During my working life, I’ve noticed that most of the people I’ve met have little understanding of early retirement or pensions and how they work. There’s no financial education in schools, and when the majority of people get a prospectus when they are asked to join a pension, they do not understand it or it’s implications.
I remember a conversation I had once with a work colleague. He was shocked when I told him that he did not have full access to his pension pot when he retired, but instead had to buy an annuity. (Thankfully, this is no longer the case due to pension reforms in the U.K).
The number of people contributing to private pensions in the U.K has actually increased from 43% in 2010 to 53% in 2018. This is likely due to the introduction of auto enrolment in 2012. This was where it became mandatory for a company to enrol you in a pension scheme to encourage saving. However, you still have the option to ‘opt out’ of the pension if you want to.
This was a breakthrough moment as it effectively forces people to save. Pension schemes have always been available, but when I first started working in the 90’s, most pension schemes had a ‘qualifying period’ before you could join the scheme. This was often several years, so for people who changed jobs fairly regularly or went travelling like me, we never had the chance to join a company scheme to save for an early retirement.
You are therefore in a very beneficial position if you have joined the workforce since 2012 as you now have the opportunity to save into a company pension which I never had when I started working.
If you put money into a savings account, you get back that same money later with a small amount of interest added. However, when you contribute to a workplace pension, you contribute a percentage of your salary, plus the employer contributes also. This is free money.
If you are 22 or over and earning £10,000 or more you will be automatically enrolled. From 6th April 2019 the employers minimum contribution increased to 3%. Under auto enrolment rules the minimum total contribution must be 8%, so your contribution would be 5% of salary. However, some employers will contribute more and even match higher contributions by you. For example, if you contribute 10%, they will contribute 10% as well.
Additionally, contributions into a pension are tax-free, so the government gives tax relief at your current tax band. This is more free money. If you are a basic rate tax payer this is an additional 20%, 40% for higher rate and 45% for the highest rate.
You contribute £100 per month into a pension. The company matches this and contributes a further £100. The government then gives you tax relief at 20% on your contributions adding a further £20. So in total you get a £220 pension contribution from a £100 personal contribution, which is a 120% return. Compare that to the best high rate savings account in the U.K which is paying 1.3% and its simply a no brainer.
As you can see, your money is starting to grow quickly, and the sooner you start the more beneficial it will be. Additionally, the incredible power of compound interest will also accelerate your path to early retirement.
Also, on average the stock market has given great returns that are far beyond what you can get from standard savings accounts or bonds. You need to be aware though that investing in the stock market carries risk and that markets can go up or down. The FTSE 100 index has returned an annualised average of 7.55% between 1984-2019. With the power of compounding the returns have been even greater.
If you had invested £10,000 into the FTSE in 1986 but withdrawn the dividends as cash you would currently have £53,394. Conversely, if you had reinvested your dividends, through the power of compounding you would have £195,852. The S&P 500 index in the U.S has over the last 90 years returned 9.8% on average.
Types of pension
- Defined benefit (DB).
- Defined contribution (DC)
Defined Benefit is a type of pension where an employer guarantees the employee an income which is based on a blend of the employees length of service, career earnings and age irrespective of stock market investment returns. It is most often calculated based on the employee’s final salary and average earnings over a certain amount of years. Contributions can either be solely by the employer, or a blend of employer/employee.
This is the best type of pension for early retirement as the overall payout is significantly higher than a (DC) pension and the fulfilment risk is taken by the employer. In the U.K there has been a major shift over the years away from DB pensions to DC pensions due to their higher cost for employers and the decline in interest rates to historically low levels. It is therefore now increasingly rare to have the opportunity to join a DB scheme.
Defined Contribution is a type of pension where the employer does not guarantee a certain income. Instead, the overall return of the employee/employer contributions to the pension are dependant on the performance of the investments that they are put into. This is most commonly the stock market where there is the risk that the investments can go up or down.
You need to be aware of this potential risk. In 2009 during the financial crisis the FTSE 100 dropped by 31%. People who retired at that time who had DC pensions and had to buy an annuity, would have seen their retirement income severely affected.
Changes to U.K pensions
In the budget of 2014 the chancellor made landmark changes to U.K pension regulations which meant that people were no longer forced to buy an annuity. An annuity is a product provided by an insurance company, where in exchange for your pension pot of money, they provide you with a regular income for the duration of your life. This typically used to be worth around 6% or 7% of your pots value annually, but has dropped in recent years due to low interest rates.
From 2015 and aged 55 or over, it’s now possible to access your pension in a more flexible way. This enables you to access your entire cash pot allowing as little or as much cash as you like at any time. You no longer have to wait until your are 65 or over to access your funds for early retirement like before.
How much can you pay into a pension?
There is no limit on the amount that taxpayers can put into a pension each year but there are caps on how much you can pay in tax free. You can pay in up to 100% of your salary or the annual allowance of £40,000 for the tax year 2020/2021, minimizing the amount of income tax that you will pay. However, your combined employer contributions, personal contributions and government tax relief can not exceed the £40,000 limit.
You may have the option under some conditions to carry forward up to 3 years unused allowances amounting to £120,000 in addition to your current yearly allowance. If you are approaching retirement and working full time it is therefore beneficial to save as much as possible into your pension, rather than taking it as wages.
There is also a lifetime total pension allowance of £1,073,100 in the current tax year. Anything paid into a pension beyond this amount will be subject to excess tax of 25% if taken as a pension or 55% if taken as a cash lump sum plus income tax at your current rate.
How can I withdraw my pension?
At age 55 plus you are able to begin withdrawing from your pension for early retirement. 25% can be taken as a tax-free lump sum, with the remaining 75% being charged at your standard tax rate. The tax- free lump sum does not use up your annual individual personal allowance, which is currently £12,500 per year. You can also choose to leave your pot invested and continue to grow, which means that you will pay no tax until you decide to start withdrawing.
There are 2 options of how to take your 25% tax-free amount, but if you do decide to take it, you can’t leave the remaining 75% invested.
You have to either:
- buy a guaranteed income (an annuity).
- get a adjustable income (flexi-access drawdown).
- take the entire pot as cash.
You have a pension pot of £240,000. You decide to take £60,000 cash as your 25% tax-free lump sum. You buy an annuity with the remaining 75% which provides you with an income of £8000 a year. This portion of your pension will be taxed at your standard rate.
Using the drawdown method you take small regular small cash chunks from your pot. If your pot is worth £240,000 and you take £1000 per month, £250 is tax-free and the remaining £750 is subject to tax at your standard rate.
If you decide to take all of your pot as cash, 25% will be tax free, but the remaining 75% will be subject to tax on the full amount. As this will be a large sum of money, you will be hitting the progressive 40% and 45% full rate of tax. Therefore, it is definitely not beneficial as you would be throwing £10,000’s and possibly £100,000’s away depending upon the size of your pot.
- When you save into a company pension, your employer also contributes plus you receive tax relief from the government. This means your savings grow more than if you were contributing alone to a private pension helping you to early retirement.
- Pensions can either be Defined Contribution (DC) or Defined Benefit (DB).
- You can contribute either the minimum or up to 100% of salary or a maximum of £40,000 per year.
- You have full access to your cash lump sum at age 55 and can access the money in a variety of ways.
Disclaimer : I am not a financial advisor. Do your own due diligence and seek the advice of a financial professional before making any financial decisions with your money.