Pensions? Why A Business is A Better Wealth-Building Strategy

Hello, dreamers and rebels! Today, we're diving deep into the world of pensions. Whether you're a salaried employee, aspiring freelancer or an entrepreneur at heart, understanding pensions is crucial. But I'm here to convince you that building your own business from day one is always the best choice for building wealth.

How Pensions Work for the Person Paying Into Them (using the UK system as an example)

Pensions are essentially long-term savings plans with tax benefits. There are three main types in the UK: defined contribution, defined benefit, and state pensions.

Defined Contribution Pensions

In a defined contribution pension, you and/or your employer contribute to a pension pot. The value of your pension depends on how much you've contributed and how well your investments perform.

Example:

Age 30: You start contributing ￡200 per month.

Age 65: Assuming an average annual return of 5%, your pension pot would be around ￡147,000.

To maintain your current lifestyle in old age, consider your retirement income. If you aim for an annual retirement income of ￡20,000, you would need a pension pot of approximately ￡400,000, assuming a 5% withdrawal rate.

Defined Benefit Pensions

In a defined benefit pension, your retirement income is based on your salary and years of service. These pensions are less common but offer more security.

Example:

Age 30: You start working for a company offering a defined benefit pension.

Age 65: Assuming you work for 35 years and your final salary is ￡50,000, you might receive a pension of around ￡25,000 per year (50% of your final salary).

State Pension

The State Pension is a regular payment from the government once you reach State Pension age. The full new State Pension is currently around ￡9,627.80 per year.

Example:

To qualify for the full State Pension, you need 35 qualifying years of National Insurance contributions.

If you have fewer qualifying years, your State Pension will be proportionally less.

The Limitations of Pensions for Wealth Building

While pensions offer tax benefits and a steady income stream in retirement, they have significant limitations for wealth building:

Complex Rules: Pension rules are complex and ever-changing, making it difficult to plan effectively.

Limited Control: You're not in full control of your investments, and performance can be lackluster.

Tax Implications: While there are tax benefits, there are also tax implications, especially when passing on your pension to beneficiaries.

Building Wealth: Why Your Business is Your Best Bet

Building wealth should not just be about covering yourself in old age; it should also be about leaving a legacy for your family. This is where the complexities of pensions come into play, especially when considering what happens to your pension when you die.

What Happens to Your Pension When You Die?

Defined Contribution Pensions

Before 75: If you die before 75 and haven’t started drawing your pension, it can be passed to your beneficiaries tax-free. They can take it as a lump sum, invest in drawdown, or use it to purchase an annuity.

After 75: If you die after 75, your beneficiaries will need to pay income tax on any pensions you leave behind, charged at their marginal rate of income tax.

Defined Benefit Pensions

Before Retirement: If you die before you retire, your pension will pay out a lump sum worth two to four times your salary. If you’re younger than 75 when you die, this payment will be tax-free for your beneficiaries.

After Retirement: If you have already retired when you die, a defined benefit pension will usually continue paying a reduced pension to your spouse, civil partner, or other dependent.

State Pension

Before April 2016: If you reached State Pension age before 6 April 2016, your spouse or civil partner can claim your Additional State Pension and may qualify for bereavement benefits.

After April 2016: If you reached State Pension age after 6 April 2016, your spouse or civil partner may be able to inherit an extra payment on top of your pension.

The Complex Web of Pension Rules

Pension rules are complex and ever-changing. You've already earned the money you put into your pension, but navigating the rules and understanding the tax implications can be a nightmare. For instance, if you die before 75 with a defined contribution pension, beneficiaries can access it tax-free. But if you've already started drawing your pension, the tax implications change. And if you die after 75, beneficiaries pay income tax at their marginal rate. Confused yet? I am.

Pension Fund Performance and Horror Stories

Pension funds don't always perform as expected. According to a report by the Pensions Policy Institute, the median real return for defined contribution pension funds over the 10 years to 2019 was just 2.4% per annum.

And let's not forget the horror stories. Remember BHS? When the retailer went bust in 2016, it left a ￡571 million pension deficit, affecting 19,000 scheme members. More recently, the collapse of Arcadia Group left a ￡350 million pension deficit.

Your Business: The Best Wealth-Building Strategy

Given the complexities and risks of traditional pensions, I would argue that the best wealth-building strategy is a business that creates passive and semi-passive income. Here's why:

Control: You're in control of your own destiny. You're not at the mercy of pension fund managers or government policy changes.

Potential for Higher Returns: While pensions can generate returns, the potential returns from a successful business are much higher.

Diversification: Owning a business allows you to diversify your risk. You're not reliant on a single income stream.

Legacy: Building a business allows you to create a legacy that can be passed on to future generations, providing financial security and opportunities for your family.

Diversify Your Risk

While I believe that owning a business is the best wealth-building strategy, I'm not advocating for ditching pensions altogether. Take advantage of tax benefits where possible, but don't let it be your only retirement plan. Diversify your risk by owning other assets and businesses.

Remember, this newsletter exists to make you think and strive to be the best you can be. So, don't settle for mediocrity. Demand more from life. And start planning for your future today.

Stay hungry,

P.S. Always do your own research and consult with a financial advisor before making any investment decisions, this is not financial advice.

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