be, rather than what age you want to retire and adjust that age expectation as expectations of longevity change. 

 

Pension tips

1) Don't rely on your state pension to provide an adequate retirement income.

2) Start saving for a pension as soon as you possibly can, so you can build a healthy fund.

3) If you don't have a pension yet, don't worry, you can make up a lot of ground in a few years.

4) Look into your employer's pension scheme as the extra contributions can be extremely helpful.

 

CONTINUE TO: The Difficulties of Planning

NEXT STEPS

The rest of the Guide covers the other aspects of planning your retirement finances. We suggest you read through the whole guide to gain a general understanding and then work through the appropriate sections to develop your personal ideas.

If you've done your initial retirement planning then use our checklist: on a regular basis:
Reviewing Projected Retirement income - Checklist

However if you feel that you need some help from a financial advisor, then visit our section on obtaining financial advice, or our page on Laterlife selected services and associated advice.

 

 
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