Making sure you plan for retirement is essential, but how do you know if a pension is really worthwhile? We investigate the pros and cons of a traditional pension as well as some alternative ways to save for retirement.
As the state pension age goes up and the UK population continues to age, if you fail to plan for retirement you face having to work into your 70’s.
Yet with poorly performing investments and other threats to pension funds regularly hitting the headlines you might wonder whether investing in a pension is really worthwhile.
We look at the pros and cons of using a pension to save for later life, as well as some different ways to plan for life in retirement.
What is a pension?
A pension is a savings plan designed to provide you with an income during your retirement. You can split a pension into two stages – work and retirement.
While in work you should aim to increase the value of your pension fund by as much as possible, you can do this through utilising company pension benefits, positive investment decisions and of course contributing as much as you can reasonably afford.
When you are ready to retire you then sell your pension fund to a company in exchange for an optional lump sum and a regular income (called an annuity) to live on in retirement.
Advantages of a traditional pension
The first significant benefit of paying into a pension is the compound profits that your fund will earn over the course of your working life.
This is where the profits you earn on your money, is re-invested and starts earning itself, which is then re-invested again and so on.
Over the course of your working life which could be up to 30-40 years, the benefit of this compound re-investment can be quite substantial.
When you pay into a pension you will usually qualify for tax relief on your contributions.
If you pay into an occupational or public service pension your monthly pension contributions are usually deducted from your gross (pre-tax) wage – meaning you don’t pay any income tax on the money.
If you pay into a personal pension then you can claim the tax relief back from the government – as the money you pay in is from your net (post-tax) salary.
For a basic rate tax payer for every £80 you pay in £100 would end up in your pension pot. At present this benefit is even greater for those who are in higher income tax bracket, although this may change in the near future.
This tax relief is a great help in building up your pension fund prior to retirement and means you are getting more for less while you are working.
When you come to the end of your working life you have the option of purchasing an annuity to guarantee you an income throughout your retired life.
There are several different types of annuities available and they can vary dramatically.
However all of them are designed to provide a weekly or monthly sum for you to live on throughout your retirement.
Another benefit of a traditional pension is that many employers will match your contributions to a certain level as a part of your salary package.
This essentially doubles the funding of your pension and is an easy way to boost the final value of your pension fund.
The disadvantages of investing in a traditional pension
Most pensions lock away your savings until you reach a certain age, usually 55 or higher.
While this means that you can’t be tempted to dip into it to fund a luxury holiday, it also means that if you are really stuck for funds the money is inaccessible.
As your pension is invested into various stocks and shares there is a varying degree of risk associated with each of these investments.
This means that your pension could decrease in value if things go badly and that you actually lose money in the short term on your investment – although in the past investments have tended to outperform cash accounts significantly.
Most pensions employ an investment strategy called lifestyling so that your money is gradually moved from high to low risk as you move closer to retirement age.
The amount of control you have over the level of risk will depend on the sort of pension you have.
You are more likely to be able to specify the level of risk if you hold a personal pension. Company pension schemes are usually all invested on your behalf by a fund manager, although it is still worth checking that this is the case.
However it is worth remembering that a pension is a long term investment and as such the higher rewards associated with shares and investments may outweigh short term losses.
Cost of an annuity
Although an annuity offers a guaranteed income throughout retirement, there is a cost involved – as in theory you could live well beyond your pension fund.
When you take out an annuity you have to pay for the privilege, especially if you want to include a pension for a partner or dependant.
Also, once you have purchased an annuity the pension fund you have built up over your working life is gone. In most cases even if you were to pass away only a few months into drawing your pension all the money from your pension fund will be gone.
Decreasing value of your income
When you take out an annuity you have to decide if you want your monthly payments to track inflation.
If you decide to take out this option your monthly payments will be lower but will in effect remain at the same value in real terms throughout your retirement.
Essentially if you live for a long time or rates of inflation rise dramatically in your retirement then a tracking pension would be a better option otherwise you could receive less. You are in essence paying for protection against these risks.
What are the alternatives?
If you are unsure if paying into a pension is your best option there are some alternative ways to save for retirement that you might want to consider – although some of them are more realistic than others!
1. Invest in Property
Building a property portfolio while you’re working that will then support you when you retire is one alternative to investing in a pension.
There are two main approaches you can take. The first is to gradually move up the property ladder, then downsize to a smaller property when you retire leaving you with a lump sum to live off.
However there are some drawbacks to this plan, property prices, as we’ve seen over the last couple of years can go up as well as down. You will also have to pay interest on the mortgages you hold rather than earning interest on a pension fund.
The second type of property investment is to build up a buy-to let portfolio. This is where you keep your own property and take out a buy-to-let mortgage on a second home.
Hopefully the rent you would earn would cover the cost of the mortgage leaving you essentially with someone else paying the mortgage on the property for you.
There are however again a number of risks to this plan, firstly it assumes that you will always be able to find a suitable tenant who pays the rent on time, secondly as you get older you will either have to sell the property to release the equity or continue to act as a landlord.
2. Use your ISAs
Currently everyone can save up to £10,680 a year tax free in an ISA or Individual Savings Account.
Many view ISA savings as a viable pension alternative and there are defiantly some benefits.
Firstly anything you save into an ISA will be easier to access than if you saved into a pension. This means that if you need to access the money in an emergency it would be easier to do so – of course it may also prove tempting to use the money for other things as well!
Secondly if you opt for ISAs you’ll have complete control over the amount of risk you take as you’ll decide the investments that you want to make.
By saving into an ISA you control the level of risk you take with your money – you can also save up to half your tax allowance in cash to reduce the risk even further, although the gains are likely to be comparatively low over the long term.
Thirdly, saving into an ISA means you won’t get a guaranteed income throughout retirement, instead when the money is gone that’s it. However, unlike with an annuity, if you die any money left in your ISAs is treated as part of your estate and can be passed on to your loved ones. With pension annuities even if you have only spent a year in retirement and therefore would have plenty left in your pension fund the money will be gone.
For many people working in retirement is simply not an option.
However with many of us spending longer in retirement and employability laws becoming more accommodating, taking a second job is often seen as a good way of supplementing your income.
4. State Pension
Perhaps not strictly an alternative to a pension, as you pay into it already through your National Insurance contributions, but the value of your state pension is definitely worth taking into consideration.
While you can’t really rely on the state to fund your retirement in full, you should still make sure to try and maximise your income by fulfilling the necessary contributions required for the full state pension.
The state pension is currently based upon the number of years you’ve paid National Insurance. The full requirement is 30 qualifying years, although years spent as a parent or full time carer can also be counted.
If you have only made 20 years contributions when you reach retirement you will be able to claim 20/30 or 2/3rds of the full pension amount, equally if you have 15 years it will be 15/30 or half the full amount.
Secondly the full state pension age is set to rise to the age of 68 between now and 2046. If you want to check the age at which you can claim a state pension then you can use the DirectGov State Pension age calculator.
Unsure what’s the best option?
Pensions for many of us are a daunting prospect, but regardless of your situation there are experts who can assess your individual situation and advise you on your options.
It’s also worth remembering that there is no reason that you can’t combine all of the above methods to spread your bets, rather than relying on one method to fund your retirement.
If you are considering starting a pension the earlier you start saving the better, as you will get even greater benefit from compound re-investment of your contributions.
If you want some advice regarding your pension or retirement options then speaking to an Independent Financial Advisor or IFA may help.
Remember, whatever your current situation, it’s never too late to start a pension, even if you are in your 60s. If you’d like more information check out our step-by-step guide “I want to save for retirement” at http://www.money.co.uk
By Martin Lane