Why you need to start saving for a pension now
By Ben Salisbury
The life expectancy of people in the UK is changing rapidly. New government figures show that over two million people currently in their 50’s will live to a hundred.
This means that as a nation and as individuals we need to fund a longer period of retirement. This is partly why the government has launched a new simplified pension scheme and why the retirement age is being increased to 66.
As we are living longer and the amount of lucky people who are on final-salary pension schemes declines because companies have stopped operating them, we need to save money ourselves for our pension and the earlier you start the better.
This is because of the effect of compound interest. When you invest money into a pension, you make a return on it each year. In the next year you will also make a return on your original investment and the return you made in the first year and this continues year-after-year until you retire. The earlier you start the more time the compound interest has to work for you.
In this article we will take a look at the elements of the state pension that we can all expect to receive before detailing the best strategy to increase your private pension and then finally looking at the benefits and pitfalls of pension alternatives such as property and ISAs.
State pension
You normally need to have paid National Insurance for at least 30 years before you’re entitled to the full state pension. However, you can make up contributions that you have missed to reach the full 30 years and get a full pension in return. You normally have to make these additional contributions within six years of the period you were not working and paying National Insurance contributions.
The new pension scheme aims to reduce the complexity of the state pension system and guarantee all pensioners a single-tier pension of about £140 a week.
NEST
NEST stands for the National Employment Savings Trust and the basic idea of this new government scheme is to encourage small employers who don’t run a private pension scheme to do so to encourage employees to save privately for their own occupational pension.
Everyone aged between 22 and 65 will make compulsory contributions to a private pension scheme. The scheme will be compulsory unless an employee specifically opts out of the scheme.
Under the new rules, all employers will have to run some sort of pension scheme. It doesn’t have to be NEST; an employer can continue to use the current schemes they operate as long as it meets the government’s requirements. The big bonus for employees is that employers will have to make contributions to their employee’s pension scheme, apart from employers who opt out of the scheme. NEST begins in 2012 for larger companies and by 2017 all employers will have to have registered a pension scheme.
The new pension system: Better but not enough!
The current state pension for a single person is £102.15 a week. The government boost the payout with a new universal pension from 2015/16. It is expected that this pension will be around £155 which is a very healthy rise. However, people who reach retirement age before then will receive the lower rate. Poorer pensioners will then be able to top up the lower figure with various means-tested benefits.
What might happen in the future?
It is not clear if future government s will make further changes to the state pension system but don’t rule it out. Whether you are retiring before or after the new single-tier system is introduced in 2015 that guarantees a payment of £140 a week, (likely to rise to £155 a week from 2015) we should all be prepared to save for ourselves rather than rely on the government.
The deficit in the nations public finances are unlikely to go away in the next twenty years and quite possibly longer so further changes to the pension age and the state contribution to your pension cannot be ruled out.
The younger you start saving the better off you will be
As mentioned earlier the benefits of compound interest means that what you save at a younger age.
For example, if you started saving into a private pension when you are 25 and saved £2,000 a year for 40 years until you reach 65, the £80,000 you have invested will have grown to around £250,000 assuming that the stock market grows by an average of five per cent after inflation. The historical average is seven per cent. The amount of this person’s pension pot would buy an annuity that pays about £12,000 a year with the state pension adding to this annual amount.
On the other hand, if you did not start saving for a private pension until you were 45 and made 20 years’ contributions of £2,000 the total at the end would be about £75,000 for £40,000 worth of contributions and the employee could expect to receive an annuity of close to £5,000 a year. Both of these annuity amounts would be paid until the recipient died.
So, from this example it is clear to see that you get potentially more for your money the earlier you begin to save but if you do leave it until later you can still make a positive difference to your own pension fund.
Read more: How much do you need to fund your retirement?
Match any employer contributions
One of the most important pieces of advice that anyone should take concerning pensions is to always match your employers contributions to ensure they pay the most possible into an occupational pension scheme that you have with them.
Along with the benefits of tax relief on your own and your employer’s contribution this can boost your pension by more than double the amount you are putting into it.
Life expectancy
As mentioned earlier, we are all living longer which means that we have a longer period to fund ourselves in retirement. This is one of the biggest factors that have influenced the changes made by the government to rules regarding pensions.
It seems likely that this trend will continue which mans that we have to fund our own retirement for longer. This means that the government will be paying out a lot more state pension in the future. The money has to come from somewhere. It will come from higher taxes and national insurance or by increasing the deficit.
Do you really have confidence that the state will be able to support you? It makes sense to take care of your own pension provision to the extent that you are able to.
Start a private pension
Because, on average, each persons pension will need to be funded for longer it is likely that the weekly amount could reduce in the future or that the retirement for drawing the state pension will increase then you need to make your own provision unless you want to keep working for longer, possibly up to the age of 70.
Final salary pensions
The amount of companies’ now offering final salary pension schemes has declined as companies realise that they can’t afford to pay pensions at these levels for ex-employees who are living longer.
If you are lucky enough to receive one then breathe a sigh of relief.
Annuities
However you save for your private pension it is likely that you will buy an annuity with the proceeds. An annuity will provide you with an income for life based on the amount you have saved and other factors including your health that influence the amount you will receive each year. The older you are the larger the amount you will receive each year and the healthier you are the less you will receive each year (because the provider expects to pay the annual annuity for longer if you are in good health).
You can buy different types of annuities. A level annuity will pay the same amount each. If you are worried about the effects of inflation you can buy an index-linked annuity which means your annuity will rise as inflation does.
Pension alternatives – Isas and property
Using property to fund your pension has become an increasingly popular alternative as savings and annuity rates have fallen and property values have increased strongly over the last fifteen years.
However, most financial advisers would say that you should not put all your eggs in one basket. It is risky to put all of your assets in one area. Although many people have made a lot of money from buy-to-let investing, it should form part of an overall retirement portfolio and should not replace saving for a private pension entirely.
ISAs
ISAs are a very useful tool for saving and sheltering income from the taxman but the actual tax breaks are not as effective as those available on pensions.
ISAs are more flexible but that can be a disadvantage when saving for retirement income. It is best not to touch this money as you lose the benefits of compound interest so having an inflexible pension that does not allow early access is actually n advantage.
Tax breaks with pensions
When you begin to receive an income from your annuity you will often be given the chance to receive a tax free lump sum, usually of about 25 per cent of the funds value.
Whilst saving into the annuity, you will already have received a tax-break where the government adds twenty per cent to your contributions. This means that if you pay in £160 a month the government will in effect increase this amount to £200 through pension tax relief because your employer takes your pension contributions from your salary before deducting tax on the rest of your earnings.
Use the Myfinances.co.uk comparison tools to find a better deal on a pension or annuity.
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