Pensions: our guide to the basics
Talk to most people below the age of 50 and retirement is simply too far away for them to get their head around and think about seriously. But, with men in the UK aged 65 expected to live a further 18.5 years and women even longer - 20.9 years - after 65 - careful planning is crucial if you want to give yourself the best shot at having the comfortable retirement you'd like.
In the UK, pensions are the most common way of saving for retirement. The government provides several tax benefits to encourage people to save for retirement. These include:
1. Income tax relief of 20% for any money paid into your pension (there's greater tax relief for higher rate taxpayers). To put it another way, you can put money into your pension before paying income tax on it.
2. Tax efficiency - the money in your pension pot is not subject to capital gains tax (it's a tax on the profits you make from investments. Isas - Individual Savings Accounts - also offer this protection).
3. Tax-free lump sum - those taking money out of their pension pot are able to withdraw 25% of the sum tax-free. The rest will be subject to income tax, payable at whatever your rate might be by that point.
These three points apply across both work pensions and private pensions. And then there's the State Pension.
Here's our quick guide to each...
The State Pension currently pays a maximum of £122.30 per week, and increases each year by a minimum of 2.5%.
In order to access the full pension, you must make at least 35 years' worth of National Insurance contributions (NI is taken from your wages in a similar way to income tax).
While £122.30 is the current maximum pay-out, the payments you are entitled to once you reach the retirement age (miles away for most of us!) will depend largely on the number of years that you've made contributions.
If you miss out on paying National Insurance contributions (e.g. during periods of unemployment), it is possible to make voluntary contributions in order to catch up.
But don't get too excited about this. For most of us, the pension age will have increased to 68 by the time we retire - and it could be higher. The government website explains more about pension ages.
As of April 2017, all companies in the UK have been required to offer company pension schemes by law. Employers must have a pension scheme in place, and workers will be automatically enrolled if they are aged over 22, earn more than £10,000 and are not already signed up to another plan.
Broadly speaking, there are two main types of workplace pensions:
1. Defined benefit schemes - these are known as final salary schemes and pay a specific annual income once you retire, which is based on your final working salary and your years of service. With these schemes, the responsibility is on the employer to ensure that these liabilities are met. Sadly for us youngsters, these are now becoming a thing of the past and are increasingly a rarity.
2. Defined contribution schemes - these schemes see employers contribute a portion of your salary each month into a specific retirement account. On retiring, you are able to access that pot, the size of which is determined by the amounts contributed and the investment returns of the retirement savings. Under DC schemes, the onus is on the individual and there is no obligation from the employer to guarantee a certain level of retirement savings. Most companies allow their employees to choose how their contributions are invested from a selected range of funds.
For small businesses that may not have their own pension scheme, the government set up NEST (The National Employment Savings Trust) in 2011 as a pension scheme to simplify auto-enrolment for smaller companies. This helps employers provide lower-cost retirement solutions for their employees, and members who are enrolled into NEST are automatically invested in a "retirement date fund" which is managed according to their age and how far they are from retirement. In other words, this will mean members are invested in higher-risk assets with greater capital growth potential (e.g. equities) towards the early stage of their lives, before gradually de-risking and focusing on preserving that pot as retirement nears.
Explaining auto-enrolment: Auto-enrolment is a government initiative which is aimed at helping more people save for retirement through pension plans at work. Under auto-enrolment, it is mandatory for employers to offer all eligible employees a workplace pension, and to make a minimum contribution to the scheme.
Finally, anyone in the UK can choose to set up a personal pension. These are either simple plans that are often offered by insurance companies. They're pretty straightforward with very little choosing of investments required. They can also be Self-Invested Personal Pensions aka Sipps). Sipps are pension plans that enable the holder to choose and manage the investments made, while still receiving the tax benefits of investing under a pension wrapper. A Sipp, as with a company pension or work pension, offers up to 45% tax relief on contributions (for those taxpayers lucky enough to be earning more than £150,000).
The key difference between a Sipp and a company pension plan is that any contributions to a pension pot are made by the individual and they are also responsible for choosing what they invest in.
As with company pensions and work pensions, you can begin to make withdrawals from your Sipp from the age of 55 (57 from 2028), and up to 25% of that can be withdrawn tax free.
The government also does not force you to take all of your money out when you turn 55, and many people choose to stay partially invested. Some people use the money to buy an annuity which guarantees a level of income throughout the rest of their lives.
The amount of money you receive at retirement from a personal pension depends on the size of the contributions, how long contributions were paid into the pension for and investment performance.
So in other words if you want to retire well, save as much as you can as early as you can and pick the best investments (or ask an expert to do it for you). All of these, it's fair to say, are far more easily said than done.
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