Why a pension is the best investment you will ever make
10th January 2020
Disclaimer- this article will talk about “Defined Contribution” pensions, and make no reference to the other type “Defined Benefit”, if you have one of these pensions, then a) consider yourself very lucky, b) read my other article here
Firstly, what is a pension?
For lots of people, a pension is something that is not really thought about until much later in life, usually in the few years before retirement. The younger generations tend to hide away from this word- it seems like something that we don’t need to worry about yet- it’s like a monster that hides behind the door, that as long as we don’t need to walk down here- it’s safe to ignore. But it’s really not safe to ignore it! In fact, the sooner that you face this “monster”, the easier it is to beat it.
A pension is just a “wrapper” that locks your money away until you retire. That is all it is. Once you retire, you can then withdraw this money as you wish (though, there are tax benefits for doing this in certain ways)
Hold on, it’s that simple?
Yeap, there is nothing more to it than that. With some pension providers you can pretty much invest in anything you want (some providers have much more limitations that others).
Ok, so I understand what a pension is now- it is really worth saving for?
If you are already a member of your employers scheme (and you should be, unless you have opt’ed out, or don’t earn enough), then your payslip will show both the amount that you pay in, and the amount that the employer pays in each month. This will probably also show the amount that your employer puts in as well. From the 6th April 2019, the government has been slowly increasing this level over the past few years as this table shows:
Employer minimum contribution
Total minimum contribution
Old rates, up until 5 April 2018 1%
2% (including 1% staff contribution)
Currently, from 6 April 2018 to 5 April 2019
5% (including 3% staff contribution)
6 April 2019 onwards
8% (including 5% staff contribution)
Wait, almost double my money just for saving?
Yeap! So, let’s work through an example:
You earn £20,000 a year
You pay the 5% contribution- this will cost you £1,000
The government add on your tax relief £250 (25% as you are a basic rate payer in this example)
Your employer puts in £600
So, your total contribution for the year into your pension is £1,850- and it’s only cost you £1,000. You have nearly doubled your investment before you even get any interest/gain on this investment! Show me another investment that nets nearly double without any risk whatsoever, it just doesn’t exist.
If you are in the 40% tax bracket- the tax advantages are even higher- but once you go above £100k there are more rules that apply.
So, what are the downsides?
As with anything in life, nothing comes without a downside. Well, with a pension, there are quite a few rules that apply to this, these are some of the big ones to consider:
You cannot withdraw your pension until you retire! There are some specific examples where this might not apply (eg. Ill health, or if you had a specialist scheme that allowed earlier retirement). For most people this will be at age 55, (or more likely age 57+)
You have to pay income tax on the amount you withdraw. Now, this might seem a little strange- but because you got tax relief on the amount that you contributed- the government sees it that you haven’t paid any tax on this money, so whatever you withdraw, you pay income tax on. Now, this might see very bad, but in actual fact, it’s not as bad as it seems. Your income in retirement is going to be much lower than when you were working- unless you have other income streams- your job was probably the main income you had. Therefore, when you stop this, your income tax level is likely to drop to the next bracket (or least, stay the same). You still get the personal tax allowance, which is currently £11,850 before you pay any tax on this at all!
There is a lifetime allowance on how much you can withdraw, currently just over a million pounds. If you withdraw more than this from your pension- then you will be hit by an additional tax I’m afraid.
I’ve heard that “pensions go bust”?
Yes, this has been the case in the past, and will probably be the case in the future. Many of the “Defined Benefit” businesses have had deficits for many years now- and will likely need help from the regulator in the coming years (though, these are protected to 90% of their value).
How safe is my pension?
There are a number of aspects to this:
The provider that you choose to manage your investments could go bust. There are a number of protections available- if you pick one of the larger companies, they have billions of pounds under management (you can also check their financials as well)
The investments that you pick could go down in value/be worthless. A topic for discussion on another post- but if you ensure that you are diversified
Note: Pensions are very complex, and if your situation is complicated- it’s definitely worth purchasing advice from somebody that offers it as a professional service. A good place to start would be https://www.unbiased.co.uk/ as they have thousands of pension professionals that can assist you.