This is one of the more common questions I get from friends and younger clients. Most are vague about the technicalities around pensions or why we use pensions to save for retirement instead of perhaps ISAs or cash savings.
If you’re in a similar situation or life stage, this is the detail you need to know.
The real advantage of pensions is their tax treatment. No tax is charged on income you pay into a pension and the investment growth within a pension is not taxable.
Most employers offer a pension scheme (in fact soon all will have to because of auto enrolment rules) and will contribute to the pension alongside your contributions. You can usually make these contributions on a salary sacrifice basis. Salary sacrifice means you give up part of your salary and it’s paid into a pension on your behalf.
If you’re a graduate with a student loan, using salary sacrifice will change your repayment obligations.
Student loans are repaid when you are earning over £21k (or £25k from April 18). Nine per cent of income over those levels goes towards paying off your loan. By sacrificing part of your salary into a pension, your income is reduced so the amount of student loan repayment is reduced. e.g. Salary of £30k means 9% of £9k goes to student loan repayment = £810.
By making a salary sacrifice of £1,500 towards a pension, your salary is reduced to £28,500 which means 9% of £7,500 goes to student loan repayment = £675.
You also do not have to pay either Income Tax or National Insurance on the £3k pension payment. As you can see in the example below, this tax advantage makes a £3k annual pension contribution more achievable than you might first think.
If you earn £30,000 a year, a 5% salary sacrifice = £1,500 gross over 12 months.
Cost to you = £885 p.a. from your bottom line pay or £73.75 each month.
If your employer matches your contribution, your £885 annual payment will actually mean £3,000 will be contributed into your pension.
If you earn £50,000 a year and contribute 5%, your bottom line cost will be £1,225 p.a. but you will have £5,000 contributed to your pension. You will not find many investments that will quadruple your savings overnight.
Of course, by making a salary sacrifice you will be reducing the amount you are paying off your student loan and it does affect your affordability in the eyes of mortgage lenders. It is important that any decision is made with careful consideration of your wider circumstances. It also highlights that you do not need a £1 million portfolio to benefit from financial planning.
So, the simple answer to the original question – should I start saving into a pension - is probably yes.
The sooner you start saving the better. The diagram below illustrates how starting early with relatively small monthly payments, will pay dividends at retirement.