How to improve your pension IQ
If you’re as puzzled by pensions as the Bank of England’s chief economist, then you need our guide on…
INTELLIGENT workers who are good with money and have long saved into a pension do not necessarily have a high ‘retirement IQ’ – despite an aptitude for handling money well. That is the verdict from experts who here try to explain the nuts and bolts of a pension to those with little confidence.
TOO many workers on the cusp of making decisions about their lifetime savings are lost in a quagmire of jargon, rules and reforms.
More than two thirds of people over the age of 55 don’t fully understand pension freedoms introduced last spring, according to Birmingham-based Wesleyan, which provides specialist financial advice to professional groups like doctors and teachers.
The majority do not know the main components of a pension, despite saving into one.
Investment management company Old Mutual Wealth says a quarter of people in the 50 to 55 age bracket admit to having a limited understanding of how pensions work.
They are in good company, because even the Bank of England’s chief economist Andy Haldane admits to being stumped and says he cannot make the ‘remotest sense’ of his retirement savings.
Jonathan Watts-Lay, of Wealth at Work, which provides financial education in the workplace, says: ‘People make some mad decisions using funny maths when they get to retirement.
‘These are perfectly intelligent people, but they lose sense of the right thing to do. Since it is the biggest financial decision they will make in their lives, other than property, it is remarkable people pay so little attention to it.’
Most have been busy enjoying life and leaving savings to accumulate in the background. But for those ready to face their financial future, here are key features of a pension you need to know.
Pension types
THERE are two main types – defined contribution or defined benefit. More than nine million workers have the former. Money is contributed, tax relief added and the pot grows over time. The final size of the pot depends on the performance of funds your money was invested in, minus charges.
Millions of workers have a pension arranged by their employer – with more joining the fold since the introduction of auto-enrolment.
Employers too can add to the pot. But personal, stakeholder and self-invested personal pensions arranged separately from your job also come under the defined contribution umbrella.
Around 7.6million employees have a defined benefit pension – sometimes called a final salary or career average pension – which is a guaranteed income from your employer in retirement.
That annual sum is based on a specific calculation, taking into account length of service in that job, contributions to the pot, and ‘pensionable earnings’ – either average earnings during employment or the wage you receive at the end.
There may be nuances that make your pension different – special clauses, guarantees, benefits, penalties and perhaps the extra complexity of an additional voluntary contribution scheme – which is why reading through the rules and seeking advice is crucial.
Pensions cannot be taken until at least the age of 55; for some it might be later. It may be possible to withdraw from one earlier because of poor health. You can also take money while you are still working.
Pot size
IT IS easy to lose track of how much has been saved and into which pension pot after decades of work and numerous different employers. WattsLay says: ‘Everyone should get a pension statement from each of their providers every year. Get those statements out and add them together for a rough idea of how much you have overall.’
Contact your provider for the most up-to-date figures. And if you know you have an old pension from previous employment but have lost the information, use the Pension Tracing Service by calling 0345 6002537, visiting gov.uk/ find-pension-contact-details or writing to The Pension Service 9, Mail Handling Site A, Wolverhampton, WV98 1LU.
Tax applies
COMMONLY people believe that a pension can be fully cashed in without penalty. Julia White, of Wesleyan, says: ‘Few people understand how pensions are taxed.’
While you are saving into one, it is tax-free. When you come to take money out, only a quarter of all combined pension savings is tax-free. The remaining 75 per cent is taxable, just as if it were income from employment.
Tax-friendly Individual Savings Accounts work the opposite way around. Money saved into one receives no tax relief, but once withdrawn does not count as taxable income.
White says she recently met one client who took financial advice too late, having withdrawn so much from his pension that nearly half of it was given away to the taxman. She adds: ‘The worst thing is that he didn’t really need the money, but thought he had to do something with his pension.
‘People often think that when they receive information from their provider they need to make a choice straightaway. But generally speaking, only take the money when you need it. Doing nothing is an option.
‘People might retire but still do a bit of work. If they take large sums from their pension as well, they could pay up to 45 per cent tax even if they don’t need the money.’
Watts-Lay adds: ‘Some people
take their tax-free cash because they are told they can and then simply invest it. But that is taking money out of a tax-free environment and putting it into a taxable one. That only makes sense if you need to pay off debt.’
Passing on a pension
RULES governing how savings are bestowed to family after death have improved for keepers of defined contribution pensions.
Jon Greer, pensions technical manager at wealth manager Old Mutual Wealth, says: ‘If you die before age 75 your pension savings can be passed down free from tax.
‘If you have bought an annuity, in many cases it will stop paying out income when you die – unless you selected a specific type of annuity that continues to pay out to a beneficiary on death.’
If you die after 75, the relative receiving the money pays tax on it at their marginal rate of income tax, which for basic-rate taxpayers is 20 per cent. Defined benefit pensions may still pay an income to a spouse or child but it depends on the individual scheme’s terms.
The funding gap
YEAR after year research by pension providers and advisers shows a ‘funding gap’ for pre-retirees. This is the difference between the level of income they expect to receive in retirement, and how much they have saved overall.
The average income for those retiring in 2016 is expected to be about £17,700 a year, including the state pension, according to Prudential but often people expect far more.
White says you should aim to have enough in your pension to provide an income that is between 50 and 75 per cent of current net income.
So if you are earning £50,000 after tax, aim for a pension pot that covers annual pay of at least £25,000. As a rough estimate you would need £450,000 to meet that goal. If you want your income to rise in line with inflation it would cost far more.
When it comes to how much people should save each year, experts say a rule of thumb is to put away half the age you start saving as a percentage of salary. So a 40-year-old should aim to save 20 per cent of salary a year.
To get a full picture of whether current saving patterns will help you to accomplish future life goals, try the interactive forecasting tool MyFuture, from the Seven Investment Management app 7IMagine. It can be downloaded on to phones and tablets from Apple’s App Store or Google Play.
Pension freedoms
CHANGES introduced last year mean there is more choice and flexibility about how to take your pension. Previously rules were restrictive and choice was limited.
There are five main options for people with defined contribution pensions.
The first option is to do nothing. If you are still working or do not need the money then you can leave your pension untouched.
The second is to cash it in as and when you need it – 25 per cent is taxfree, the rest will be taxed at your marginal rate of tax.
State pension benefits and other earned income will be taken into consideration, which could push you into a higher tax bracket if you withdraw a large chunk or all of it.
Everyone can take £11,000 this year free of income tax. Anything between that personal allowance and £43,000 is taxed at 20 per cent. The next band is up to £150,000, with a rate of 40 per cent and anything over that 45 per cent.
The third option is to take some cash and leave the rest invested. For example, taking the 25 per cent taxfree ‘lump sum’, and drawing on the remainder as needed in future. This is verbosely referred to as ‘flexi-access drawdown’.
The fourth is to buy a guaranteed income for life – an annuity – sold by insurers. Those in ill health can get a better deal through an enhanced annuity.
A fifth choice is to mix the options above. For example, you might want to cash in one pension pot to pay off debt, partly withdraw on another while leaving some invested, and use some of the money to buy an annuity.