This piece first appeared in Reader's Digest in March 2001
The text here may not be identical to the published text
Some people give up chocolate for Lent others stop drinking alcohol or caffeine. But this Lent – which started on 28 February – why not decide to give up something that will help you in later life? Be poorer not just for 40 days but for up to 40 years – to make sure you are less of a burden to others in what, for the great majority of us, will be a long and healthy old age.
There is probably never a good time to start thinking about giving up some pleasures or extravagances, to make sure you have more when you are retired. But there is never a bad time either. The answer to the question ‘When should I start saving for my pension’ is usually ‘ten years ago’. Given the choice, most of us leave it too late and save too little to ensure that we will have a comfortable retirement. Of course, some people do not have much of a choice – they are in a company or public service pension scheme and although joining can no longer be made compulsory, it is usually done routinely and seen as one of the important perks of the job.
But more and more people are not in that position and have to save for their own pension voluntarily. From April, when the new stakeholder pensions start, that choice will become easier and extend to more people than ever.
Rule 1 If your company has a pension scheme, join it.
Most employers with pension schemes put money into your pension too. So if you do not join, you are turning down a pay rise. Some employers do not ask for any contribution from their employees. Others ask for a moderate one – usually around 5 per cent of gross pay. The money is taken off BEFORE tax is calculated so the Chancellor also contributes – saving you 22p on every pound you pay into your pension if you are a basic rate taxpayer and 40p in each pound if you pay tax at the higher rate.
There are two kinds of company scheme. One sort, mainly found in the public sector and among some of the bigger companies, guarantees you a percentage of your final salary when you retire. For each year of contributing you will get a fraction of your final pay – typically one eightieth. That would mean that after 40 years’ work you would get half your final pay as a pension for life. In many cases, especially in the public sector, that pension will rise with inflation each year. These schemes can be called ‘final salary’ or ‘defined benefit’ pensions.
Nowadays another sort of pension is becoming more popular. They are the so-called ‘defined contribution’ or ‘money purchase’ schemes. Here, all the money you pay in is saved into a fund and your pension will depend on the size of that pot of money. So there is no guarantee what you will get. At retirement you take your pot of money and convert it into an income for life, usually through an annuity (see this column for November 2000 for more on annuities). The annual income you will get from an annuity has fallen dramatically over the last few years as interest rates have dropped.
The new stakeholder pensions will all be money purchase schemes. From April more and more employers will offer their staff the chance to join one and from October 2001 every employer with more than 5 employees who does not offer an adequate alternative pension scheme, will have to offer their staff access to a stakeholder scheme. Anyone, in work or not, will also be able to pay into a stakeholder without involving an employer.
One of the most common reasons for not joining a pension scheme is that you do not intend to stay with the company long enough. That is not a good reason. First, by law schemes have to let you take the value of your pension contributions with you when you leave. Second, the longer you put off paying into a pension the more it will eventually cost you.
Rule 2 No amount of pension is ever enough.
Unless you are in top company scheme and work for the same firm for 40 years any pension is likely to disappoint. Each year the Inland Revenue allows us to put up to 15% of our gross pay tax-free into a pension plan. Most company schemes take far less than that off us, and people can put extra money into a separate pension as long as the total they contribute does not exceed 15% of pay. These are called additional voluntary contributions or AVCs. Your employer will be able to advise you about the arrangements for making AVCs.
From April you will also be able to put money into one of the new stakeholder pensions on top of any company scheme as long as you earn less than £30,000 a year. Stakeholder pensions will in many cases be cheaper than AVCs. Alternatively you can put money into a personal pension, though the costs of stakeholders are likely to be less and the rules for the maximum annual investment are the same.
If you are self-employed the rules are different. The amount you can invest depends on your age, starting at 17.5 per cent of your taxable earnings if you are under 36 and rising to 40 per cent at 61.
Rule 3 Do it now
So how much should we be putting by in a pension? A handy rule of thumb is to take the age at which you START contributing, halve it, and then put in that percentage of your gross earnings every year until you retire. So if you are wise enough to start at 20, you will put 10% of your gross pay into a pension each year. But if you are foolish enough not to start a pension until you are 40 then you will have to put in 20% of your gross pay until you retire. If you follow this rule, your pension will be equal to around half your pay.
Of course this rule of thumb is very rough and ready – and it certainly would not be enough to put in 30 per cent of your pay at 59 and then retire at 60! But for younger people it is a good rule and certainly if you invest much less than that, your pension is going to be very disappointing. It also follows fairly closely the maximum which the Government allows self-employed people to invest.
And in case you were thinking that the state pension would suffice, even with the £5 a week rise in April it will only be £3770 a year, less than a fifth of average pay.
Remember that if you retire at 60 you will on average have to live on that pension for 24 years if you are a man and 27 years if you are a woman. So this Lent, find out what you pay into a pension, check the age when you started, divide that by two and commit yourself to putting at least that percentage into your pension from now on. And if you do not pay into a pension at all, start this Lent. It’s a penance you will not regret.