Understanding Pensions Is Easier Than You Think

I want to share with you my personal tips and principles for investing in a pension plan, so you feel naturally motivated to start or increase your contributions, to build your financially independent future. I am a Leeds-based financial adviser who enjoys the teaching aspect of financial literacy. If you want to learn more about why being engaged about your pensions is important, then keep on reading.

Compounding Is Key

Principle no. 1.Compounding is key. Let me show you by example. From this example, you will see, that the earlier you start, the more time you have on your side for compounding to do the work. There are many rules of thumb that suggest you should pay 50% your age to get 2/3rds of your final salary, etc. However, with this compounding logic, it makes more sense to max out as much as you can when you are older, so you can go easy on contributions when you get older and let compounding take care of all the hard work for you.

Wrapper Not Rapper

The word pension can sometimes muddy the waters and confuse people. Just think of a pension or a retirement plan as a tax-efficient wrapper. Not a rapper like JayZ, A Wrapper.

Think of a pillowcase. Now, an ISA is also a wrapper. You can pack the same feathers inside both wrappers – an ISA and a pension – so the same kind of investments like mutual funds or stocks or Investment Trusts. So, a pension or an ISA is nothing more than a way to hold those investments. So, why use the wrapper word then? It determines the tax treatment.

Tax-Efficiency

Now, I don’t want to get too technical but pensions really are a lot more tax efficient than ISA’s. You get tax relief on your pension contributions at the highest rate of tax payable. There isn’t any tax relief on an ISA. Think of a snowball coming down a mountain. The bigger the snowball at the beginning, the quicker it can grow. A pension is certainly a bigger snowball than the ISA – if you get 20% tax relief or higher like 40% you can just imagine. You cannot access your pensions until you reach the age of 55, although you need to check with your individual provider if it is a work scheme… and while you can access a 25% tax free amount, the remaining 75% is taxed as PAYE – that means at source.

Access To Your Funds

You also need to weigh upwhether you need accessibility therefore to your investments and you could use both wrappers to plan for financial independence. It’s just that pensions are more tax efficient!

Foxes And Chickens

My third handy tip talks about tax and inflation at retirement. Consider these as 2 foxes that can steal the chickens from your coop when you retire. These are inflation and tax.

When it comes to tax and pensions, there isn’t a great deal you can do to reduce tax at retirement although with drawdown, you have some flexibility about when and how much you access, so there is some degree of control. You may want to invest in ISAs.

The 4% Rule

I will stick with 4% for this example. It is quite simple to work out. Work out the gross amount you can live on, risk-adjusted for inflation is more conservative – for example, you may have more medical expenses and travel but less work related expenses- and be realistic. It is much easier for most to save more than it is to earn more, so being realistic helps. Then, multiply that by 25. That is how you work out the target amount you need in your pension pot. A £20k spender like me for example, needs £450kAlso, the higher your savings rate, the less years you will have to work till financial independence. So, why 25? That is simply how the maths works.

If you have your retirement savings invested in stocks or other assets, they grow via dividends and capital growth at a total rate of 7% per year, after fees and before inflation. Inflation eats 3% on average, leaving you with 4% to spend on.

Flight Path Can Change

If you are, let’s say, only 30 years old and your plan is to keep working until you are 50…your life may change radically from now until 50…your needs may change. If you think of a pilot flying from London Heathrow to New York but then the plan changes to let’s say, Mumbai, then he may need more fuel, a stop, etc.

So also, you can just continue adjusting your pension contributions,tweak your expenses and your expectations accordingly by considering what kind of a lifestyle you want. Some people prefer being really minimalistic and some want a more extravagant retirement – nothing to judge, it is just that the amounts change and as long as there is a plan for this, it’s all good.

Review Your Pensions Regularly

My final tip is look at your pensions. Look at the funds you are investing in. Know what the fees are. Remember the other investment options your pension fund offers – whether they be ethical, active, passive. Most people simply don’t look at their pension statements enough. How can you know if you are on course for financial independence if you don’t?

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