Investing

Simple guide to pensions

20 November 2020 | Posted by Anna Panayi
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What’s it all about?

Pension funds are investments that give you an income when you are looking for a change in lifestyle when you are older.

Why should you care?

Planning now can allow you to have a comfortable future.

The state pension you get from the government is currently set at just £9,000 a year. So planning for your retirement is crucial if you think you’ll need more than that to live on.

What will you learn?

In this pack, you’ll learn about the different types of pension, how they work, and what to consider if you want to get in on the action.


What are pensions?

It’s an investment that gives you an income when you retire. You need to pay into a scheme throughout your working life to get the income when you retire.

The key types are:

State – the income you get from the government when you hit retirement age.
Employer – set up by your employer, also known as a workplace pension.
Personal – you make direct contributions to the fund yourself.
Self Invested Personal Pensions (SIPPs) – a ‘do it yourself’ scheme where you pick your investments.

Like ISAs, pensions are a ‘tax wrapper’. You do not pay tax on pension contributions. The allowance for the tax year 2020/21 is £40,000.

Most UK taxpayers get tax relief on their pension contributions, which means that the government effectively adds money to your pension pot. Basic rate taxpayers get a 25% tax top-up; HMRC adds £25 for every £100 you pay in. For higher tax ratepayers – for every £100 they pay the government adds £66.67.


How do pensions work?

If you are a UK resident and have made National Insurance contributions throughout your life, you should qualify for a state pension. Currently, this is about £9,000 per year for those over 65. State pension age is currently set to rise to 68 for those born after 6th April 1978.

When you invest in a personal pension, a SIPP or if an employer sets up a workplace one for you, your money goes into a fund. As with other types of an investment fund, this is a pool of money invested in stocks, bonds and other assets. The financial goal is to grow the fund before you retire.

When you retire, the size of your pension pot will depend on:

How long you saved for.
The amount you paid into your pension scheme.
How well your investments performed.
How much your employer paid in (for workplace scheme).
What charges your pension provider has taken.

Employer’s pension

If you’re employed, aged 22 or over, and earn at least £10,000 a year, you’ll be automatically enrolled into a workplace pension. Your employer must contribute. Typically, these do not offer much flexibility for employees to choose the provider or portfolio asset allocations.

Personal pensions

Personal pensions are ones you set up yourself. You can choose the provider and portfolio you want. You can set up a personal scheme in addition to your employer’s one, and employers can make contributions to it.

Self-invested personal pensions (SIPPs)

SIPPs give you the most freedom to choose and manage your own investments. You can think of it as a ‘do it yourself’ scheme. They are ideal for more experienced investors who want to manage their fund and switch their investments when they want. The downside is that SIPPs can have higher charges than other personal pensions. You can seek advice and support from an Independent Financial Advisor (IFA). We have friendly clued up IFAs that you can chat to here at Claro.


What to consider

How much you need to save will depend on you and your lifestyle choices.

Quite simply, you should put in as much as possible, as early as possible. The longer and more you contribute towards your fund, the larger the value of the pot when you retire. The value will be made up of your (and where relevant your employer’s) contributions, and the returns generated as your investment grows.

The basic rule of thumb

There is a very rough rule of thumb for what to contribute for a comfortable retirement: take your age at the time you start your pension and divide it by two, then put a % sign after the number. Contribute that percentage of your pre-tax salary to your pension every year until you retire.

For example, if you started contributing to your pension at 35, this works out at putting away 17.5% of your salary for the rest of your working life. If you’re employed, take into account your employer’s contribution to this figure and then make up the rest yourself.

If you are employed, you can opt out of employer’s pensions, but if you give this up, you may be giving up your employer’s contributions too.

Depending on how much control you want over your pension fund, you might want to ask your employer to contribute to your personal scheme.

SIPPs

With investment strategies for your personal and self-invested personal pensions (SIPP), you can pick funds with varying risk levels. Historical data shows that stock and property are the only two asset classes that have grown faster than the rate of inflation. If you have a long time before you retire, you might consider picking funds that have portfolios with a high allocation of these assets – especially stocks. But remember, with higher potential returns comes higher risks. The advantage of having time on your hands is that the longer your pension fund is in the market, the more opportunity it has to ride the ups and downs. People closer to retiring may want to reallocate their asset mix to less risky investments such as bonds.

Tax considerations

Earlier, we discussed that you do not pay tax on your contributions. The flip-side of this is that you will be liable to tax on your pension income when you receive it. With ISAs, it’s the other way round. You pay tax upfront on your income before making your investment contributions, but you won’t pay tax at the other end.

You generally won’t be able to access your pension until you reach a certain age, whereas most ISAs are available if you need them for an emergency.

If you are self-employed, your pension provider should claim tax relief at the basic rate of tax on your behalf and add it to your savings. This is the same for employed people as well. It’s only higher rate taxpayers that need to claim the extra tax relief back.

Ethical considerations

As with other investment funds, there are socially responsible pension funds popping up. The bad news is that often they come with higher fees. The good news is that evidence is building up that shows these types of funds are performing better than other funds in the long term.


Where to get them

You automatically qualify for the state pension when you pay National Insurance.

If you’re employed, your employer will set one up for you.

For personal pensions and SIPPs, you have a variety of options including supermarkets, brokers, platforms and traditional institutions like banks and building societies.

You can also get advice from an independent financial advisor (IFA) or pension advisor.



Key takeaways

That’s a wrap. Here are the key takeaways from this pack.

A pension is an investment that you can’t access until you reach a certain age.
There are state, employer, personal, and self-invested personal pensions (SIPPs).
When you invest in a pension fund you are generally pooling money to invest in stocks, bonds and other assets, to make your money grow.
You get a tax-free allowance each year towards your pension contributions. This is £40,000 for the 2020/21 tax year.
Personal pensions and SIPPs provide the most flexibility for you to choose a provider and portfolio mix that suits your appetite for risk and socially responsible investments.

Remember, as with all investing, your capital is at risk.

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