By Nathan Barnett, Editor at Finance.co.uk. Last updated 11th April 2023.
Planning for retirement is often the very last thing on your mind when you’re younger, because it feels like such a long way off and you’re understandably focused on your current financial situation.
The thing is, you’re actually never too young to start planning for your retirement. Working out how you’re going to afford to pay for all your bills once you’ve reached an age you can no longer work is pretty crucial.
Pensions are complicated beasts, but don’t worry; we’re here to help you break them down and understand all the complex jargon so you can start saving for your future self. (We promise you’ll thank yourself for it!)
Pensions are a way for you to put money aside for your retirement, so when you stop working you can still live comfortably and enjoy the stage of your life when you no longer have to worry about earning money.
When you retire and stop working, even if you’ve paid off your mortgage, and your kids have all grown up and moved out, you’re still going to need to pay for things like food, petrol, energy bills, water bills, broadband and council tax.
Currently pensioners do get financial support with some bills in the UK, but how much isn’t guaranteed by the time you’re ready to retire, so it’s best to assume any support you’re going to be entitled to may be minimal.
There are several types of pensions, from workplace pensions to SIPPs and each has its own pros and cons.
Your employer will provide some types of pensions, whilst others you’ll need to take out and contribute to yourself.
Pensions are a great way to make sure you retire comfortably, but to get the most out of your pension it’s a good idea to contribute to them regularly over a long period. This way, you’ll have enough money to retire, without noticing a big change to your financial circumstances or the life you’ve become used to.
The bottom line is - the earlier you start contributing towards a pension, the better.
Pensions can seem pretty complicated, so we’re going to explain the different types as simply as we can.
There are two main types of pensions:
Defined contribution pensions can also be called “money purchase” pension schemes where the money contributed is put into a “pot” and invested on your behalf by the pension provider.
The amount you get when you reach retirement age will depend on:
Defined contribution pensions can be either:
With workplace defined contribution pensions both you and your employer contribute to your pension pot. The amount you contribute is taken directly from your wages.
By law, all employers must offer a workplace pension and automatically enrol you if you’re eligible. Even if you’re not eligible for automatic enrolment, you can still request to join the workplace pension scheme; and your employer can’t refuse.
You can use the Gov.uk website to learn about automatic enrolment, check the rules surrounding workplace pensions, and find out what your employer can and cannot do.
Private pensions (or personal pensions) are pensions you can arrange directly with a pension provider, without going through your employer, meaning you choose how much and how often you contribute.
You could decide to set up regular contributions if you have a steady income, or, you could simply make contributions whenever you have excess income.
These are personal pensions where you’re responsible for managing the investments yourself.
With a SIPP, you decide exactly where your money is invested and can choose what portions of your total pot go into each investment. SIPPs can be a good choice for experienced investors or those with larger pension pots.
SIPPs can potentially provide higher returns than regular personal pensions, depending on how you choose to invest, but they can also bring higher risk.
These types of pensions are typically workplace pensions and can be either final salary or career average pensions. These pensions are most common with large employers and the public sector.
Defined benefit pensions pay a fixed amount annually when you retire, which normally increase with inflation. The amount you get will depend on how long you worked at the company before you retired and either:
With defined benefit pensions, your employer contributes to the scheme and is responsible for ensuring there’s enough in the pot to pay your pension when you retire.
Some defined benefit schemes will also require you to make contributions, and it’s common for these pensions to continue to pay out to your spouse when you die.
You can learn more about how defined benefit pensions are calculated on the Money Helper website.
The state pension is a regular payment from the government given when you reach the state pension age. The age you qualify for a state pension varies, depending on when you were born and your gender.
The amount of state pension you’ll be entitled to will depend on your national insurance contributions; this includes contributions you make by paying national insurance and contributions credited to you when you were unemployed, ill or a parent or carer.
To claim any state pension, you will need to have paid national insurance for a minimum of 10 years, and to be able to claim the full state pension; you will need to pay at least 35 years of national insurance.
The full state pension is currently £185.15 per week. If you don’t qualify for the full state pension, you may be able to make voluntary contributions to make up missing years.
It’s worth noting that this is specifically the case for men born after the 5th of April 1951 and women born after the 5th of April 1953.
You can find out how much state pension you qualify for, how it’s calculated or what your state pension age is on the Gov.uk website.
Pension contributions are tax-free, but only up to certain limits - including contributions to workplace and private pensions and some overseas pension schemes. Pension schemes must be registered with HMRC to qualify for tax-free contributions.
The limits for tax-free contributions are:
If you have a workplace pension, your pension contributions will normally be taken before your income tax is deducted. If you’re contributing to a private pension, your provider will claim 20% as tax relief and add the money to your pension pot; this is called relief at source.
You may be able to claim additional tax relief if you pay above the 20% tax rate and your provider claims the first 20% or your pension scheme isn’t set up for the automatic tax relief.
When you start receiving your pension, you will pay income tax if the total amount you recieve over a year exceeds the personal allowance. The standard personal allowance for the current tax year (6 April 2023 to 5 April 2024) is £12,570. Below is a guide to the different tax rates for different annual incomes:
Remember, you only pay the higher amount of tax on anything above the lower limit, so if you had £58,000 annual income, you wouldn’t pay any tax on the first £12,750. You would then pay 20% tax on anything up to £50,270, and 40% on the additional £7,730.
When you reach retirement age, your taxable income could consist of:
You will also be able to take 25% of any pension as a tax-free lump sum, without it affecting your personal allowance. When you can take this lump sum will depend on the specific rules set out by your pension provider, but you normally have to be at least 55.
Ideally, when entering retirement, you will have a decent pension and some savings.
Having savings in your retirement is a good idea to help cover any unexpected expenses or to help you enjoy your retirement.
However, having a pension is vital because pensions are invested to offset inflation. If you were only to put money aside in a savings account, inflation would mean that your money is worth less in the future. The interest paid by savings accounts today won’t offset inflation.
The best way to understand this is to use the price of everyday items ten years ago compared to now. For example; the average price of 4 pints of milk rose by 33% between July 2010 and October 2021. No savings accounts currently offer anywhere close to that sort of percentage rate.
Another benefit of pensions is the tax relief on pension contributions; if you’re paying into a private pension, your pension provider will claim 20% tax back from the government, so if you pay £80 into a pension, there would be £100 in your pension pot.
Another reason pensions are useful is because you can’t just take money out of them to buy something you fancy; most pensions will have a minimum age you can withdraw the money, normally around 55. This forces you to put the money towards your retirement, and means you won’t be tempted to use it.
If you have a workplace pension, your employer will also make contributions, meaning your pension pot will be bigger too.
If you have a workplace pension, you’ll leave that scheme when you leave your job. The money you’ve built up is still yours, and you can either keep the pension where it is, or transfer it to another pension scheme.
If you’ve been a member of a defined benefit pension scheme for over two years, you’ll still be entitled to the guaranteed income you’ve built up when you retire.With defined contribution pensions, you can choose to keep the money you’ve built up invested where it is or move it to another pension, such as your new workplace pension.
This can help you keep track of your pensions.
It’s common for people who’ve worked for many different companies to not keep track of their workplace pensions, so it’s a good idea to transfer your pensions with you when you change jobs. If you haven’t done that, don’t worry - there are services available that can track them down and combine your pensions for a fee.
How much money you need you need to retire depends on your individual circumstances.
It’s common to assume you’ll need your pension income to match your current salary, but typically your outgoings will decrease significantly in retirement.
Ideally you’ll stop working once you’ve paid off your mortgage, your children have left home and you’re no longer dependent on your income.
However, this isn’t the case for everyone, and if you think you’ll still have the same level of outgoings by the time you stop working, you’ll want to get your pension income as close to your current salary as possible.
There’s no magic figure you should have saved by retirement, although some experts suggest you should have 10 x your current salary in your pension pot.So for example, if you currently earn £38,000 per annum, you should aim to have £380,000 set aside with a combination of pensions and savings by the time you retire.
Everyone’s financial situation is different though and you should consider what your outgoings are likely to be in retirement, and importantly, what sort of lifestyle you’d like to have too when deciding how much to save for retirement.
For a fee, you can speak with an independent financial adviser, who specialises in pensions for further advice on how to save for retirement.
The information provided does not constitute financial advice, it’s always important to do your own research to ensure a financial product is right for your circumstances. If you’re unsure you should contact an independent financial advisor.