How to Make Your Pension Work For You #1

Ask people about their view on pensions, and you’ll hear one common answer: confusion. This is problematic, because pensions, when used correctly, are a key tool for financial independence.

If you understand pensions, you will be light years ahead of your peers. Looking back, it will be one of the best financial decisions you ever made. No-one regrets optimising their pension; but with hindsight many wish they had. It’s not rocket science, and it’s worth it. Let’s dive in.

Jargon-Busting

There is too much jargon in the world of pensions. Let’s break this down.

Firstly, the three main types of pension:

• state pensions

• defined benefit (DB) pensions; and

• defined contribution (DC) pensions.

The state pension is what you receive from government at the official retirement age (currently 66). This is based on the number of years for which you have worked and paid national insurance.

The full state pension in the UK is nearly £10,000/year. It can provide for the basics, but it’s nowhere near enough to cover a comfortable life. As such, you need to look to other forms of pension saving. If you don’t, you will be poor.

Defined Benefit (DB) pensions are old-fashioned. They exist almost exclusively in the public sector and are based on years of service. There are variations, but a typical DB pension would pay you 1/60th of your final salary, multiplied by years of service.

For example, a worker who had spent 30 years in a company and had a final salary of £50,000 would receive 30/60ths (or one half) of £50,000 – in other words, £25,000 – each year for the rest of their life.

Defined benefit schemes are generous, but they are rare. Defined contribution schemes are more common.

Defined Contribution (DC) pensions are easier to understand. As the name suggests, DC pensions require contributions – from the employer and the employee.

These contributions are invested – typically in a portfolio of stocks – and grow over time. We will discuss the contents of this portfolio in a separate article.

Ten years before retirement age, you can withdraw assets from this pot, with various tax benefits. These benefits make the pension highly appealing for long-term saving and investment.

The bottom line – you need to make your DC pension work, as a top-up to the state pension. Without it, you are missing a trick.

Tax Benefits In

When you sacrifice your salary and contribute to your DC pension instead, you receive immediate tax relief. This is because you don’t pay tax or national insurance.

If you are a basic rate taxpayer, your tax rate is 20% and national insurance is 12%, meaning an effective 32% tax. In other words, for every £100 of salary earned, £32 goes to taxes, and £68 goes into your pocket. But if you sacrifice that £100 into a DC pension directly, you receive the full £100. Effectively, you have turned what would have been £68 in net salary into £100, a 47% increase.

If you are a higher rate taxpayer (i.e., earning over £50,000), the tax benefit is even greater. Your tax rate is 40% and your national insurance rate is 2%, meaning an effective tax rate of 42%. As such, £100 of extra salary becomes £58 by the time it lands in your bank account.

By contributing to your pension instead, you get the full £100 - the pickup from £58 to £100 is a 72% gain.

Tax Benefits Through Time

The tax benefits of pensions go beyond the initial contribution. Throughout the time between your contributions and eventually withdrawing money, your gains within the pension vehicle compound tax-free.

If you held investment assets outside your pension, you would owe tax on the gains and dividends. But within the pension, there is no tax due.

Tax Benefits Out

There is, of course, tax payable when you withdraw money from your pension. However,

• 25% of what you have can be withdrawn tax-free

• Above that, the first £12,570/year will be tax-free under current rules

• Any further income up to £50,000 will be charged 20% tax; and

• Any income above £50,000 will be charged 40%.

So, you get back 25% of what you have saved tax-free, and then pay no tax on your initial £12,570/year income, then no national insurance on income over that level. That seems like a worthwhile deal. In light of this, why is the pension so under-utilised?

Psychological Blocks

It’s all down to psychology. Although the benefits of a pension are profound, they exist in the future, and can’t be quantified today. This future pay-off leaves us psychologically vulnerable to the concept of instant gratification.

Rather than seeing the enormous future upside, we see uncertainty and delays to our reward. Consequently, we fall into the easy habit of thinking about today and little else. The result is to ignore or under-use the pension, which is the best long-term investment tool.

The unfortunate reality of this psychological bias is that pensions work best when you save early in your life – at the exact time when your psychological bias to ignore the future is at its strongest. So you become trapped by psychology until it’s too late. Avoid this if you can.

Your Immediate Steps

Pensions are complex. But if you understand these basics, you’ll be well on the way to success. The key points are:

• There are several advantages of a pension. Understanding these will save you hundreds of thousands of pounds.

• Your psychology often works against you. Don’t fall into this trap.

• You need a strong DC pension to be financially independent. The later you leave your contributions, the more you need to sacrifice in the future. It’s not saving £1 now vs £1 later – it’s more like £1 now vs £10 later. Choose wisely.

• You’ll never regret taking charge of your pension. But I can guarantee you would regret not having done it.

In short, think about your pension. It may sound boring, but you can thank yourself later. It’s well worth the work.