If you haven’t yet started saving into a pension, you might be wondering whether it is truly worth it. After all, you are putting money away for decades that you could just spend today. You may also think that it’s too early to start saving, and that you will start in a few years’ time. The thing is, it is never too early to get started. If you leave it too long you may be missing out on thousands of pounds each year during retirement. This article explains 8 different reasons why you need to start saving into a pension now, even if you are only 18 years old.
⇒ Compound growth
Imagine if you invest a small amount of money into a pension at the age of 18. After the first year, your investments would have generated some returns (hopefully). The original money remains invested, and so are the returns. This means that the following year, you generate returns on the initial investment, and on the returns from the first year. Over time, this cycle where your returns are reinvested means that your pension pot will snowball in such a way that even a small amount of money can grow very large.
According to the FT Adviser, if you had invested £5,000 into the FTSE All Share in 1986, and withdrawn any returns, then the value of your investments would have grown to £28,357 by the end of 2016. With compound growth, however, where the returns are reinvested, the value of your investments would have grown to £88,396 over the same time period.
Compound growth is perhaps the most important reason why starting a pension early is much better than leaving it too late. If for example you start at the age of 18 and retire at 65, you get 47 years of the snowballing effect, as opposed to just 35 years if you start aged 30. That’s an extra 12 years of growth using returns from all the previous years of saving. Just imagine how valuable your pension pot would be by the time you retire, if you started saving at the age of 18!
⇒ The earlier you start, the less you have to save
The general rule of thumb is that the age you start saving into a pension, half your age, and save that percentage of your pre-tax income each year until you retire. This means that if you start at the age of 18, you only have to save 9 per cent of your pre-tax income each year, compared to 20 per cent if you start at the age of 40 for example.
Whilst this is a lot from an early age, this will also include employer contributions (if you receive them) and tax relief, so the actual amount that you have to pay is less than 9 or 20 per cent in the above examples. Still, it is vital that you start early and save small so that you do not have to play catch-up later in life.
In addition, if you start saving when you get your first job, you will be used to having slightly less income to spend. If however you have worked for 15 years where you spent 100 per cent of your salary, it will be much more difficult to adjust to having less disposable income when you do start saving. This may require drastic cost-cutting measures if you want to be able to fund your retirement.
Please note that this ‘half your age’ rule is not necessarily what is best for you. It makes a number of assumptions and can be heavily influenced by several variables. How much you need to save each year is highly dependent on your desired standard of living during retirement. For a more personalised calculation of how much you should be saving, please click here.
⇒ Workplace pensions are like getting a pay rise
If you have a defined contribution pension scheme, your employer is required to make contributions to your pension pot every time you do. The exact amount that they give you varies between employer, however most simply match your contributions. This means that if you save 5 per cent of your salary into a pension for example, your employer will also add the same amount. Technically, by saving into a workplace pension you are receiving a 5 per cent pay rise, which you will benefit from during retirement (along with all its compound growth between now and then).
If you do not save into a workplace pension, you are missing out on free money from your employer. This can amount to tens or even hundreds of thousands of pounds by the time you retire. Start as early as possible to maximise the benefits you receive.
Automatic enrolment means that all workers aged 22 or above have a small proportion of their salary automatically put aside into a workplace pension, unless they opt out. If you are under the age of 22 and have a job, you will not be automatically enrolled, but it is important that you still opt in to your company’s workplace pension schemes so that you do not miss out on the benefits.
The government has revealed plans to lower the minimum automatic enrolment age to 18, however this will not take effect until the mid-2020s, and therefore will not benefit anyone who is currently 18. If you want to start saving into a workplace pension and you are under the age of 22, you will need to opt in manually until this rule is put in place.
In addition, automatic enrolment only makes you contribute the minimum required proportion of your salary, which is currently 2 per cent of pre-tax earnings (0.8 per cent from the worker, 1 per cent from the employer, and 0.2 per cent from the government in the form of tax relief). This will rise to 5 per cent in April 2018, made up of 2.4 per cent from the worker, 2 per cent from the employer, and 0.6 per cent from the government. If a workplace pension is your only way of saving for retirement, it may be worth increasing the proportion you contribute so that you can reach your desired retirement goals.
Unfortunately, automatic enrolment does not apply to self-employed workers. If you are self-employed, you may not be entitled to the benefits of employer contributions, however you will need to check with your employer first. In this case, it may be better to save into a private pension instead.
⇒ Pensions help you pay less tax
Whenever you save money into a pension pot, you receive tax relief on your contributions. You get back the tax you pay on any contributions, and this is added to your pension pot. Basic rate taxpayers receive 20 per cent tax relief, higher rate taxpayers receive 40 per cent, and additional rate taxpayers receive 45 per cent.
This means that to save £100 into a pension for example, you do not actually have to contribute £100 of your own disposable income. If you are a basic rate tax payer, you only have to pay £80 as the government will pay the other £20. For more information on tax relief, please click here.
Tax relief is essentially free money from the government, and so it is important that you do not waste this benefit by not saving into a pension. The earlier you start saving, the more tax relief you will get over your lifetime, which can amount to tens of thousands of pounds by the time you retire.
There are however limits to the amount which you can contribute to your pension pot each year and still receive tax relief. The annual limit for any person is £40,000. Any contributions exceeding this will not be tax-free. If you earn less than £40,000, the earnings limit applies. You cannot contribute more than 100 per cent of your salary and still receive tax relief. This is for if you have a salary of £30,000 for example, and £50,000 in non-pension savings, and you would like to transfer it all into a pension instead. In this situation, it would be better to transfer it over a few years to maximise your tax relief.
Finally, everyone has a lifetime limit of £1,000,000, however this is increasing to £1,030,000 in April 2018.
⇒ The state pension is not enough to rely on
There is no universal figure for how much money you need during retirement, however most people aim for an annual income of approximately two thirds of their pre-retirement earnings. For the average UK worker on £25,000, this means a target of about £17,000 per year during retirement.
The new state pension, which applies to anyone who retires after April 2016, pays a maximum of £159.55 per week. Per year, this amounts to roughly £8,300.
Clearly, the amount received from the maximum state pension is still far below the target retirement income even for the average UK worker. In fact, the UK has the worst state pensions out of any country in the OECD, being beaten by countries such as Mexico.
Unless you want to see a severe fall in your standard of living during retirement, you simply cannot rely on the state pension. It is absolutely vital that you have your own ways of preparing for retirement, for example through a workplace or individual pension.
In addition, the age which you can retire and receive a state pension is much later than if you had a private pension. The state pension age is currently 65 for men and 63 for women; with a private pension, you can retire at 55. The state pension age is also being pushed back further and further, so by the time most of us retire, it will likely be in the 70s. Click here to use the official government calculator to determine what your state pension age might be.
⇒ When you retire, you are entitled to a huge lump of tax-free cash
This is known as your Pension Commencement Lump Sum (PCLS). When you retire, you are allowed to take up to 25 per cent of the value of your pension pot as a lump sum of tax-free cash. This is completely optional, and the money can be used on anything you choose.
If for example you have a pension pot of £400,000, you will be allowed to take £100,000 tax-free.
The advantage of this is that you can use it to pay off a mortgage, or get rid of any outstanding debts, allowing you to be much more financially free during retirement. You will still have the remaining 75 per cent of your pot which can be used to buy an annuity, or to take income drawdown.
It is however vital that you do not waste your PCLS. Careful planning is required so that your funds do not ‘run dry’ during retirement. Having lots of cash in the short term does not mean you should splash out on a luxury car or go on lots of holidays, as it needs to last you the rest of your life.
⇒ Be financially secure and practise financial discipline
With a pension, your money is locked away from you until at least the age of 55. This is a great way of ensuring you do not ‘waste’ the money during your working years, as you simply do not have access to it. If you have a defined contribution workplace pension for example, your contributions are taken away from your salary before you get paid. This removes any temptation to spend the money before it can be saved.
Whilst you are working, you know that the money you do have left over you can spend on whatever you want, as you are already building up a pot that will ensure you are financially secure during old age.
Pensions are a great way of practising financial discipline and preparing for retirement at the same time.
⇒ Pensions are generally safe, and if you die, the money can be passed on
Pensions in the UK are generally considered to be quite safe. There are always risks involved, however there are a number of measures which can be taken to protect your savings. These measures vary with the type of pension.
If you have a defined benefit pension scheme for example, and your employer goes bust, you will be left with no retirement income. To counter this problem, the government set up the Pension Protection Fund (PPF) to protect individuals in such situations. Click here to read more about the PPF.
This is just one example, and there are many different types of protection available. These can be very complex and so it is important that you check with your provider what specific protection you receive (or would receive if you are about to start a pension).
In addition, if you die when you still have money in your pension pot, it can be passed on to your beneficiaries. Your money does not disappear or all go to the government as some people might think. If you are below the age of 75 when you die, it can be inherited tax-free. If you are over the age of 75, the money will however be subject to taxation. Click here to read more about what happens to your money when you die.