The most common pension mistake is waiting too long before starting one. This might happen for a number of reasons: you believe you can’t spare the money, or you tell yourself there are many years before you’ll retire, or you simply don’t want to think about getting old.
The truth is, the very best time to start a pension is when you are young. It doesn’t matter if you can afford only very small payments into it at this stage – you can increase your payments later as your income rises, while compound interest means that the extra years invested will give a huge head start over someone who delays.
Why Start a Pension Early?
Consider the example of Adrian and Brian. Adrian starts his pension at the age of 20, investing just £50 a month. Brian waits until he is 40, but invests £100 a month.
Supposing an average interest rate of 4%, when Brian is 60 he will have a pension pot of just over £36,500. Adrian, however, at the same age will have a pension pot of nearly £60,000. Notice that the two men have invested exactly the same amount of money over time – but because of compound interest, Adrian has ended up with nearly twice as much.
However, both pots will actually be even bigger than that – thanks to tax relief.
Compound growth isn’t even the best thing about a pension. What makes them unique is the tax relief they bring. When you make a payment into a pension, the government repays you tax at the highest rate you normally pay – which effectively means you are ‘given’ extra money.
This means that, in the example above, each time Adrian pays £50 into his pension, what actually gets paid in is £62.50. This is because Adrian (a basic rate taxpayer) normally pays tax at 20%, and £62.50 taxed at 20% would be £50. The money arrives in the pension as if it had never been taxed.
When you take tax relief into account, Adrian’s final fund will actually be over £72,800.
(As for Brian, let’s suppose he is a higher rate taxpayer. He pays tax at 40%, so each of his £100 payments becomes around £166. However, even with this advantage, he won’t quite match Adrian, as he will finish with around £60,600.)
Types of pension
All employers must now (or soon) offer a workplace pension by law (see Auto-enrolment below). There are two kinds of workplace pension:
- defined contribution (DC), also known as money purchase schemes
- defined benefit (DB), also known as final salary schemes
DB schemes are increasingly rare, but are good if you can get them as they offer a guaranteed retirement income for life. DC schemes, on the other hand, involve building up a pot of money which you later use to provide a retirement income. Find out more here.
All personal pensions are DC schemes. They fall broadly into two categories: stakeholder pensions and SIPPs (self-invested personal pensions). Click on the links to find out more about these.
The government has made it compulsory for all UK employers to offer workplace pensions to their employees, into which they will be automatically enrolled unless they choose to opt out. Employers also have to make contributions to the scheme, in addition to any that the employee pays in. However, if you are self-employed then you will need to make your own pension arrangements (which you can do anyway if you choose to opt out for any reason). Read more about auto enrolment and workplace pensions here.
If you’re starting a pension, whether through auto-enrolment or not, talking to a financial adviser can make a big difference in the long term. Likewise if your salary changes significantly or your life plans alter, advice can ensure that your pension arrangements remain tailored to your needs.
Questions you might like to ask an independent financial adviser:
- Will I have to pay charges on the pension accounts?
- How often should I review my pension savings?
- What happens if I can’t afford to pay in contributions?
- Under what circumstances might I consider opting out of an auto-enrolment workplace pension scheme?