Pension Planning

Are pensions worth it?

Do you have to have a pension? As ever, there’s no right or wrong answer, and even if you’re well into your 50s and have yet to start thinking about how you will fund your retirement, it’s worth questioning whether pensions are worth it.

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Are pensions worth it?
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It’s the £1 million question. Literally for some people! Are pensions worth it?

There’s no simple yes or no answer to this. There are many pension options available, and the choices vary from person to person.

Let’s jump right in. 

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The purpose of pensions

Firstly, let’s recap on why pensions even exist.

The Old Age Pensions Act 1908 established the first State Pension in the UK.

A State Pension is a pension paid by the UK government based on our employment record.

When we work, we pay National Insurance Contributions that qualify us for the State Pension and other benefits.

State Pensions are designed to provide a foundational income to support people after reaching the State Retirement Age, which is currently between 65 and 66, and due to rise to 67 and 68 in the coming years. 

As our average life expectancy increases, we tend to work for longer, and thus, the State Retirement Age will only increase.

The State Pension has also risen with the rise in people going onto higher education, which means people, on average, begin full time work much later now than they did even in the 80s.

The State Pension benefits both the pensioner and the state. Life expectancy rapidly rose after the industrial revolution, and the UK government quickly realised that older people needed financial support in their post-working life.

The self-sufficiency of pensioners helps reduce strain on the welfare and healthcare systems.

The State pension was viewed as a triumph of the modern welfare state - a hallmark of a country that cared about its working populations.

In 1975, The Social Security Pensions Act formed the State Earnings Related Pension Scheme (SERPS). 

This created the first workplace pensions to which both employers and employees could make contributions and bolster their State Pension.

And that’s pretty much where we are today.

The purpose of pensions in the 21st century

Today, common knowledge that the State Pension will rarely provide enough to support us later in life, even if we have the full 35 qualifying years on our National Insurance record.

Additionally, pensions have diversified, and the pension options available to us have increased rapidly. 

There are two main types of pension in addition to the State Pension:

  • Defined benefit pension schemes.
  • Defined contribution pension schemes.

Defined contribution schemes

Defined contribution (DC) schemes can be workplace pensions, personal pensions or SIPPs - self-invested personal pensions. DC pensions are the most common types of pension schemes in the UK right now. 

Defined contribution schemes accumulate a pot of money - a pension pot - that can be accessed later in life. This pension pot is usually invested in a range of assets, including cash, bonds, shares and property. In the case of a SIPP, you manage some of your investments.

For most other defined contribution pensions, the pension provider manages your money for you, though you will have some say in what you invest in. This applies to both workplace defined contribution pension schemes and personal or private pension schemes.

A defined contribution scheme is a type of investment product - the aim is to grow your savings into a pot that provides for you in later life. Many of these schemes progress from higher-risk investments (with more significant potential gains and losses) to lower risk investments for later life. Most pension funds have diversified portfolios that smooth out any variance in fund performance.

Since the investment window is quite long, the swings of investments should balance out to a net gain that outperforms inflation, but there are no guarantees.

Since you can’t withdraw your money from a defined contribution pension scheme before the minimum national retirement age (55 now and set to rise in the future), this essentially provides a large window of time for you to grow your pot. Growth can be significant if your investments do well.

In short, the aim of investing your money in a DC pension scheme is to:

  • Protect your pension pot for later life.
  • Beat inflation and grow your pension pot.

Defined benefit contribution schemes

Defined benefit contribution schemes work differently and are more common in the public sector.

Defined benefit contribution schemes do not accumulate a pot of money. They instead pay a secure income for life, rising each year to accommodate for inflation. Your pension payments will be calculated from your salary and employment record.

Though increasingly rare in the UK, defined benefit schemes are generally lower risk and more straightforward than defined contribution pension schemes. They’re not subject to the same market forces as a defined contribution scheme.

You may be offered a final salary early retirement package in some professions if you’ve worked for many years with the same company.

The aim of a defined benefit contribution scheme is:

  • To provide a guaranteed salary-based pension from retirement age. 
  • Reward long terms of service to the same company.

Joining a pension a scheme

When you start a new job, you should be asked about your pension preferences. If you aren’t confronted with this, then ask your employer about your options.

Firstly, you’ll have to decide whether you even want to join your workplace pension scheme.

For defined benefit pension schemes, your pension is directly related to how long you’re employed. However, to get the most out of a defined contribution pension, you should start paying into it immediately. You can also decline to pay into a pension for now and rejoin later if you wish. 

Should I join a workplace pension?

When you join a new employer, you may be wondering whether you should join their pension scheme.

You will be auto-enrolled into a pension scheme by law if you don’t opt out of it when asked. If you’re encouraged to opt out, you don’t have to; auto-enrolment is your legal right providing you earn over £6,240 annually.

You might be put off as you’re effectively taking a pay cut to join a pension scheme (in the case of DC pensions).

Both you and your employer will contribute, and you’ll be able to claim tax relief on your overall contributions. 

Tax relief is the first significant advantage to pensions that makes joining a workplace pension worth it.

With tax relief, a pension contribution of £100 is worth £80 in your pocket. Instead of 20% tax being deducted from the £100 in your pay packet, the government essentially ‘chips in’ the £20 they would take as tax. 

  • If you take that money in your pay, it’s worth £80.
  • If you take that money in your pension, it’s worth £100. 

Tax relief will vary between income tax thresholds.

That isn’t the only benefit to a workplace pension, though, as your employer will also contribute to it.

Under auto-enrolment, total employer contributions must be at least 3% of an employee’s earnings. Most employers will contribute more or will at least match your contributions up to around 6%. 

This is essentially ‘free money,’ but you won’t get it unless you enrol in a workplace pension. 

In the case of defined benefit pension schemes, your employer may contribute as much as 15% to your pension in order to fulfil their promises.

The tax advantages of pensions don’t start and end with contributions, though; they also apply when you withdraw your pension and when you pass away.

When you pass away, then depending on whether you die before or after 75, your pension pot will usually be passed to a surviving spouse, civil partner or dependent child tax-free. Similar arrangements apply to defined benefit pensions, where a lesser amount of the pension will be paid to the surviving spouse, civil partner or dependent child.

Pension withdrawals

When you come to make your first pension withdrawal at the age of 55 or over, you’ll have the option to take 25% of your pot as a tax-free lump sum. 

You can usually take the entire thing as a lump sum if you want, but there will be tax consequences and fees.

The entitlement to take a 25% tax-free lump sum will nearly always apply to private pensions or SIPPs, as well as the vast majority of DC workplace pensions.

It can also apply to defined benefit pension schemes, where you may be offered a 25% tax-free lump sum in addition to your final salary pension.

Pensions vs ISAs

Many people consider ISAs the main alternative to traditional pensions.

ISAs are a type of shorter-term savings product that do confer some tax advantages.

Namely, you won’t pay income tax on the interest or dividends you receive from an ISA, nor will you pay capital gains tax on profits from investments. 

You can also make withdrawals from an ISA tax-free. You can withdraw the entire thing if you want without paying any income tax. This is not the case with a pension, where only the first 25% is tax-free - the rest does incur income tax.

However, ISA contributions do not come with any tax relief, as they come from your already taxed income.

In essence, ISAs are advantageous on the withdrawal side. Pensions are more beneficial on the contribution side, but the tax-free lump sum mitigates some of your tax liability on the withdrawal side, too.

The two options are closely matched in many ways, but ISAs are not well-designed for long-term savings. Locking your money away in a pension is a security measure in itself; you simply can’t dip into it before the age of 55 unless you’re unable to work or terminally ill.

The ‘out of sight, out of mind’ nature pensions mean that people are often pleasantly surprised by how much they’ve accumulated by their middle age. Since you can’t dip into a pension in the same way you can dip into an ISA, that money is safely protected for when you need it most - after you stop working.

That said, it’s probably ideal to combine both an ISA and a pension. A pension provides longer-term, inflexible but secure savings, tuned for long-term growth, while an ISA offers a more flexible means to save.

Are pensions worth it compared to alternatives?

When we weigh up our options for future savings, pensions generally come out on top compared to their alternatives.

  • If you save money in your bank and savings accounts, you’ll likely fall behind on inflation. You need a way to grow that money for the future.

  • If you exclusively use ISAs, you don’t benefit from the same level of tax relief as you do with a pension. You might also withdraw that money before you need it and effectively blow it before retirement age. 
  • If you make your own investments, you'll need to spend some time researching the best options for long-term saving. This can be risky, and many people simply don’t have the time. Besides, a SIPP allows savers to invest according to their risk appetite with the additional tax advantages of a pension. 
  • If you want to continue working, you still need a contingency plan in the event that you simply can’t work. The State Pension is usually not sufficient for retirement without additional savings. According to the ONS, 65-year-old men and women have around a 10% chance of living until they’re 100, and this is rising all the time. Those born beyond the 70s or 80s are odds-on to reach their 85th birthday and have a 15% chance of reaching 100. Even if you do stay at work at 65, you might live for another 35 years or longer - you’ll need some sort of savings eventually. 
  • If you want to invest in property or even other assets like cars, technology, collector’s items, or anything else that might appreciate value, you’re subjecting yourself to a good deal of risk. And there’s no real tax benefit of doing this either.

So, are pensions worth it? Compared to all of these typical pension alternatives, the answer is they probably are, for most people.

Of course, diversifying your options with a mixture of the above is a solid choice, but a pension is an excellent place to start when it comes to saving for your future - that isn’t about to change anytime soon.

Are pensions worth it?

Are pensions worth it? In the vast majority of cases, they are certainly worth it. 

Pensions bring three unique elements to the table:

  • Tax relief on contributions
  • The employer also makes contributions 
  • 25% withdrawable tax-free lump sum

Pensions also provide solid long-term growth on your investments in the case of defined contribution (DC) schemes. Defined benefit pensions provide a secure income for life.

Mixing and matching a pension with other types of savings, e.g. an ISA and other assets like a house, is the most robust approach to saving for retirement.

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