Often described as a political football, the pension landscape has been overhauled by a government tasked with the unenviable job of tackling an aging population that isn’t saving enough for retirement in an era of rock-bottom interest rates.
The state pension age was recently increased from 67 to 68 for those in their 40s. You’ll get £164.35 a week from the state pension, unless you reached state pension age before 6 April 2016, which means you’ll get the old state pension of £125.95 a week. The new state pension increases each year by either UK wage growth, inflation, or 2.5%, whichever is higher. This is known as the state pension triple lock.
The question is, can you rely on the state pension alone to see you comfortably through retirement?
Starting early is one of the best ways to reduce your monthly contributions thanks to the magic of compound interest. But many overestimate how much they’ll need anyway, with Which? suggesting £26,000 a year for a comfortable retirement.
Although we all need to save for our future, pensions are complex – before Pension Freedoms the customer was usually a financial adviser or employee benefit consultants, and providers had to prove their worth.
But the government has tried to unlock this freedom and choice in its overhaul of the pension system, which was billed as the most radical changes of a generation. Choice drives competition and performance, which can unlock a range of opportunities – if you understand the product and risks attached to them.
What are pension freedoms?
Defined contribution pensions – where you and your employers contribute to your savings – are celebrated for having generous tax benefits attached to them, and for good reason; you receive tax relief on your contributions and can withdraw 25% of your pension tax free from the age of 55. After that, you pay tax according to your income tax band.
Whilst the 25% tax-free incentive hasn’t changed, you now have more freedom over how you use the remainder of your pot to fund your retirement.
There isn’t one option that works for everyone, what’s suitable for you might not be for your colleague – that’s why it’s so important you understand what you have and how you want to live out your retirement.
Three options for your pension pot after taking your 25% tax-free lump sum
- Buy a flexible income drawdown
- Buy an annuity
- Withdraw it and keep it as cash
Savers used to have to purchase an annuity with the remainder of their pension, guaranteeing an income for the rest of their life. This sounds like a good deal, but rates can be paltry. For example, if you had saved £200,000 for retirement and were offered an annuity rate of 5%, you’d get just £10,000 a year.
Pension freedoms opened this playing field; today, you can choose whether you want to purchase a flexible income drawdown product instead, keeping your pot invested in the meantime. This allows you to decide how much you want to take out and when, and can be especially useful if you like to be in control of your finances. You can even withdraw your savings and keep it in cash, although you might want to consider inflation risk first.
Whilst 72% of pension pots are accessed by those under the age of 65, nearly a third of these are choosing to keep their 25% tax-free lump sum in cash, according to the latest data from the Financial Conduct Authority.
With interest rates at a record low for 100 months now, but inflation running ahead at 2.6% in June¹, this cash is losing purchasing power – especially with wages failing to keep up with inflation.
You can use Moneyfarm’s Pension Calculator to help you work out how much you need to be saving a month to get the income you want in retirement, or start one of Moneyfarm’s regular investment plans.
Making sure you plan for retirement in the best way for you and your family can be difficult. If you need any help, talk to an independent financial adviser and be sure to read our pension guide.
Get more from your pension
Instead, you should look to get more from your pension pot – this isn’t an interest rate environment that will reward the cautious like in the past.
By keeping the remainder of your pension invested as you draw from it, you will make your money work harder for you as you kick back and enjoy putting yourself first, maximising any return during retirement.
1 Office of National Statistics