Independent surveys show that most people think that the state pension will not provide them with enough money to retire, and recognise that they need to generate additional income.
The traditional way to do this is through a pension plan. However, surveys show that a large minority distrust the pension industry and find the subject confusing, complicated and boring. As earnings are squeezed it becomes increasingly difficult for workers to find the resources to save for their future at the expense of their present living standards.
So what are the arguments for a pensions plan and are there alternatives to them - other than lowering expectations in retirement or simply working longer?
Pension pluses
Workplace pensions give the clearest benefits because:
- They include contributions from the employer. By 2018 all employers must offer staff a pension and contribute at least 3% of their salary though most contribute more.
- All pension contributions attract tax relief. Basic rate taxpayers get £100 for every £80 they put in - more if they pay at the higher rate. Quite high limits are placed on the extent of this tax relief - these limits apply to contributions made towards a pension in a tax year, and to the value of the pension pot as measured at the point of retirement.
- Public sector pension schemes offer a guaranteed, index linked, retirement income linked to salary, benefits for dependents and safeguards for death in service.
- There is an option to take a tax free lump sum payment.
- Many schemes offer the chance to take benefits at 55.
By 2018 all employees will be automatically enrolled into their scheme and contribute 4% of their salary. Those not wishing to take part can opt out.
Pension plans for the self-employed are always defined contribution schemes. Contributions are invested over time to build up a pot of money which is then used to provide an income. There is no employer contribution but tax relief and a lump sum are available.
Pension minuses
So what’s the downside?
- Money is locked away. A pension scheme is designed to be long term and schemes don’t allow access to funds until at least 55.
- Charges can be high. Most schemes charge a management fee. Steps have been taken to place a legal cap on the amount of money that can be charged and to ensure that only members who actively choose how their pension is managed can be subjected to higher charges.
- You don’t know what you will get. It’s true of all defined contribution schemes though less so in defined benefit schemes. But it’s true of all long term investments which depend on market variation.
- You have no input into the scheme. That’s generally true of defined benefit schemes though you can add extra years if you were late into the scheme. Most people think it’s worth the returns you get in such schemes. Most non-occupational schemes allow you to vary your contribution and some to manage your own investments.
- Annuity rates are poor. Annuity rates have been falling for the past 15 years but the changes which come into effect in 2015 mean that people have more choice about how they use their pot. They can take the whole pot as cash to spend/invest as they please, use drawdown to take an income whilst still maintaining a capital sum or still take an annuity.
What are the alternatives?
Two main alternatives have emerged:
- Property investment has seen good returns over the last forty years. Buying a second property, equity release and downsizing to release capital have all been used to provide retirement income. Each have their downside – capital gains, mortgage and other interest costs, disruption etc. Property is also subject to both market, regional and regulatory change over time.
- ISAs (including the new Lifetime ISA) are a tax efficient saving scheme. They provide a range of risk options and can offer guaranteed returns with easy access to the funds. Put together they can provide an income like the draw down option. Minus points are that there is a maximum you can invest, you don’t get tax relief and they need active management.
It’s rarely a mistake to join an occupational scheme and with a generous employer contribution, members are expected to get out much more than they put in.
Defined contribution schemes now offer a significant tax incentive for long term savings, a guaranteed minimum contribution from the employer and almost complete freedom to spend or invest the results. Public sector employees, who opt out of their defined benefit scheme, turn down the equivalent of an extra 20% of their salary through the employer’s contribution.
Personal pensions are trickier because there is so much choice and variation. A poorly chosen scheme with risky investments and high charges will give a poor return so get independent advice before deciding.