A workplace pension is a way of saving for your retirement that’s arranged by your employer. There are two main types of employer pension: defined contribution pensions or defined benefit pensions. Many employers provide defined contribution pensions where the pension pot is based on how much is paid in. Defined benefit schemes are usually based on your salary and how long you’ve worked for your employer. This article will focus on defined contribution pensions as these tend to be the more popular workplace pensions nowadays.
When you contribute money into your workplace pension, this contribution is usually paid pre-tax, meaning you have not been taxed on this amount and so a larger amount is invested than if you had invested the equivalent post-tax into something other than a pension, eg, an ISA. As the intention for pensions is to enable you to save for your retirement, in order to achieve this tax benefit, you are restricted from withdrawing from your pension before the age of 55. In 2028 this age will increase to 57.
With most pensions, you are entitled to 25% tax free and the remaining 75% will be subject to income tax. This may sound like it mostly counteracts the benefits of being paid pre-tax in the first place but by the miracle of compounding returns (if you earn a return on your investment, then next year’s return factors in the original investment plus the previous returns… return on returns!) over time this can be extremely attractive, especially when you start investing early. Of course, it’s always important to bear in mind that the value of your investment can also fall.
Auto-enrolment began in 2012 in order to ensure that saving for retirement was the status quo. So, any business that has employees must not only automatically enrol any eligible employees into a pension but also contribute into that pension on their behalf. The minimum contribution is 8% of your pensionable salary, split between yourself and your employer.
Your employer must contribute a minimum of 3% of this but many employers will contribute more, and some will match your own contribution up to a certain level. If the latter is the case, it is certainly worth considering making the maximum contribution that your employer will match as this is the closest thing to free money that you are going to come across. It’s worth remembering that any pension money you have may affect your entitlement to certain State benefits, so it is recommended that you seek professional advice before making any pension decision.
Your pension investment
If you have a workplace pension, you have an investment. No stocks and shares market expertise is needed from the individual, and there will ordinarily be a default pension option into which you will have been enrolled. Usually, this will have been designed with the average saver in mind in that it either will be something of average investment risk, or a strategy that starts at a higher level of risk and reduces to a lower risk as you approach what your company has as your retirement age (often this is 65).
If you want to know more about your pension investment and possibly even change it to something more closely aligned to your personal circumstances, it can often be done through an online portal or through contacting your pension administrator, who manages your pension on behalf of you and your employer. If you do not feel comfortable or equipped to make decisions around your investments you can also seek professional guidance. There are free government resources such as the Pensions Advisory Service, or your work may have free pension guidance arranged. An independent financial adviser can also provide advice based on your entire financial circumstances.
How much to save into a pension?
We all know we should be putting money aside for the future. When attempting to work out just how much we should be setting aside each month it can be useful to start with an understanding how your savings can grow. Let us look at an example:
- You earn £50,000 a year
- You and your employer both contribute 4% of your pre-tax salary to your pension,
- This grows at 3% a year (after costs and inflation) until you retire at age 60.
The below table shows the size of your investment pot at 60, having started contributing at a range of ages:
|Reduction in monthly take home pay*||Start age 30||Start age 40||Start age 50|
These figures are only indicative and returns will be dependent upon how the fund grows.*Accounts for basic rate income tax of 20% and national insurance contributions of 12%.
We mentioned earlier that 75% of your pension was taxed on withdrawal. Looking at our 5% contribution example starting at 30, assuming you withdraw your pension within basic rate tax (currently of 20%), this would result in a net amount of £212,500 (and higher with judicious use of your annual personal allowance). Compare this with 30 years of additional take-home pay of £142, which amounts to £51,000, the magic of tax-free compound returns achieved from investing in a work-place pension becomes apparent.
Naturally, these generous pension benefits come with restrictions. We have already mentioned the restriction on accessing your pension, currently until age 55 but due to increase to 57. There are also two limitations on the amount you can put into your pension without tax penalties. At a high level these are:
- Annual allowance – currently you can contribute the lower of £40,000 gross and 100% earnings per year, with this amount potentially reducing if you earn over £240,000. There is potential to carry forward unused allowance from the previous three tax years.
- Lifetime allowance – the total of all your pensions can currently grow up to £1,073,100 without incurring a penalty.
The details around these are complex and if you are concerned about breaching either, please do seek advice.
There are several key points to take away from this on workplace pensions:
- Auto-enrolment in a workplace pension and employer contributions can be very beneficial.
- The earlier you start contributing, the better it can be for you.
- If you can afford to, consider contributing the maximum your employer will match.
- A small reduction in your take home income can go a long way when saving through a pension.
- You assess what you are invested in and get some guidance on changing your investments if necessary.
- Pensions are effective for tax-efficient retirement saving butyou are restricted from accessing your funds until 55+.
- The value of your investments can fall as well as rise.
If you need further guidance around the benefits of workplace pensions, or any other aspect of your financial planning, please get in touch. This article has been written based on current government and tax legislation which is subject to change.
This article is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable but is not guaranteed.
Past performance is not indicative of future results and the value of investments can fall as well as rise. No representation is made that the stated results will be replicated.