Steady saving from an early age is key to pension potency
Paying into a pension pot is a good habit to cultivate. But with complex pension rules in place and plenty of different pension plans on offer, understanding what's what can significantly affect your pension income in retirement.
It certainly pays to take charge of your pension destiny. Lengthening lifespans mean we need to make our pension savings last across more years of retirement.
The government is increasing the full state pension to around £155 a week in April 2016, but this is still less than most people would be content to live on.
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government top ups
'The earlier you start saving into a pension the better,' says Tom McPhail, head of pensions research at Hargreaves Lansdown. 'When it comes to building a decent pension pot, the most significant factors are how long you've saved and how much you've saved.'
There is an even stronger case for saving when you consider that the government tops up any pension contributions you make at the rate of 20 per cent for basic-rate taxpayers, so a £100 contribution only costs you £80.
Higher-rate taxpayers do even better, with tax relief at their top rate of tax, so a 40 per cent taxpayer pays only £60 for a £100 contribution.
Knowing how much you need to save can help shape your plans properly. As a rough rule of thumb, to get a pension income equivalent to half your salary, you need to put away a percentage of your salary equivalent to at least half your age.
'This rule gets more ragged once you get into your late 40s, so I'd recommend using a pension calculator for more accurate figures,' says McPhail. These calculators can be found on pension provider websites or on the Money Advice Service site.
However, there are limits on the amount you can pay into a pension. Each year you are allowed to pay in up to 100 per cent of your earnings and receive tax relief on the total contributions (including those from your employer). These contributions are capped at £40,000 annually, with a lifetime limit of £1.25 million.
The rules allow you to carry forward an unused portion of your annual allowance. Jason Witcombe, a certified financial planner at Evolve Financial Planning, explains: 'You can carry forward any unused annual allowance from the three previous tax years, providing you have sufficient income to cover this.
'This could allow you to pay in up to £190,000 this year, depending on your previous contributions.'
At the other end of the scale, even if you have no income, you can make a gross pension contribution of up to £3,600 a year. This equates to a payment from you of £2,880 topped up by £720 in tax relief from the government.
Once you've decided how much you can afford to pay into a pension, you need to find a suitable pension plan. Robert Forbes, a chartered financial planner at Plutus Wealth Management, suggests looking to your employer first.
'Automatic enrolment means all companies will eventually have to offer eligible employees access to a pension and make contributions to it on their behalf,' he says. 'There is a minimum employer contribution, but some have been more generous.'
Currently, the minimum contribution level is set at 2 per cent of earnings of between £5,772 and £41,865, split between your contribution (0.8 per cent), your employer's (1 per cent) and tax relief (0.2 per cent).
By October 2018 this will increase to 8 per cent of your earnings, of which 4 per cent is paid in by you and 3 per cent by your employer.
Automatic enrolment is still being rolled out, so some smaller companies will not have a scheme in place yet, but every employer is expected to offer a compliant scheme by 2018.
It's important to note that, as long as an employer meets the contribution rules, it doesn't matter what type of pension is offered.
'It is worth sticking with your employer's scheme to take advantage of its contributions, but if you want extra investment options or you're not happy with the charges, you could set up a separate scheme and ask your employer to pay into it,' says Forbes.
He adds that this is more common with smaller schemes, where employers have greater flexibility with regard to the rules.
If you decide to sidestep your employer's scheme or you are one of the 4.5 million self-employed people without access to an auto-enrolment scheme, you will still find personal pension schemes to suit your needs.
There are two main types of pension you might consider when you're starting out: personal pensions and stakeholder pensions. These operate in exactly the same way, although stakeholders are designed to be simple and must meet minimum standards on charges, contributions, transfers and investments.
You can take out one of these pensions alongside your workplace scheme, providing you don't exceed the annual contribution limit across the two. This might be worth considering if your employer's scheme doesn't offer enough investment choice.
However, Forbes warns against focusing too much on these aspects of pension saving. He says: 'It's really about getting money into your pension, so don't consider anything else until you've taken advantage of the maximum contribution from your employer.
Many will match your contribution in some way, so make sure you are not forfeiting cash for the sake of a fancier pension.'
As your retirement savings grow, your pension approach is likely to change, and you might want to consider a self-invested personal pension or Sipp. A Sipp offers you much more control over your investments, so they are best suited to more experienced investors.
Sipps give you access to a broad range of investments, including funds, shares, bonds, deposit accounts and even commercial property in some cases.
'If you just want to throw money at a pension, don't bother with a Sipp,' says McPhail. 'But if you want extra choice and control, they're worth considering. Many sit on platforms alongside Isas and other investments, which can make them very convenient.'
Low-cost Sipps can have very keen pricing structures. Hargreaves Lansdown's Sipp, for example, has no set-up charge but levies an annual management charge (capped at £200) based on a percentage of your investment. It also imposes dealing charges for share, exchange traded fund and similar investments.
Flat fees are common with Sipps. For example, the Sipp from our sister website Interactive Investor costs £80 plus VAT a year, plus four quarterly £20 charges that each include two free trades.
Your ability to pile cash into your pension will be the biggest determinant of its value, but it still pays to spend time looking after your pension.
McPhail recommends a review every year or so. 'Make sure you're paying in as much as you can and check the performance of your pension investments, rebalancing your portfolio where necessary,' he suggests.
As you change jobs you may find yourself accumulating several pension pots. It can be tempting to just leave these as they are when you move on, but pension management is easier and safer if you keep all your pension savings together.
Thousands of people have lost touch with their pensions, although they may be able to find them again through the government's Pension Tracing Service.
Witcombe says: 'It's much easier to manage just one or two pensions. You'll have a better overview of your investments, and it will be easier to see how your retirement plans are shaping up.'
Start early to secure a solid pension pot
Retirement can seem a long way off and you may feel you have more pressing things to do with your cash than build a pension, but it's worth starting your contributions as early as possible.
The longer you leave your money invested the more you'll benefit from compound interest. Compounding means your savings snowball, with growth building up on growth, transforming a small initial contribution into a useful pot.
Delaying entails losing out in two important ways. You miss out on tax relief from the government and you forego the employer contribution offered with most workplace schemes - including auto-enrolment plans. Missing out on these contributions and compound growth on savings can severely restrict your pension pot.
For example, research by actuarial and consultancy firm Barnett Waddingham found that a 25-year-old with a £25,000 salary and access to a generous workplace pension scheme (5 per cent employee contribution, 10 per cent employer contribution) could lose out on £97,900 of employer contributions, tax relief and investment returns, as well as 15 years of their own contributions, if they delay joining until they are 40.
The delay would effectively halve their pension pot at age 70 from a generous £1.27 million to £600,000. The annuity they could buy at that point would fall in value from £86,000 to £41,000.