A Guide to Pensions
Could you survive on £5700 a year? That’s the maximum basic state pension. If the answer is no then you need to make your own arrangements.
Why should you consider a pension over other types of investment or savings? Well the main reason is their tax efficiency. In other words pension contributions are paid into your fund before income tax is taken off. So if you are a 40% tax payer and you pay in £1000 into your pension it has effectively cost you £600. Sounds interesting? Well it gets better. If you can pay into your pension via salary sacrifice, it costs even less.
Salary Sacrifice
Salary Sacrifice is a method of paying for something, in this example a pension, before Income Tax or National Insurance is deducted. Using salary sacrifice a 40% tax payer would pay £580 for £1000 worth of pension contribution.
How much should I put into my Pension?
By now I hope you can see that the government have shaped the tax system to encourage you to save for your retirement. So how much should you be saving? In short, as much as you can but circumstances and life plans play a big part in this decision which is where financial planners come in.
As a rough rule of thumb half your current age expressed as a % is the amount of your salary you should be contributing to pension. i.e. if you are 40 years old and your salary is 50K your should be contributing 10K to your pension.
When can I have my money back?
You can’t withdraw your pension when you feel like it and there are some conditions surrounding how you use it. You cannot touch your money until you are at least 55. When you decide to draw your pension you will receive 25% as a tax fee cash lump sum, officially these days known as a pension commencement lump sum.
The remainder has to provide an income for the rest of your life, usually from an annuity.
Why have pensions had such a bad rep?
Pension mis-selling
In 1988 personal pensions were introduced to extend consumer choice. They were supposed to offer a means of saving for retirement for people who couldn’t have a company pension, for example, self-employed people, which included the professions. Unfortunately, too many people were encouraged to move their existing company pensions into the new personal pension schemes.
At the same time, the requirement for employers to provide compulsory pensions for all was removed. The advice to move from a company scheme to a private pension plan was usually not the best option, because of the loss of the employer’s contribution and the often quite opaque charging structures of the original contracts, hence these pensions where said to have been mis-sold.
The consumer was generally left worse off. It is difficult to see, looking back, why so many people did opt out. At the time, people regarded their (typically) 5% employee pension contribution as an expense and did not know how much the employer was contributing for them as well. Today, we might welcome the final salary pension scheme. At the time many were happy to reduce their outgoings by opting out of company pension schemes.
Failed Guarantees
Some of you will recall the high interest rates in the 1970’s and 1980’s, bad news for spenders but good news for savers. This meant that pensions annuity rates were much higher than they are today. A 60 year old in 1984 could expect an annuity to be round about twice as high as a 60 year old today could buy with the same fund value.
Some insurance companies offered guaranteed annuity rates to their customers. At the time, the guarantees were not particularly attractive. The open market rates were high because long-term interest rates where high so people retiring at that time tended not to need to make use of the guarantee. As interest rates fell and we moved into the 1990’s, the annuities became more and more attractive and the insurance companies, most famously Equitable Life, found that they had not set enough aside to service their promises.
Equitable Life has attempted to offer redress but the whole situation has strained pensions in the eyes of the policy holders. Many of the people affected were the solicitors, accountants and doctors who relied on the Equitable Life pensions because they were not able to join a company scheme.
Many other companies including Prudential, Pearl Assurance, Phoenix and many others have offered guarantees and honoured those guarantees. Where we encounter a customer who has a pension with a guarantee, we tend to look very closely before making any changes because criteria for qualifying for the guaranteed rates can sometimes be stringent and it is often worth adhering to the terms of the contract, even if it is not always convenient to do so.
Falling assumptions
If you are considering saving into a pension plan or making any type of long-term savings the first thing you want to know is “what will I get back?” Usually, the simplest answer to that question is “we don’t know”. This is because stock market movements are unpredictable. However, it is fair to say that stock markets have still given the best long-term returns over cash and property.
This answer isn’t very helpful to a new investor so pension quotes always show a range of projected growth figures. When pensions regulation began, the projections showed just two expected growth rates, a lower growth rate of 8% and the higher rate of 11%. Clearly, they were not the worst-case scenario projections. These numbers were not set by the pension companies, but by the regulator at the time. They were based on the fact that equity returns, interest rates and inflation were high and we could not foresee lower rates so It seemed reasonable to assume those projection rates. As the years went by and equity returns began to fall, as did annuity rates and interest rates, the regulator responded by instructing pension companies to use lower growth rate assumptions i.e. 5% and 10%. In addition they introduced a new mid value of 7.5%.
The reduction in the assumed growth rates was a good idea, it clearly was no longer appropriate to tell an investor that it was reasonable to expect gross returns of 11% a year. However, it did upset many investors to see their projections suddenly plummet, this happened again as the regulator responded to further falls in long term interest rates and growth expectations.
In May 2012, the regulator instructed that projections reflect the actual investment fund that an investor really plans to use. This makes sense, after all, It is not realistic to expect a cash fund to work as hard as a worldwide equity fund over a 20 year period. This means that, again, the projected rates fall as a result.
My view, nobody is really getting it wrong here, the regulator is right to adjust assumptions when expectations change. The consumer is right to be unhappy, unhappy about a reduction to their projected pension. Change in projected rates reflects a change in macro economic conditions, not rising costs or any other attempt to reduce pensions. Perhaps the next stage will be an additional assumption with a negative growth rate, so that people can see what could happen if it goes wrong and then make up their own minds.
At Parsonage, we still feel that most people benefit from saving for their retirement.
Is a pension for you?
Pensions are great if want to save to provide a long term income in retirement and you don’t need the money before hand. If this is you the government will give you a 20% boost to your savings to help you along.
