Sorting your pension can seem incredibly daunting and all-too-easy to push to the bottom of the to-do list. And let’s face it: who wants to think about getting older? But it’s not nearly as complicated as you might think – and the sooner you start, the easier it will be.
Your future self will thank you for taking a little time now to get your retirement savings on track. Plus, there’s no feeling like seeing your pension pot grow – and knowing your future is sorted. Here’s our introduction to pensions to help you take control.
What is a pension?
The idea is actually pretty straightforward. Most people don’t want to work forever, so you need to save throughout your working life to build up enough money for later life.
Perhaps it’s better to think of it as a future fund. Building it up now gives you more choice further down the line. You could quit work sooner (or gradually reduce your hours), have more money to travel, help your family and generally enjoy yourself. And the sooner you start, the younger you’ll be able to do that.
Pensions have been around for about a century. They used to be funded primarily by the government and (later on) by employers when life expectancy was lower and therefore people’s retirements were relatively short. Thanks to medical progress, most people are now living longer. But that also means your retirement could last many years, and there is only so much the state and businesses can pay in.
Today, the state pension is only a small part of most people’s retirement income and private employers contribute much less to workplace pensions (though some public-sector workers can still get a generous deal).
That means most of us will have to pay more into our pension pot if we want to enjoy a long and happy retirement. But actually, if you start soon – even with small amounts – it isn’t difficult to build up your pot.
How does a pension work?
Pensions have several different features, that combined make them a no-brainer for saving for retirement.
1. You receive tax relief from the government.
Tax relief is probably the biggest advantage of a pension – it is basically free money from the government. The tax you would normally pay on income is waived if you pay this cash into your pension. If you’re a basic rate taxpayer it only costs you £80 to add £100 to your pension, or only £60 for higher rate taxpayers and £55 if you’re a top rate taxpayer.
2. It’s invested for the long-term through funds.
Pension contributions are pooled into big collective funds with other people’s pensions. These funds are then invested in assets (an asset is simply something that can be converted to cash) that are expected to increase in value over time. These assets could be shares in companies, known as equities, or government or corporate bonds, which are a kind of IOU to investors who lend the money to companies or to the government.
Due to their size, pension funds end up having a massive stake in the economy. They can use their power as major shareholders to make sure companies are well-run, sustainable and profitable.
While investing is riskier than saving, it’s unlikely you would be able to save enough for your retirement with cash alone. By putting money into a pension you are investing over the long term, which gives you the time to ride out the market ups and downs. Generally the longer you invest, the more likely it is that you’ll have positive returns, though there’s no guarantee that will always be the case.
The chart shows return on the FTSE All World and the Bank of England base rate from 2008 to 2018. £1,000 invested in 2008 would have been worth £2,384 ten years later. Remember, past performance is not a reliable guide to future performance.
3. Your pension is super-charged by compound interest.
When you save money, you typically earn some interest on it. If you leave it untouched, that interest will itself earn interest. This is known as the miracle of compounding. When you leave your returns to compound over time, your money can grow exponentially all by itself. And happily, the same applies to your pension – with even more incredible results. (See our guide on Compound Interest).
Remember, the earlier you start, the more time your money has to benefit from compounding. As an example, if you were to invest £10,000 aged 40 and benefited from an average return of 7%, you’ll have £41,406 when you’re 60. Start ten years earlier at 30 and you’ll have £81,451 when you’re 60 – almost twice as much.
Remember, past performance is not a reliable guide to future performance.
4. If you’re a full-time employee, you get an employer contribution into your workplace pension.
Auto-enrolment rules have forced employers to contribute to employee’s pensions which is a bit like a free pay rise. Your contributions into a workplace pension are taken directly from your pay.
5. Pensions are protected by the Financial Services Compensation Scheme.
Generally speaking, like with cash savings, your pension is covered by the Financial Services Compensation Scheme for up to £85,000 per eligible person, per firm. With pensions, you usually invest in funds via a platform or broker (like Moneybox) so if the company was declared bankrupt, your money would still be held separately by the underlying fund or bank and would be safe. Do remember though, the FSCS doesn’t cover you if your investment performs badly.
How do pension fees work?
You will need to pay charges while you’re investing – and the level of these could REALLY affect how much is eventually left in your pot.
Fees on workplace pensions are capped at 0.75 per cent. For other kinds of pension, costs differ from provider to provider. The most common are:
- An annual management charge or platform fee – usually a single percentage charge, which falls as your fund gets bigger;
- A fund management fee – fixed service charges, which cover things like setting up the plan, annual administration, income withdrawals and buying funds
- Transaction fees – sometimes you’ll pay a fee for buying and selling investments.
- Exit fees – some providers will charge to move your pension to another provider.
The level of fees can depend on what funds you invest in. Active funds tend to be more expensive because they involve managers making personal calls about where to invest. Passive funds (often known as tracker or index funds) are usually cheaper because they are invested to closely track indices, such as the FTSE 100.
Costs often drop once your pot reaches a certain level (such as £100,000). So, usually it will be cheaper to have everything in one big pot than pay for a clutch of smaller ones.
Over time, costs can take an amazingly large slice off your future fund without you even realising. So, make sure you aren’t paying over the odds on any of your pension plans.