Everyone likes to dream about what they might do in retirement – perhaps move to a sunnier country, take up new hobbies, or start a renovation project.
Making sure your finances are in order is the less exciting part of scoping out your later years, but without careful planning it could mean the day you finally leave work could never arrive.
Here, we explain everything you need to know about your pension – what types there are, how to improve them, and which one might be the best for you.
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How do pensions and annuities work?
A private pension is a way of saving money to provide you with income in old age, when you are no longer working. Most workers have a private pension thanks to a system known as “auto-enrolment”, which was introduced in 2012. It means that businesses are legally obliged to offer a pension saving scheme to their staff, and enrol them unless they actively opt out.
There are two main types of private pensions. These are “defined contribution” and “defined benefit”.
These days the most common is a defined contribution pension. In this scheme, your money is invested over the course of your working life, and the value of your portfolio will fluctuate according to stock and bond market moves.
Defined benefit pensions, sometimes known as “final salary” pensions, were once the mainstay of Britain’s retirement income but are now very rare outside the public sector. They promise an income in retirement, regardless of stock market moves. All the risk is borne by your former employer, or the Pension Protection Fund, if it has gone bust.
Self-employed workers often opt for a “Sipp”. This is a self-invested personal pension, which allows you to choose how to invest your savings.
Is it worth setting up a private pension?
A workplace pension is one of the most efficient ways you can invest your money. It allows you to invest in a range of stocks and bonds, and in most cases is managed by professionals so you don’t have a huge amount of control over the investment performance, although you can often pick which funds your money goes into.
Private pensions also offer generous tax relief on contributions at your “marginal” or highest income tax rate, which significantly increases the value of your pot. Plus, any investment returns within a pension fund are free of income tax and free of capital gains tax.
You will also benefit from employers paying into your pot. Current rules dictate that employers must contribute at least 3pc of your salary, and in many cases your workplace will match your own contribution. This means that the cash in your pension could effectively double, growth further with income tax relief (which is claimed on your behalf) even before you enjoy any investment gains.
There is one more tax-free element – you can take a quarter of your pension completely tax-free once you hit the “normal minimum pension age”. This is currently set at 55, but is scheduled to increase to 57 by 2028, and could then soon after rise to 58 to follow any further state pension age increase.
The best private pension schemes
Most people do not choose their pension provider, as they automatically join the scheme that their employer has already chosen. Some of the largest are Fidelity, Legal & General, Now: Pensions, Nest, Aviva, and The People’s Pension.
If you do not make an active decision about where your money is invested, your pension will be invested in a “default” fund. The returns your savings achieve will vary according to your age, as the professional investor managing your funds will generally take more risk with your money if you are younger.
This could mean higher returns when the market is doing well, but much lower returns when it is going through a downturn. If you are unhappy with the way your pension is performing, you can opt out of your workplace pension and opt for a “Self invested personal pension” of Sipp instead, but this might mean that you miss out on contributions from your employer.
While the “auto-enrolment” revolution has meant millions more are saving for a pension, the self-employed are excluded. Those self-employed workers who do save, generally use a personal pension or Sipp, and while they do not have the luxury of an employer contribution, the money they pay into this account still benefits from government tax relief.
One of the cheapest Sipp providers is Vanguard, with a holding fee of just 0.15pc, capped at £375 a year for accounts worth more than £250,000.
Flat fees are most advantageous for people with large portfolios. Interactive Investor has one of the best offers, as it charges a flat rate of £12.99 per month for its Pension Builder plan, or you can add a Sipp to an existing Isa or trading account on its Investor (£9.99) or Super Investor plan (£19.99) for an extra £10 a month.
Should you consolidate your pension pots?
People move jobs much more often than they used to, which means they collect a lot of pension pots along the way. This means there is a greater risk of losing track of funds.
More than 2.8 million pension pots are considered lost, an increase of 75pc on 2018 figures, according to October data from the Pensions Policy Institute, with the value of those missing pots estimated at £26.6bn.
How your pension can save you tax
Pensions are so popular partly because they can be an extremely tax-efficient way to save money. For example, paying into your partner’s pension – or having them pay into yours – is a little trick that can help you cut your collective tax bill.
But things can be a bit tricky if you split up, particularly if you’re not married – read our guide here for pensions savings for couples.
When you start drawing down from your pension pot, the income you take from it is also taxable. But there are ways to reduce this too.
When should you draw down your cash?
Retirement is lasting longer than ever – the average life expectancy in Britain is currently around 81 years, so a pension taken at 55 would have to last for more than a quarter of a century.
Choosing how and when to access your savings could make a huge difference to your quality of life in retirement – it can be tempting to cash in as soon as possible – especially if you’re planning a project, like improving your home, or you want to help your grandchildren onto the property ladder. But planning carefully is the best policy.
There are a large range of options, from ad-hoc withdrawals to an annuity, or claiming 25pc as a lump sum free from tax.
How can you make your pension last?
Making sure you have enough to enjoy a carefree retirement requires diligent saving throughout your working life – including during times when there are pressures on household finances, such as when you start a family or move house.
But how much should you take from your pension when you’re ready to retire? The general rule of thumb is that a safe level of withdrawal is 4pc. But if your investments fall, you might need to change your approach.