Pay into a pension or work into old age?
A pensions crisis is brewing within the UK’s rapidly growing army of the self-employed.
Since 2001, the number of self-employed individuals has swollen from 3.1m to nearly 5m today. Only a quarter of these are saving into a pension, a dramatic drop from 40 per cent a decade ago, according to recent figures from the Office for National Statistics.
This contrasts with nearly three-quarters of workers in traditional employment now building retirement nest eggs — a record high — largely due to the “automatic enrolment” policy.
Recent growth in self-employment is being led by workers in relatively “privileged” high-skilled, higher-paying sectors such as advertising and banking, according to the Resolution Foundation, a think-tank.
There is also a growth in self-employment in more “precarious” sectors, such as construction and cleaning, where earnings for a new breed of freelance workers remain well below that of employees.
These “ gig economy” workers go from job to job, but do not benefit from workplace benefits, such as an employer paying into a company pension on their behalf. These workforce trends are storing up trouble for the future.
Getting into the pensions savings habit can pay dividends for the self-employed but too often lies at the bottom of the to-do lists of those busily lining up the next job or managing their businesses.
Here is the Financial Times guide to sorting out your pension if you are self-employed.
Why should I save into a pension and not something else?
Many people in “traditional” self-employed roles, such as entrepreneurs and “one-man-band” businesses, may see their business as their retirement fund or use other savings vehicles, such as Isas and cash accounts, to build a nest egg.
Deciding not to use pensions means they could be missing out on valuable tax breaks unique to these long-term savings vehicles.
To encourage people to save for later life, the government pays an upfront bonus to those saving into a pension. This tax break is not available in other savings structures, such as Isas.
The way it works is that you get tax relief on what you pay into a pension at the rate you pay income tax, either at 20, 40 or 45 per cent.
Those not earning enough to pay tax (less than £11,500) will, in most cases, still qualify for a 20 per cent tax top-up on what is paid into a pension.
For example, if you are a basic rate taxpayer and pay £80 into a pension fund you will get a further £20 from the government added to your pension pot. If you are a higher rate, or additional rate taxpayer, you could claim a further £20 and £25 respectively from the taxman, in addition to the basic rate paid into your pot. The fund can grow free of tax, up to a cap of £1m, and you can take a quarter of the pot tax-free from 55, with the rest subject to tax.
Do I need to save now? Retirement is a long way off
Self-employed workers should take the same approach as other workers when it comes to pension planning, said Patrick Connolly, financial planner with financial adviser Chase de Vere. “This means starting to save into a pension as early as possible, even if they cannot afford to save very much to start with; it is better to do something than nothing at all.
“They can then look to increase contribution levels when they are more confident about the security of their earnings and can potentially add further amounts through lump sum payments if there are spikes in their earnings.”
How much should I save?
As a rule of thumb, advisers say workers should be setting aside 10-15 per cent of earnings for a decent retirement income. This is trickier for the self-employed, who do not benefit from matching employer pension contributions and often have variable income. It will nonetheless be worthwhile saving regular amounts into a pension and the earlier you start the better.
Aviva, a pension provider, has calculated that a 25-year-old, self-employed individual, with gross earnings of £18,000 a year, could build a fund of £74,000 by the age of 68 if they saved 5 per cent of their earnings each month.
This equates to contributions of about £60 a month, boosted by £15 in tax relief, meaning £75 was going into the pension pot each month.
Starting later will mean a smaller fund. If the same person started saving 10 years later at 35, they could build a pension pot of £48,000 by 68. If they did not start saving until 50, however, they may expect a fund of only £19,000 by the time they reach state pension age, all things being equal with earnings and contributions.
How do I save when I have ‘lumpy’ income?
Paying in a lump sum can make a lot of sense if you have a great year, you sell a business or finish a large, lucrative project, said Holly Mackay, founder and chief executive of Boring Money, a financial website.
“I have talked to people who sell a business and leave cash sitting in a current account because they don’t know what to do next. The available tax relief on a pension is chunky — especially if your earnings put you into the higher rate tax band that year — and you can often use previous years’ allowances too, which make pensions a no-brainer for many in this position.”
How much can I pay in to my pension?
Tax relief depends on your total earnings and total personal contributions paid. For most the annual pension savings limit is £40,000.
However, the very highest earners with incomes of £150,000 or more will have a lower contribution limit, it reduces by £2 for every £1 of income above £150,000, to a floor of £10,000. Some over-55s could have a much smaller allowance of £4,000 if they have been dipping into other pension savings.
What if I need my cash?
Pensions are long-term savings accounts so you should expect to keep your money locked away until you are 55 at the earliest.
Mr Connolly said a mix of pensions and Isas are a sensible savings approach for the self-employed. “Self-employed workers, especially younger workers with irregular earnings, might favour the added flexibility of Isas to investing in pensions, at least until they have built up adequate accessible savings.”
What is the best pension plan for the self employed?
When selecting a pension product where a workplace pension is unavailable, the options are:
- Personal pensions — these are offered by most large providers
- Stakeholder pensions — here charges are capped at 1.5 per cent and you can stop and start premiums without penalty
- Self-invested personal pensions (Sipps) — these have a wider range of investment options, including commercial property, but usually involve higher charges
The right decision will depend on the amount of flexibility you want in terms of your fund options while you are younger, and in terms of how you decide to take pension benefits as you get older.
“For many the starting point could be a personal pension,” said Mr Connolly. “Annual charges, including both fund and wrapper costs, should be less than 1 per cent per annum and many products also have between 100 and 300 external fund links if you want them, although these are likely to come with higher charges.
“Some people may prefer the extra flexibility of investing in a Sipp. However, they need to be aware that this extra flexibility may come with higher charges, and having more choice is only beneficial if you then make the right decisions.”
Accessibility, ease of use and flexibility in a pension are key for self-employed people, said Ms Mackay. “When you’re running a business or working for yourself you want to minimise non income-generating activity. So you need a pension that can be managed online, which will support irregular top-ups, which makes contributions easy and ideally can be managed on an app.”
What about charges?
Fees and charges are also important to the self-employed who, unlike workers automatically enrolled into a company pension, are not protected by a 0.75 per cent cap on fund charges.
“Charges vary dramatically and are usually driven by the underlying investments,” said Romi Savova, chief executive of PensionBee, a pension consolidation service. “It is not uncommon to see pension fees between 1 and 2 per cent when adding up all the costs. This will typically include a platform cost, of say 0.35 per cent to 0.5 per cent, and then fund costs, which could go as high as 1.5 per cent and even more.”
Ms Savova said some providers also charge when making contributions, including Nest, the government-backed workplace pension scheme open to the self employed.
“It is important to understand all the types of charges and, if that is too much hassle, to pick a provider with an all-in fee that includes the platform, the funds contributions, transfers in, transfers out, etc,” said Ms Savova. “Adviser charges also typically come on top of this.”
For comparisons of low-cost Sipps, look at comparefundplatforms.com, which explores the costs of each.
I have pensions from old jobs. What should I do with these?
If you have pensions all over the place and do not know how much they are worth, it is a generally a good idea to bring them together. The government offers a free service so you can check if you have any savings from old workplace pension pots that you may have forgotten about (gov.uk/find-pension-contact-details).
Before moving any of your pensions, make sure you do a few important checks on your policies to ensure your decision is best for the plan.
“If the pension offers defined benefits (often called ‘final salary pensions’) then there’s a good chance staying put is the right thing to do. In any case schemes will insist you take advice before transferring,” said Justin Modray of advice website Candid Money.
“Otherwise check whether there are any valuable benefits that would be lost by transferring, which include enhanced tax-free cash, a guaranteed minimum pension and a guaranteed annuity rate, as well as penalties for moving elsewhere.
“You’ll need to do a careful comparison to determine whether transferring elsewhere is still worthwhile.”
How should I invest my money?
“It is important to consider how long you have until you will need to access your pension when it comes to investing,” said Nathan Long of Hargreaves Lansdown. “If you have more than 10 years then investing predominantly in shares will serve most people well.”
Those closer to retirement may look to funds that invest in a mixture of assets including bonds and cash in an attempt to lessen any fluctuations in value, he said. “Getting started is easier than you think. Most investment brokers will have their own list of the best funds they believe to be available. If you are unsure, a financial adviser will be able to design an investment strategy to suit you.”
What are pensions like for the employed?
Workers who are eligible to be enrolled into a company pension by their employer will have a minimum 5 per cent of their earnings paid into a pension in 2018. The employer must pay at least 2 per cent of this. Many employers pay much more than this minimum.
If you are still unsure how to get moving on a pension, it would be worth consulting a regulated financial adviser, who will make a recommendation based on your needs and circumstances.
I’m a freelancer. What should I do?
Annaliese Edwards is typical of a growing army of workers shunning full-time employment in favour of the flexibility of the “gig economy”.
A freelance television producer and director in Manchester, Ms Edwards works on contracts typically lasting from days to weeks but not usually longer than three months. Her earnings fluctuate but tend to be about £40,000 a year.
“I have always managed to be in work, but as I freelance I often don’t know what is going to happen one week from the next,” said Ms Edwards, 42, a single parent to two children aged 11 and 7.
The uncertain timetable makes it hard to plan for the long-term. “I am quite good with money in terms of savings, not having credit card debts and a good mortgage deal, but I have no regular money going into pensions.”
Ms Edwards has accumulated a healthy emergency fund, which she does not touch, and other savings. She could spare about £200 a month for a pension but admits she does not know how to set one up.
She has two workplace pensions, with providers Now and Nest, which she does not save into currently.
“I feel I should be doing something but with pensions I genuinely don’t know where to go and what is the right amount to save,” she said.
FT Money asked two experts for ideas on how she could get her retirement planning sorted.
Alistair Cunningham, financial planning director at Wingate Financial Planning
As a basic rate taxpayer who is self-employed, the benefit of a pension for Annaliese is less now than it might be in the future. Contributions as a self-employed individual will receive her highest rate of income tax relief (20 per cent) and grow free of most UK taxes. Under current rules only 25 per cent can be taken as a tax-free lump sum at retirement, but she will pay income tax on the rest.
As she plans to retire at about state pension age this income would probably use up most of her personal allowance, so she would pay tax at 20 per cent on most of her pension withdrawals.
For this reason an Isa provides a good vehicle for “pension” savings — it also has the benefit of being more accessible in the event of emergencies or if her circumstances change.
Specifically, as she moves into direct employment occasionally, or if she enters the higher-rate tax band, that may be the time to contribute into a pension. In the first case, she may benefit from an employer’s matching contribution, and in the second she enjoys 40 per cent tax relief, rather than 20 per cent, even though her retirement circumstances would not necessarily have changed.
After retaining about a year of expenditure in cash (not necessarily in a cash Isa) an investment Isa is a good choice. As her intention is to leave the funds alone (other than sometimes using the Isa to fund a pension as above) an equity allocation of 50-80 per cent is quite reasonable. A low-cost multi-asset fund is an efficient way to gain exposure to a broad range of investment types.
A realistic investment return is probably only 2-3 per cent above inflation and of course values will fluctuate. For now it is probably more important to focus on the habit of saving than the ultimate outcome. With a mortgage and children there will be time to catch up later, but the power of compound interest means a £200-£300 contribution today will generally be worth more than the same amount (even adjusted for inflation) in 5 or 10 years’ time.
Claire Walsh, a chartered financial planner with advisers Aspect 8
As someone who freelances, as a starting point, Annaliese should go online and get a state pension forecast to make sure there are no gaps in her National Insurance record.
She should consider topping up her workplace pensions rather than setting up a new personal pension for additional contributions, to keep things simple.
For example, her Nest plan will accept monthly personal contributions by direct debit. However, she should review the investment strategy on the Nest plan as the risk level may be too low for someone of Annaliese’s age.
She should definitely consider moving some cash savings into a stocks and shares Isa instead of a pension, where it would be locked away until age 55. In an Isa she could have the potential for above-cash returns, while still having the benefit of accessibility. This could be viewed as a medium-term fund in case she needs to support her children through university or to meet other expenses ahead of retirement.
The opinions in this column are intended for general information purposes only and should not be used as a substitute for professional advice. The Financial Times Ltd and the authors are not responsible for any direct or indirect result arising from any reliance placed on replies, including any loss, and exclude liability to the full extent.