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What is the state pension?
The state pension is a regular payment from the government to help with the cost of living in old age. The payments begin when you reach the government’s state pension age (currently 65 for men and rising from 60 to 65 for women).
You won’t automatically be paid the state pension – you have to make a claim for it. Four months before you’re due to reach the state pension age the Government’s Pension Service should contact you and guide you through the process. There are three ways to claim your state pension – online, over the phone (0345 604 3349), or by post.
The size of state pension payments depends on the number of ‘qualifying years’ of National Insurance you have. You need at least 10 years to qualify for any pension at all – these don’t need to be consecutive years but could be spread out across your lifetime. Qualifying years of National Insurance come from payments made while working, as well as credits earned while training, having a family or if you have been sick or disabled.
10 years entitles you to the basic pension – 10/35ths of the potential total (currently £46 a week). Prior to April 2016, there was no minimum qualifying number but recent government changes mean that if you don’t have 10 qualifying years you aren’t entitled to any state pension. To claim a full state pension (£159.55 a week) you will need 35 qualifying years.
- To work out what each qualifying year of yours is worth, multiply the number of years you’ve got by £4.55
- The ‘additional state pension’ has now been scrapped but if you earned under it prior to April 2016 you’re still entitled to keep what you have
- Beware: not all calendar years count as qualifying years – there are earnings thresholds that must be met (£113/wk, £490/mth, £5,876/yr for employees and £115.90/wk, £502/mth, £6,025/yr for the self-employed).
How much do I need in my pension?
This very much depends on how much you’re likely to want in retirement. A recent survey carried out by consumer campaigners Which? found that the average retiree household currently spends around £2,200 per month (or £26,000 per year). This pays for a comfortable lifestyle that includes basic costs and expenses, as well as some travel (Europe) and a few of life’s luxuries. Retiree households taking longer haul flights and regularly making larger purchases, such as new cars, spent £39,000 per year, or £3,250 per month.
The amount you’d need in your pension pot to support these different lifestyles depends on the type of pension that you have, as well as how you choose to take it. The state pension will go some way towards costs but at £159.55 a week (if you qualify for the maximum) that still leaves a considerable gap. According to the Which? figures, a retired household (i.e. a couple) looking to spend around £2,200 a month would need a joint income pot of £370,000 (with an index-linked, joint-life annuity pension) – for £3,250 a month income this figure rises to £1 million.
Another, very straightforward way to get some idea of the size of the pension pot you’re likely to need is to take the annual income you’d like to have on retirement and times it by 20. Remember too that there are some key factors that could significantly influence how much you’re likely to need:
- Will you be mortgage free or renting/paying mortgage payments?
- The extent of the NHS medical coverage – in the future it may become necessary to pay for the cost of medical treatment. In the US, a survey by Nationwide found the average couple spends $266,600 on healthcare costs throughout retirement.
- Are you likely to have debts other than a mortgage that may need to be serviced or paid off?
How much is the average pension?
Predicted income for people retiring in 2017 is £18,100 per year. However, this includes, not just a private pension, but income from state pension, savings and investments too. So how much does the average Brit have in their pension pot?
A survey by life insurance, pensions and asset management company Aegon found that the average pension pot in the UK is now around £50,000. This has risen from £35,600 in 2016. However, it’s worth bearing in mind that there is a huge gender gap when it comes to pensions – Aegon’s figures showed average pension pots for men at £73,600, while for women this was just £24,900. Reasons for this include the gender pay gap, which means men earn significantly more, as well as the fact that women take time off work to care for family and children and are often in lower paid jobs.
The current average pension pot of £50,000 would produce an annual income of just £2,500 – or £5,000 per year for a retired couple household. This is quite significantly short of the expectations many of us have for the finances we need for a comfortable retirement.
What is an occupational pension?
Occupational pensions are organised by an employer for its employees. There are two main types of occupational pension: final salary or money purchase.
Since April 2017, all employers must now enrol employees into a workplace pension of some sort if they are eligible.
Eligible employees are:
- not already in a workplace pension
- aged 22 or over
- under State Pension age
- earn more than £10,000 a year
- work in the UK
If you don’t want to be part of the workplace pension scheme then you can opt out later but employers are now legally required to opt everyone in first (this is called ‘autoenrolment’).
What is the current state pension age?
The current state pension age is 65 for men and is increasing from 60 to 65 for women. This age limit is not set in stone and will continue to rise in the coming years as life expectancy increases and it takes longer to save for retirement.
For both men and women the state pension age is predicted to rise to:
- 66 between 2018 and 2020
- 67 between 2026 and 2028
- 68 between 2044 and 2046
How much should you put in your pension?
Most experts will tell you that it’s a good idea to put as much into your pension as you can. Start paying into your pension as early as possible so that you can build up a sizeable pot for your retirement.
There are two useful approaches to use when pension planning:
Take the figure that represents the age you are when you start your pension. Halve this and treat it as the percentage of pre-tax salary you should pay into your pension right now. So, for example if you are 40 when you start paying into a pension, you should pay 20% of your pre-tax salary into that pension each month.
Each time you get a pay rise put a quarter of the increase into your pension. You will get used to not spending that extra money and create a financial buffer for your retirement with the extra pension cash.
How much of your pension is tax-free?
The tax-free part of your pension is twofold:
1. Tax relief on contributions
If you’re under 75 you get tax back on all your pension contributions, subject to the upper limits set out below. 20% tax relief is automatically applied to pension contributions you make, or which are made direct from your salary by an employer. Higher rate taxpayers can claim an additional 20% and top rate taxpayers an additional 25% (this is not automatic and must be claimed).
20% tax relief doesn’t mean that you receive 20% of your contribution back. Instead it is the difference between your contribution amount and your pre-tax earnings. So, for example, an £80 pension contribution would have been generated from earnings of £100 (from which the taxman deducted 20% to leave you with the £80 to put into the pension). In that situation the 20% of the earnings (not the contribution) produces tax relief of £20.
2. Tax free investment gains
Investments that are made with your pensions cash benefit from high levels of tax relief. In most cases, any gains that you make from those investments can be enjoyed tax-free.
While there’s no upper limit on how much you can pay into your pension, there are restrictions on the level of tax relief you will get.
- The earnings limit – this uses your annual earnings as a guide for the limit on tax relief available to you. So, for example, say you earned £35,000 each year and accumulated savings of £45,000. If you one day transferred the entire £45,000 into your pension you would only get tax relief on the first £35,000.
- The annual limit – this limit only applies to high earners. Tax relief applies up to the current higher rate annual allowance (£40,000) and allowance from the three previous years that hasn’t been used. Where income, pension contributions and employer pension contributions total more than £150,000 per year, tax relief allowance reduces by £1 for every £2 earned. So, for example, if you earn £210,000+ per year you will get tax relief of just £10,000.
- The lifetime limit – where total pension savings (including gains/interest) amount to more than the lifetime limit (currently £1 million) no further tax relief is available above that limit.
What are the different types of pension?
1. The state pension
This is paid to you by the government when you retire.
2. Occupational pensions
These schemes can be either final salary or money purchase.
A final salary pension scheme (or defined benefit schemes) is linked to your salary and based on pay at retirement, as well as the number of years worked. An accrual rate is set by your employer and used to work out the pension amount. For example, an accrual rate of 1/60th means you get 1/60th of your final salary for every year of service. So if you worked for 45 years, you’d get 45/60ths, or three quarters of your final salary at that company on retirement.
A money purchase scheme (or defined contribution scheme) is based on the amounts paid in to the scheme – by either the employee, or employer, or both – and the way that this money has performed when invested. The income you get from a money purchase scheme depends on when you choose to access your cash, what charges apply and how successfully the money was invested.