Pension: What is it and why is it important?

We’re onto the second article of this enticing series – covering what some people might what consider a ‘dull’ topic: Pensions.

The flip side is that you need to put money away for the ‘future you’, and a Pension is probably the most tax-advantageous way to do it.

The aim of this article is to demonstrate that pensions can be a powerful tool that could be considered when saving toward your future (and potentially saving you some tax along the way!).

What is a Pension?

A Pension, like an ISA, is simply another ‘box’ in which you can put different ‘investments' into. The key advantage of this particular ‘box’ is favourable tax treatment. However, the tax treatment is slightly different to that of an ISA. More on this below.

There are two categories when it comes to pensions: Defined Benefit (final salary) and Defined Contribution (money purchase).

Defined Benefit – a member receives a guaranteed income in retirement, which is typically a fraction of their ‘final salary’ for each year of service worked. These schemes offer a guaranteed level of income for the rest of one’s life.

Defined Contribution – member contributions (and often contributions from the member’s employer) builds up a pot of investments during their working life. At retirement, this pot is either used to buy a guaranteed income for the rest of the member’s (an annuity) or drawn upon gradually by the member (whilst remaining invested) as needed. This is how most schemes operate today. ?

This article will focus on Defined Contribution Pensions.

Tax Treatment – On Contributions

Any eligible pension contribution could benefit from 100% income tax relief. There will also be National Insurance Savings and savings on any student loan obligations if contributions are made via salary sacrifice.

Salary Sacrifice involves sacrificing some salary so that an employer can make a larger contribution to the member’s pension. The member won’t pay tax or student loan repayments on the amount of salary they have given up.

By way of example, Joe Bloggs earns ￡100,000. He has been enrolled into a workplace pension and elects to contribute 10% (￡10,000) to his pension via salary sacrifice. Joe’s salary will now be ￡90,000 and his employer will pay ￡10,000 to his pension.

Earnings between ￡90,000 - ￡100,000:

• fall into the 40% tax bracket (saving ￡4,000 of tax).
• fall into to 2% National Insurance contributions (saving ￡200 of National Insurance)
• 9% student loan repayments (if you are paying student loans and saving ￡900 in student loan repayments).

Making this ￡10,000 contribution over the course of the year has saved Joe ￡5,100 in tax, National Insurance and student loan deductions!

Tax Treatment – On Growth

Joe will not pay any tax on his investments while they are in his pension. Joe’s investments are growing tax-free.

Tax Treatment – On Withdrawals

This can get quite complex given the recent Pension Freedoms that were introduced in 2015 and the ever-changing pension landscape (see the recent budget announcement!).

At the simplest level, 25% of your pot (up to a maximum of ￡268,275) can be taken tax-free as a Pension Commencement Lump Sum and the remainder is taxable at your marginal rate of income tax. There is the flexibility (dependent on who your Pension provider is) to draw this tax-free lump sum over time rather than taking it all at once.

How much can I put into a Pension every year?

In theory, you can put as much as you want into a Pension every year.

However, you only receive tax-relief on a maximum of ￡60,000 (or 100% of your salary, whichever is higher) … unless you are ‘carrying’ forward unused Pension allowances from the previous three tax years. Above this point, you are not eligible for any tax relief and there may be some unintended consequences in making the contribution.

To complicate things further, those who are higher earners can start to see the full ￡60,000 allowance tapered above and beyond earnings of ￡260,000 to a minimum of ￡10,000 if earnings are high enough.

You will typically need to be UK resident to benefit from the tax relief discussed.?

Should I be putting money into my Pension?

Generally speaking, yes. Unless you want to be reliant on state pension (currently ￡10,600 per annum) you are going to need to start saving something.

At a minimum you want to make the most your workplace scheme. Not only will this save you tax (and potentially National Insurance and Student Loan repayments), but employers will often match the contribution you are making – this is essentially ‘free’ money.

However, only saving into a workplace scheme is typically not sufficient for most people’s aspirations in a life post work. Therefore, additional contributions to pension and other investments may be sensible dependent on your financial priorities and circumstances.

This is often where speaking to an adviser can be a good use of time to ensure that you can balance the benefits (tax efficiency) against any drawbacks (inaccessibility before retirement).?

Are Pensions accessible?

Not very – unless you are already over the age of 55 (or 57 by 2028).

Pensions are a long-term savings vehicle. Any money invested into a pension is money that is locked up for a ‘future you’ and cannot be touched before the above-mentioned pension ages.

There is often a balancing act when it comes to making pension investments above and beyond the typical workplace schemes.

On the one-hand you’ll save tax at your marginal rate which would have otherwise gone to HMRC. However, this money is locked up until at least 55 (moving to 57). So, once invested into pension there is no way to access these funds before this time.

It comes down to the following thought process: “if I don’t need this money before I retire then making additional tax-efficient pension contributions could be a very strong option”.

Can I have multiple Pensions?

Yes, you can have as many pensions as you so desire. While having multiple pots might seem sensible in an effort to ‘diversify’ where each pension is held, it can often create unnecessary complexity in managing your finances and the potential to lose track of what sits where.?

What happens to my Pension if I move abroad?

You can access your pension when living abroad. Importantly, you are also still eligible for state pension payments too (as long as you have a sufficient National Insurance Record).

If this is a possibility, it is best to speak with an adviser who is well versed in this area as there can be some complexity when it comes to the way different countries treat UK pensions.

The Importance of a Pension

Graphs can be a good way to illustrate the power of pensions. Find below a (‘classic’) line graph on the impact of opting out of your pensions.

The key message, opting out of your pension may seem appealing to have a higher ‘net’ monthly pay package – but you are only making life more difficult later on down the road.

These are real values i.e. they take into account inflation eating away some of the growth in your investments.

Assumptions:

• 100% Global Equity Portfolio – using the below forward-looking asset class assumptions (pre-charges):

• The above performance is the ‘average’ (median) return from a range of 1000 different economic scenarios run. Returns are gross (not adjusted for inflation). There is the potential for returns to be better or worse than the average used above.
• Charges of 0.50% applied to the investment – this is the ‘typical’ workplace scheme charge.
• Contributions will rise with median inflation figure from a range of 1000 different economic scenarios. This reflects the strong possibility of pay rises in line with inflation will result in higher monthly contributions to a Pension.

Comparing this to an ISA…

Let’s assume Joe is a higher rate taxpayer, so his income tax rate is 40%. So, a ￡500 contribution would be subject to income tax of ￡200 leaving ￡300 in his pocket to invest – remember, ISAs do not benefit from tax relief upfront like a Pension. So, ￡500 becomes ￡300 after you pay income tax. This is what you could then invest into your ISA.

Above is a graph highlighting the difference the upfront tax relief has within Pension over different timeframes.

Summary

A Pension can be a vital tool in one’s arsenal when it comes to investing tax-efficiently towards your future self. As more of the burden is shifting onto the individual to manage their income in a life post work, Pensions may be one area you wish to consider.