Charges and not taking enough risk can massively dent your long-term savings.
Seismic shifts have taken place in the pensions world in recent years - and there may be more to come. Generous employer pension schemes have all but disappeared, and new freedoms brought in by the government this year aim to offer savers autonomy over their pension pot after the age of 55.
But pensions are still not a priority for many people, and coming up with a long-term saving strategy can be difficult. Following these five simple principles should help you build a decent pot – and make the most of it.
At the Summer Budget, the chancellor made the sober declaration that “Britain isn’t saving enough”. Perhaps surprisingly, it is middle income earners, not necessarily the very low paid, who are undersaving the most, says Tom McPhail, head of pensions research at Hargreaves Lansdown.
Indeed, many are unclear about exactly how much they will need to enjoy a reasonable standard of living in retirement. For example, you may think that £290,000 sounds like enough for a sufficient retirement. But this has been classed as “serious under-saving” by some in the industry. Scottish Widows has found that a pot of this size would provide an income of around £12,000 a year – when most undersavers expect it to give them over £25,000 annually.
So how much should you be saving? Naturally, this depends on your expected lifestyle, when you’re seeking to retire, and whether you have other assets you can rely on (like your house), but the figure of 12 to 15 per cent of your current salary is often bandied about by experts. It also depends on how early you start saving.
A 25 year old earning £70,000 a year could save £735 a month (12.6 per cent of gross income) and amass a pot of £998,000 by the age of 68, assuming that their investments grow by 5 per cent annually, according to Adrian Lowcock at Axa Wealth. This would buy them an annuity of roughly £48,000 a year. By comparison, if the same person waits until they’re 35 before they start saving, they would need to put away £1,365 a month (19.5 per cent of gross income, if they earn £70,000) to amass roughly the same amount. The savings you will need to make will rise more steeply the longer you leave it.
Labyrinthine though pensions tax may be, the substantial tax benefits mean it pays to know the facts. Pensions tax relief is essentially deferred tax, designed to encourage long-term saving. You receive tax relief on contributions at your current rate of income tax (20 per cent for basic rate taxpayers, 40 per cent for higher rate, and 45 per cent for top rate), but you pay income tax on whatever you withdraw from your pot after the age of 55 (whether via an annuity or otherwise). You are also entitled to take a 25 per cent lump sum completely tax free.
But the rules around tax relief are also changing for higher earners. Each year, anyone contributing into a pension is given an annual allowance (currently £40,000), which limits the total amount of tax relief they are eligible for in a single year. But if you earn more than £150,000 a year, that allowance is falling. For every £1 you earn above £150,000, the tax free allowance drops by 50p up to £210,000. Those earning this upper figure or more may set aside only £10,000 without incurring tax charges.
Special rules this year mean higher earners can save even more tax-free.
This does make pensions relatively less attractive for higher earners, but remember that any investments held in your pot will still be exempt from tax on the income and capital gains generated. Also, new rules mean that some people will be able to pass on their pension pot free of inheritance tax.
THE £1M LIMIT
But the changes don’t end there. From 6 April 2016, those with very large amounts of money in their pensions could face punitive tax charges if their total pension savings exceed the £1m mark. This threshold, known as the lifetime allowance (LTA), currently stands at £1.25m, and Hargreaves Lansdown estimates that 460,000 savers could be caught out when it is lowered.
If you are in danger of exceeding the new £1m limit, you have a number of options. The government is rumoured to be coming up with a list of exemptions to this £1m limit – which many pensions experts think is punitive and too low. Look into applying for exemption once the government publishes exact details. And if you’re over 55, you should also consider “crystallising” your benefits. “This involves releasing tax-free cash and putting the remainder in drawdown,” explains Richard Parkin, head of retirement at Fidelity Worldwide Investment. Drawdown is one alternative to buying an annuity. With drawdown, your pension manager starts exiting each investment one by one and handing you the money as income. That means the range of investments in your portfolio becomes smaller, so there can be more risk involved.
KNOW YOUR CHARGES
Charges can make a huge difference to the value of your pension pot over time. A 2 per cent annual charge may not sound like much, but according to Nutmeg, a portfolio of £500,000 charged at 2.4 per cent a year would be worth £843,624 after 20 years, assuming a 5 per cent annual return. The same amount, charged at 0.53 per cent, would grow to £1,178,463.
“Fees and charges are not uniform throughout the industry and can vary wildly,” says Nutmeg chief executive Nick Hungerford. Most providers will take an annual management fee for your investments, and may charge for other services on top, such as set-up costs, trading costs, commission and transfer charges, he says. “These charges often won’t be explained to you until you have a need for the service, and they may not be itemised on a statement, so it’s not always easy to know exactly how much you’re being charged.”
The money you pay a pensions provider or investment platform is not the end of it. The funds you hold in your portfolio will also have charges that can vary widely. “Actively managed equity funds which require the close supervision of a fund manager will naturally be more expensive than a passively managed fund,” says Jeremy Wake of Stafford House Investments. Also watch out for exit charges, which are imposed if you switch out of a pension.
TAKING RISKS CAN PAY OFF
If you are investing your pension pot yourself, be mindful of the mix of assets you’re holding at any one time. Failing to embrace risk could stunt your pot’s growth early on, but too much later in life and you could seriously deplete your investments.
If you’re at the beginning of your career, you should consider a higher risk portfolio, which focuses on equities, commercial property and alternative assets. “These tend to be higher risk,” explains Joo Hee Lee at Fidelity Solutions, “but offer higher potential rewards”. Such assets will be subject to more market volatility but if your investment horizon is long, any losses incurred should be ironed out over the years, to give you strong growth and more to play with.
However, as you grow older, you may want to preserve capital and explore lower risk assets like bonds, cash or maybe derivatives which allow you to alter the amount of risk exposed to an investment fund.