Pensions and why they really matter
October 13, 2020
You’ve probably caught a glimpse of this in the news. The state pension age changed at the beginning of this month meaning that anyone born after 5 October 1954 has to be at least 66 years old to receive state pension. By 2028, that's likely to be 67. By the time you or I retire, we could be far into our 70s. Not a pretty sight considering I pictured my 60s spent travelling the world from one beach to another.
You might think retirement is way too far in the future to worry about right now but one of the most common mistakes is thinking that a state pension alone is enough to help you retire. To put things in context the current state pension of £175.20 a week is equivalent to just £9.1k per year. Try to imagine living off just that amount each year....
If that's got you thinking and in the mood to prepare, we've outlined the options available to us all in today's market.
Planning for your own retirement
What is a pension and what's so good about it?
One day you'll retire 🎊 and your salary will stop gracing your bank account with its presence 💸. You'll still need an income to live on so that's where a pension kicks in. Think of it as your retirement income. You will not have to do anything extra to receive that money if you plan for it early on.
The key benefit of a pension is the tax relief you get when you put money into it while you're still earning. For every £1,000 you put into your pension, the government tops it up with £250 if you're a basic-rate tax payer, roughly £660 if you're a higher-rate tax payer and roughly £820 if you're an additional-rate tax payer. Effectively they're paying back the tax you paid when you earned your salary.
In practice what normally happens is your pension comes straight out of your paycheque so you never really notice this - but trust us, they are.
To get this tax relief, there's a few things you need to be careful about;
- There's an annual limit of how much you can put in. For most people, this is £40k but if you're fortunate enough to be on a salary above £240k, then your limit might be lower.
- There's an earnings limit which means the maximum you can contribute towards your pension every year is the total of your annual earnings. Got £40k sitting in a savings account but you're only earning £30k this year? Unfortunately in that case you can only move £30k of the full £40k to your pension.
- There's a lifetime allowance. If your total pension pot is greater than £1,073,100 (the limit for 20/21), you'll have to pay a tax charge (this charge is only paid when you take money out of your pension).
All a bit overwhelming? Well there's one more thing... your annual limit can be carried over. So if you didn't use it over the last few years, chances are you can use it this year. If you think you're near some of these limits then it may be worth a chat with a financial adviser (hopefully one day that will be us) to put you at ease a little bit.
Please note that tax treatment depends on the individual circumstances or each client and may be subject to changes in the future.
Now that we've got that out of the way let's talk about the different types of pensions. There are three main ones:
Think of this as the state trying to help get you started. You will need to work and pay National Insurance for a minimum of 10 years to qualify for this (and 35 years to get the full amount) and while it's likely not enough to get you by, who can say no to a "free" c.£9k from the government each year. As we explained earlier, the age you start receiving this has just increased and so we don't suggest you rely on the state pension for your retirement plans.
This is probably the most common type of pension. One where you and your employee contribute towards it. Currently, the minimum that you can contribute to it is 5% of your salary and your employer needs to contribute the equivalent of 3% of your salary to it. Some employers contribute much more and sometimes match your contributions. It's worth really understanding what yours offers as it's effectively a pay rise if they can contribute more.
SIPP (self-invested personal pension)
You can call this a DIY pension. It works in a similar way to workplace pensions except you manage it yourself. Ideal for combining old workplace pensions or if you're self employed / a freelancer and don't have a workplace pension.
One difference though is how you claim the tax relief if you make contributions in to a SIPP. You'll automatically get the basic-rate tax relief but if you're a higher-rate or additional-rate tax payer you'll get the rest of the relief through your end of year self assessment.
What does this mean for my children?
"Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn't, pays it."
Your child may still be in school, or maybe even still in their nappies but that doesn't mean it's too early to start thinking about their future and what you can do to help them not work in to their 70s. As Albert Einstein once said, "Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn't, pays it." and so it's never too early to start earning it.
We see two main options you have as a parent to help your child's retirement.
Option 1: Junior SIPP
The first, and probably most obvious, is to open up a Junior SIPP (self-invested personal pension) for your child. Similar to an adult pension, a Junior SIPP allows you to contribute towards retirement and even get a government top up. The annual contribution limit for each child is £2,880 a year (which rises to £3,600 with the government 20% tax relief). Another great benefit is that anyone can contribute to this (not just the parents).
The con? This type of account locks the money until your child is 55 (which will rise to 57 by 2028 and probably even further until your child is old enough to start thinking about using the money). With that in mind you may not be comfortable locking up nearly £3k a year into a Junior SIPP. But before you completely rule it out, here's an example of how quickly a small contribution of £50 per month into a Junior SIPP (for their first 18 years) can make a huge difference to your child's long term financial future. Imagine if your pension pot was boosted by £250k at the age of 68!
Like we were, you're probably now wondering what this looks like if you contribute the full £2,880 each year (and get the tax relief & 5% annual growth) until they turn 18. Drumroll please... 🥁🥁🥁
Their pension pot would be worth over £1.2m by the time they're 67!
While opening up a Junior SIPP makes great sense mathematically, it's sometimes hard to save for something that far in the future. As a parent, it would be nice to see your child reap the benefit of all the hard work you put in over the years. While we're not saying this is impossible with a junior SIPP (as life expectancy rises and technological advancements are made), it's unfortunately not a common sight for parents to be around when their children are in their 60s and 70s…
There is however another option you could look into if you’d like to enjoy the reward together (and if you don't want to have to explain to them that it's ok that they can't get on the property ladder because they have £50k in a pension they can't access for another 40-50 years...).
Option 2: Help them achieve more medium term goals
Think back to when you first started working. Chances are (a) you didn't really understand the benefits of a pension and minimised your contributions, or (b) you did understand them, but you were enjoying your youth as well as paying rent, repaying student debt or saving up for a house.
Now imagine if your parent had given you the best 18th birthday present imaginable and helped you get on the property ladder or paid for your university education. You would've then been able to contribute more towards your pension from a younger age.
So back to our previous example where you saved £50 a month towards your child's future. If you did this in a Junior stocks and shares ISA (with 5% annual growth) instead and gave them the money at the age of 18 it would be worth around £17.5k. While that may not pay off their entire student debt it would certainly give a helping hand.
And this helping hand may just be what your child needs to free up another £100 a month to contribute towards their own pension. If they did this from the age of 21 all the way to retirement their pension pot could be worth £280k. This is assuming they get 0 employer contributions (which is unrealistic) and also assumes they're a basic rate tax payer. In reality their pension pot is likely to be worth a lot more than that and when you add the state pension too, that gift you worked for 18 years to give them might have just unlocked the door to financial freedom for them. We're not saying they wouldn't have to work at all, we're just saying they won't need to live to work!
This post is written to provide you with helpful guidance around pensions and should not be interpreted as financial or investment advice. Our worked examples assume an annual growth rate of 5% but please note, as with all investments, your capital is at risk and the value of your investments could go down as well as up. Past performance is not a reliable indicator of future performance. Please note that tax treatment depends on the individual. For personal advice on your pensions please speak to a financial adviser.