Perk Up Your Personal Pension

We hear a lot about crises these days. There’s the credit crisis, housing crisis, oil crisis and so on. One crisis that appears to have to have taken a back seat at the moment is the pensions crisis. However, saving for retirement is still a humungous issue, it’s just that it’s been drowned out by short-term concerns.

The cause of the pension crisis is simple. Not that long ago we worked for 40 odd years and saved up for a retirement that lasted for around 10. Now we expect to work for 30 years and be retired for another 30. This means we need to save much, much more in the shorter time we’re working.
The main way we do this is via a pension. As an incentive, the government gives us tax relief on any contributions we make. When we retire, the money we’ve built up is used to buy a regular income for the rest of our lives (which is taxed unfortunately).

Company pensions

We’ve heard a lot about the decline of company pensions. The same basic sums apply here too – it’s just too expensive for employers to fund the types of pensions we enjoyed in the past. Some of these schemes, known as final salary pensions, still exist though particularly in the public sector. Here you pay a little and your employer pays in a lot more. When you retire you get a pension based on your length of service and final salary. If you’ve got one of these schemes hang on to it for dear life. It’s the most valuable perk you can get.

There is a second type of company pension scheme called a money purchase scheme. Here you and your company pay contributions into an investment scheme. Your pension will depend on how much these investments grow by the time you retire. You take the final sum and use it to buy an annuity which will pay you an income for life. These types of pensions are usually less valuable because employers put less money in money purchase schemes than they do final salary schemes.

As a general rule, if your company has a pension scheme that your employer puts money into on your behalf, it is nearly always worth joining.

Personal pensions

A personal pension is essentially the same as a money purchase scheme, but without any contributions from your employer.

There are essentially two things you need to decide with regards to a personal pension. The first is how much money to put in. The second is what to invest it in.

To understand the first point you need to have a basic understanding about annuities. As we mentioned previously, annuities provide you with an income for life. Although they are much maligned, the importance of the “for life” bit shouldn’t be underestimated. Insurance companies essentially bear the risk that some of us will live longer, using money from people that die earlier than expected.

Annuity rates are lower for women as they live longer. You can also get annuities that increase each year in line with inflation and ones that will pay a proportion of your pension to your partner if you die before them. You can also get higher annuity rates if you smoke or your health is impaired. You can shop around for an annuity just like you can for any financial product – you don’t need to get it from your pension provider. Rates can vary quite significantly and a difference of 20% or even more is not unheard of.

So say you want an annual pension income of £20,000. How much will you need to achieve this? A standard annuity rate for a 65 year old man, increasing in line with inflation and with a 50% pension for his wife after he dies, is around 4.3%. Make sure you’re sitting down and you have a stiff drink within reach before reading on.

A pension income of £20,000 therefore requires a pension pot just north of £450,000. It’s a shocking amount to most people but remember we are talking about replacing your salary for around 30 years. It needs to be a substantial sum. You can also see why company pensions are considered such a valuable perk.

Start early

All is not lost though. It is possible to build up a pension pot of this level. The key is starting early. The longer you have until retirement, the more chance your contributions have to grow in size. Someone contributing £100 a month for 40 years should build up a similar size pot to someone paying £300 a month for 20 years. Even if you can only manage a small amount to start with you can increase the amount you pay as a proportion of your salary each year.

The government adds tax relief to any amount you pay into a personal pension. Basic rate tax is now 20% so for each £100 you pay in, the government tops this up to £125. If you’re a higher rate taxpayer you’ll get additional tax relief either through your tax return or by an amended PAYE code.

There’s a limit to this tax relief. For the 2008/09 tax year, it’s the lower of 100% of your salary and £235,000. Usually neither of these is a problem for most people! There is also a lifetime allowance, currently £1.65m, of the final amount in your pension pot. Any amounts above this level get hit with a higher rate of tax when you withdraw a pension. Again, not a problem for the vast majority of us!

Even if you’re a non-taxpayer the government will still top-up your pension with tax relief. You can put in up to £2,880 which the government will top up to £3,600. If you’re particularly flush with cash then this relief can be used to start a pension for your children. The extra 20 years or so these contributions will have to grow can make this very worthwhile, although you probably won’t be around when your children benefit from it!

What sort of funds?

Having decided how much to put into your pension you need to decide where the money should go. It’s hard to be specific here so here are some general pointers.

Low-cost funds such as index trackers tend to do better than most types of investment funds.

Typically you want to be paying less than 1% a year in charges. Additionally, the longer you have until you retire, the more aggressive you can be with your choices. So you many want to look at emerging market funds rather than corporate bonds.

Also don’t be dazzled by funds that have performed spectacularly well in the last couple of years. They are quite likely to crash back down to earth again.

Finally, make sure you monitor how you’re investments are performing. You can then use this pension calculator to see if you’re still on track to get the pension income you think you’ll need and increase your contributions if necessary.