Pensions – some considerations when developing your strategy

Pensions_savingI want to outline some of the factors I consider important when saving into a UK pension under various circumstances. This is not financial advice (please see my disclaimer) but just some headline factors to bear in mind in case they can help anyone think more, and think differently, about their approach to pension savings, whatever their situation in life. This particular article is about saving into pensions, not what or how to invest any money that is in there

Towards the end of the article I’ll talk about my personal pension strategy and how it fits into saving for ISAs, and ultimately share the principles behind my own very early retirement plans

Employer contributions – many employer pension schemes offer a contribution from the employer into your pension scheme. For example your employer may “match” some or all of your pension contributions. This is always worth taking advantage of if you can afford it – for a 20% taxpayer with an employer match scheme, this means £80 invested would put £200 into your pension. For a higher rate taxpayer this £200 could only cost £60 (or £50 for those on the top rate), and there may be National Insurance savings too.

Not taking advantage of an employer contribution scheme is effectively agreeing to take a pay cut

Defined benefit (aka “final salary” schemes) – These are less common these days as they are expensive and risky to run from an employers point of view. Typically they offer the saver a guaranteed return on investment, regardless of stock market performance, and so are usually very easy to recommend to anyone who is lucky enough to be offered one. However there are examples of pension schemes collapsing which can undermine the “guaranteed” part, although there may be better safeguards in place these days. You can also save outside your defined benefit scheme if you choose and can afford to, with the same tax benefits as regular pension savers

In your 20s – great, you have time on your side! Make sure you have a contingency fund and and save as much as you can afford into your pension. As a minimum try to maximise your employer matching contributions, then make sure you pay off any really expensive debts if you have any. Check out these benefits:

  • You will get into the habit of saving,
  • You will reduce your tax bill,
  • Your pension will have more time to grow,
  • You’ll get used to living on a lower take-home salary, making saving easier in the future.

Try to avoid lifestyle inflation and put as much of any pay rises as you can away. All of these things will put you in a great place when you come to plan your retirement in more detail. Also consider whether you can fit ISAs into your savings/investment strategy…

The real kicker here unfortunately, is that this is usually a time of life when there is huge competition for your money – moving out, saving for a deposit, buying a car, repaying student loans, having fun before you have kids, etc, etc. However, do remember that, as mrmoneymustache.com says, if you think you can’t afford something after you’ve put aside at least 50% of your income as savings, then really – you can’t actually afford it

In your 30s – keep plugging away, saving as much as you can to maximise employer contributions and minimise your tax bill. Balance your savings objectives across Pensions and ISAs

Aged 40-55 – much as per your 30s, but you may wish to research your investment risk as you approach retirement. Also, you are closer to being able to withdraw your 25% tax free lump sum (tax rules may change). If so…

Within 5 years of retirement – if the opportunity to withdraw 25% of your pension tax-free still exists, you may wish to invest as much as possible. A £100 investment would cost £60-80 net, and you are very close to being able to get £25 tax free back into your bank account very soon afterwards. Effectively this means the £75 left in your pension has only cost you £35 instead of £45 as a 40% taxpayer, or £55 instead of £60 as a 20% taxpayer

Looking at this another way, your lower rate tax relief would be equivalent to 27% instead of 20%, or higher rate relief of 53% instead of 40% after you take your lump sum, but as you are so close to cashing this in, this is an even sweeter benefit

Non taxpayers – even if you don’t pay any tax, the government will top up your pension contribution up to an annual cap of £3,600 (at an effective cost to you of £2,880)

Lower rate taxpayers – I have heard people argue that there’s no point in saving 20% tax today, only to pay 20% tax on your pension income when you cash it in and retire. My response is in 3 parts.

  1. You get a head start on compound gains by saving tax today
  2. You can currently withdraw 25% of your pension in a tax free lump sum at retirement (tax rules may change), and
  3. You are currently allowed to earn a set amount before paying tax (personal tax allowance), so with a small pension or around £10k pa you may never actually pay tax on it at all (tax rules may change)

Higher rate taxpayers – A no-brainer as far as I’m concerned. Save as much as you can in your pension to make huge tax savings, doubly so if you expect to pay tax at a lower rate when you retire. Don’t forget ISA’s as well though, especially if you want to retire early (see below for more on this)!

Have kids and earning above £50k – see my post on HICBC implications as you could save even more by increasing your pension contributions to reduce the child benefit clawback as well as save on income tax. A £60k earner in a single income household with 2 kids might be paying an effective marginal rate of 60% tax on earnings between £50k-£60k

Pension Limits – There are annual and lifetime limits to how much you can put into your pension which you will need to be aware of if you are a high earner, want to invest more than your earnings, or have built (or expect to build) a very large pension pot. The rules change frequently, check www.hmrc.gov.uk for the latest pension policy

Very Early Retirement – this is the one that I’m obviously very interested in. How does a pension which I can’t touch until I’m at least 55 help me if I retire before I’m even 45? Well, the principle of huge tax breaks and more recently the HICBC rule changes mean that I think it would be madness not to take advantage of these benefits and save as much as I can into pension schemes. The problem is of course that the more you squirrel away into a pension, leaves you with less money today to invest in other passive streams of income such as property and shares

I’ve personally reached a point where I’m comfortable with my exposure to property investments (although I will probably buy at least one more property in the next 10 years, possibly to move into and add my existing house to the rental portfolio), so my early retirement plans are focussed now on UK stocks and shares ISAs.

The 2012-2013 rules allow each qualifying individual to shelter £11,280 into an ISA, where any interest/dividends/capital gains are completely sheltered from tax. Furthermore, any money in an ISA can be withdrawn at any time without (tax) penalty This means that with a large enough sum stashed away in ISAs (say £400k) I could draw an annual tax free “salary” of £16-24k+ indefinitely, which would be equivalent to a £20-30k+ full time wage (I’m assuming I’ve used up my personal tax allowance with rental or pension income for this assumption)

How do I get a £400k ISA? Well, if a couple can max out their allowance of £22.5k per year then it would take 13.5 years at 5% return to build such an amount, so start now if you haven’t already! We’re at the equivalent of 6.5 years into such a plan but it’s not easy saving £2,000 per month after tax, that’s for sure. I’ll post some more in the future about how to live a decent lifestyle whilst saving aggressively for retirement (although there’s plenty out there on this topic already – check out www.mrmoneymustache.com, for instance), and it’s another reason why I am not in a hurry to pay off my mortgage, but right now back to the subject of Pensions…

If I retire before I’m 45 and pensions won’t help me until I am at least 55 (and ideally you would wait even longer before converting your pension into an annuity, as your rates improve significantly as you get older, plus your fund has more time to grow), I need to be slightly more sophisticated with my retirement calculations. Let’s say my household has expenses of £30k per year and property income of £6k per year. This means I need to find £2k per month in passive income to retire. However if I achieve this on a sustainable basis (ie my capital is preserved and I’m getting the £2k per month from interest only) then I have saved up TOO MUCH for retirement, and when I get to 55-60 years old I will also start to earn a pension that gives me more money on top that I don’t need

Sounds like a nice problem to have on the face of it, doesn’t it? 🙂 However, the problem with saving TOO MUCH MONEY is that it means you’ve been saving for TOO LONG, and missing out on precious retirement years! 😦 If I had a pension pot that was big enough to allow me to take the maximum tax free lump sum and then provide me the inflation adjusted NET income (Ermine kindly reminded me to more clearly point out that pensions, unlike ISAs, may attract income tax) equivalent of £24k after tax from age 60, then my other source of passive income doesn’t need to be sustainable – the capital sum can reduce to a point where hypothetically it all runs out on the day I draw my pension

So for example I could take £24k pa from a £300k ISA pot and it would last for 20 years (assuming growth of 5% and inflation at 2%), meaning £300k would be enough to retire at 40 years old and last until 60, when the pension kicks in

When WHAT pension kicks in??? Ah yes, I almost forgot. This plan assumes you have ALSO saved enough into a pension by the age of 40 for it to replace your ISA income at 60, even if you make no further contributions in the successive 20 years. So as well as your £300k in ISAs, you would also need in excess of £200k in a pension at age 40 (assuming here that with 5% growth, £520k will buy a sufficient annuity at age 60, which still may not be enough)

Can you save £500k in pensions and ISAs by age 40? Have you kept on top of your lifestyle inflation to have expenses under £30k per year? Then pensions and ISAs in this combination might just get you out of the rat race forever…

Any holes in my maths or logic? Am I being too risky? Too cautious? Too ambitious? Leave a comment or contact me and let me know, I look forward to hearing from you

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2 responses to “Pensions – some considerations when developing your strategy

  1. You have a good basic plan, though your 24k pension income is not equivalent to a 24k ISA income. Because you get to pay income tax on it, which loses you 20% of 14k, a shade under 3k.
    You can also expect governments to increase taxation because there is a deficit in spending and tax income, so I would say any income exposed to tax is a more risky proposition. Say, f’ristance, that by the time you draw your pension NI has been integrated with tax to produce a single basic rate tax level of 32%, you would now eat a hit of 4.5k.

    That’s not to say pensions are a bad thing, particularly since you are paying HRT. But there is something to be said for managing your pension income so it doesn’t stray too far above the tax threshold. You do this by a combination of the total amount you save, and can influence it by drawing your pension earlier (from 55 onwards). I’d be loath to run that ISA income into the ground for that reason.

    • Hi Ermine, welcome and thanks for your great comment around taxable pensions not being as valuable as ISA tax-free income

      You’re 100% right and I will amend my post to highlight that pension income needs not only to be inflation adjusted but also NET as I agree this is critical

      “If I had a pension pot that was big enough to give me the inflation adjusted NET equivalent of £24k after tax from age 60…”

      Thanks again for dropping by Ermine, hope to see you again soon!
      Perry

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