The pros and cons of a pension
Not everyone thinks a pension is the best way to save for retirement. Here, we run through some of the pros and cons.
I think it’s safe to say that retirement is a long way off for me. However, that doesn’t mean I shouldn’t be thinking about it. And yet, I would say that it’s only over the past couple of years that I’ve really started to give it some serious consideration.
The problem is, if you don’t think about it early enough, you could find yourself working until you’ve got one foot in the grave, or simply end up retiring in poverty.
Here at lovemoney.com, we’ve always been big fans of investing in a pension scheme as a method of saving for retirement. However, this isn’t everyone’s cup of tea. So here, I’m going to run through some of the major advantages of a pension, as well as the disadvantages.
1. Tax relief
The first major benefit of a pension is the fact that you can enjoy tax relief on your contributions. If you’re paying into an occupational or public services pension scheme, your employer usually takes your pension contributions from your salary before deducting tax. (Note that this does not include National Insurance contributions.)
You then only pay tax on the remainder of your salary – so you won’t have paid tax on your pension contribution.
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Meanwhile, if you’re paying into a personal pension, you pay Income Tax on your earnings before you make your pension contribution. However, the pension provider then claims this tax back from the government. So if you’re a basic taxpayer at 20%, for every £80 you pay into your pension, £100 will go into your pension pot. So this really is a massive benefit!
If you’re a higher rate tax payer, you can claim the difference through your tax return or by phoning or writing to your tax office. And if you’re an additional rate taxpayer you will have to claim the difference through your tax return.
2. Compound interest
Another advantage is compound interest. The earlier you start investing in a pension, the more you will benefit from this.
In a nutshell, when you invest money in a pension, you make a return on it. In the following year, you’ll make a return on both your original sum as well as your first year return. In the third year, you’ll make a return on your original investment plus two years of returns – and this continues until you reach retirement age. So you’ll be earning gains on previous gains – helping you to build up a decent-sized pension pot!
The earlier you start, the more time you have for compound interest to work in your favour!
What’s more, because you benefit from tax relief on these investments, the savings you will make will be higher than if you were to simply put your money in an ISA, for example. Although when you withdraw money from an ISA it is tax free, the contributions you make towards your ISA come out of your net income. You can find out more about this in Pensions vs. ISAs: The best way to save.
(That said, when you come to withdraw money from a pension, you can only withdraw 25% as a tax-free lump sum - the remainder is taxable.)
3. Employer contributions
If you are lucky enough, your employer will match your pension contributions each month up to a certain level. So this means double the amount of money will be going into your pension each month, and ultimately you’ll have an even bigger pension pot to enjoy at the end of it.
4. Guaranteed income at the end
Once you come to retire, you can choose to buy an annuity which will provide you with a regular income. Annuities can be adapted to provide an income that is fixed, increases in line with inflation or increases by a fixed percentage each year. Find out more in How to buy the right annuity.
Of course, you don’t have to buy an annuity. If you prefer, you can draw an income from your pension fund while it remains invested in the stock market. This means your pension can continue to grow (potentially).
1. Lack of access
The major disadvantage of pensions for many people is that they can’t be accessed until you retire - and certainly not before you reach the age of 55.
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For this reason, many people prefer to rely on ISA investments for their retirement because that way you can access your money whenever you want (unless your particular ISA has access restrictions of course).
That said, The Government is consulting on opening up early access to pensions.
2. Risk of poor returns
Given that your pension will be invested into stocks and shares, there will be a fair bit of risk involved. Of course, if your pension investments do perform terribly for a while, the good news is that if you’re still far off retirement, there’s plenty of time for those investments to bounce back.
What’s more, you’ll be able to acquire more shares for your money in a falling market. So this may work to your advantage.
However, if you are approaching retirement and your pension scheme is performing badly, it can be extremely worrying. That said, most pension schemes use ‘lifestyling’ – a process where your pension money is automatically moved out of shares and into a lower risk investment such as fixed interest bonds and/or cash as you come closer to retirement age.
As a result of this risk, some people prefer to rely on property to see them through their retirement – but as many of us know, investing in property doesn’t come without its own risks.
3. Too complicated
Finally, many people find pensions complicated.
After all, when you approach retirement age, you will be given the option to take up to 25% of your pension pot as a tax-free lump sum. By doing this, however, you will reduce the amount that remains to provide a regular income. Whether it’s better value to do this depends on how long you survive. You can find out more in Make the most of your pension pot.
You’ll also be asked whether you want to take out an annuity, and if you do, whether you want to take it out with your provider or with someone else. (Many people don’t like the idea of an annuity because annuity rates are relatively low at the moment.)
If you do opt to take an annuity, you will then need to decide whether you want a single life annuity, or a joint life annuity, and whether you want a level or increasing annuity.
Alternatively, as I mentioned earlier, you could choose instead to draw an income from your pension fund while it remains invested. So there really are a lot of decisions to make, and for some people this can be a little overwhelming. If you are confused, it's always a good idea to seek advice from a financial adviser.
Overall, however, despite the disadvantages, I still think pensions are an excellent way to save for retirement – although I am sure many of you will disagree!