Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.
Managing your pension in your 20s and 30s
Pensions offer people of all ages the opportunity to grow their hard-earned savings tax efficiently, providing an upfront incentive via tax relief and tax-free investment growth.
Furthermore, when you reach age 55 you can access 25% of your pot tax-free and have total flexibility over how you draw an income.
However, what you prioritise is likely to evolve as you go through different phases of your life.
In the first part of a series, we look at some of the key things that savers in their 20s or 30s should be thinking about as they get started on their retirement journey.
THE EARLIER YOU START, THE EASIER IT IS
Anyone aged 22 or over who is employed and earning £10,000 or more should be automatically enrolled into a workplace pension scheme.
When you are auto-enrolled at least your first 3% of contributions are matched by your employer. If you opt out of auto-enrolment you’ll be waving goodbye to this free money forever, so make sure you stay in the scheme if you can afford to.
The minimum auto-enrolment contribution is 8% of earnings between £6,240 and £50,000 – of this, 4% comes from the employee, 3% from the employer and 1% via pension tax relief.
Who qualifies for automatic enrolment?
To be eligible, you must be:
At least 22 years old
Not yet at state pension age
Earning a salary of at least £10,000* p.a. (under current rules)
Normally working in the UK under a contract of employment
*This is known as the earnings threshold and you will be assessed for eligibility at each pay period. The earnings threshold will be prorated meaning the actual earnings threshold amount will differ if you are paid monthly, four weekly, fortnightly or weekly. As you are assessed for eligibility at each pay period you may find that you are automatically enrolled if your earnings increase – if only for a short period.
For example, if you are paid monthly, you will be deemed to meet the earnings threshold if your monthly earnings reach at least £833. If you are paid weekly, you are deemed to meet the earnings threshold if your weekly earnings reach at least £192.
You will receive tax relief on your contributions. If you’re not eligible, you can still ask to be put into a pension scheme and your employer may pay into it.
Source: The Pensions Advisory Service
HOW MUCH SHOULD I SAVE?
One very rough rule of thumb is to aim to save half the age at which you started as a percentage of your salary each year.
For example, if you start saving at 20 then you aim for 10%, while delaying until 30 means you’ll be targeting 15%, and waiting until you’re 40 will mean you need to set aside 20%.
Don’t let these numbers scare you though – any money saved in a pension is a good investment. But be aware that by taking the bull by the horns and starting early, the journey will be much easier.
HAVE A BUDGET AND WRITE DOWN YOUR SAVINGS GOALS
For most people in their 20s and 30s there will be many competing financial priorities. For example, individuals may have their sights set on paying off debts or saving for a first home (or both).
Clearly all of us only have so much money and it’s unrealistic to save every penny you earn, but writing down your outgoings and incomings is a good first step to understanding what you truly can afford to set aside for later life. And the earlier you do this, the easier it will be.
WHAT IS PENSION TAX RELIEF?
If you think you can afford to save above and beyond your workplace pension, your contributions will benefit from pension tax relief. This will automatically convert an £80 contribution into £100 in a pension, while higher and additional-rate taxpayers can claim back extra tax relief from HMRC.
Some workplace schemes – such as salary sacrifice pension arrangements and so-called ‘net pay’ schemes – will pay this tax relief automatically, provided your contribution comes from salary taxed at 20% or higher.
Because of this generous tax treatment, annual pension contributions are capped at £40,000 for most people (or 100% of your UK relevant earnings if this is less than £40,000).
Think about your investments
It’s worth noting that long-term saving isn’t just about pensions. Those wanting to prioritise buying a first home may want to save their spare cash in a Lifetime ISA, for example (although you should aim to do this alongside your workplace pension if you can).
It’s also sensible to build up a decent-sized ‘rainy day’ fund in an easy access cash account you can get at quickly in case of emergency. Aiming to have around three months’ fixed expenses in this emergency account is a good place to start, and make sure you shop around for the best interest rate you can find.
THINK ABOUT YOUR INVESTMENTS
While how much you pay into your pension (and how early you start) is arguably the key factor in determining your eventual retirement outcome, investments can provide a significant boost too – particularly over the longer term.
If you’re in your 20s or 30s, your investment time horizon is likely to be 30 to 50 years, which is long-term in anyone’s book.
Your auto-enrolment pension will be picked for you by your employer. If you take no action you will be placed into the ‘default’ investment fund, which benefits from a cap on charges currently set at 0.75%. This fund will not be designed based on your attitude to risk, however, but rather targeted at the broad scheme membership.
Furthermore, different default funds have vastly different investment strategies and as such will deliver different investment outcomes for their members.
At the very least you should have a look at the default fund into which you are being put and make sure you are happy with the investments you own and the level of risk you are taking.
While attitude to risk differs from person to person, generally younger investors can tolerate greater fluctuations in the value of their pot over the short-term as they don’t need to access the money for decades.
Historically, those who have been willing to accept volatility over the short-term have generally been rewarded via returns over the long-term.
CAN I RUN A PENSION MYSELF?
If you save over and above auto-enrolment in a pension such as a SIPP (self-invested personal pension), you’ll enjoy a whole world of choice for your investments.
If you aren’t confident in choosing individuaL stocks or bonds, you may want to look at funds or investment trusts where a fund manager will select everything that goes into their portfolio.
An alternative is to use a tracker fund or exchange-traded fund which mirrors the performance of a specific basket of stocks, bonds or other asset classes, or a mixture of them.
Lots of ISA and SIPP providers also offer ready-made portfolios based on attitude to risk, ranging from cautious to adventurous. You can usually choose between ‘active’ funds – which are run by a manager trying to beat the market – or ‘passive’ funds which simply track an index.
Saving for your children
For lots of savers in their 20s and 30s the focus isn’t just on their own savings but building a pot of money tax efficiently for their children as well. If this is a priority there are two ‘junior’ versions of traditional savings products you could consider.
You can save up to £2,880 a year on your child’s behalf in a Junior SIPP and it will be topped up automatically via pension tax relief to £3,600. The mechanics of tax relief are the same as for an adult saver, just with a lower annual contribution limit.
In all other ways a Junior SIPP works in the same manner as a regular SIPP, with 25% of the pot available tax-free from age 55 (due to rise to age 57 in 2028) and the rest taxed in the same way as income.
The other main option is a Junior ISA where the annual allowance is £9,000. Once your child reaches age 18 their Junior ISA will convert into an adult ISA and they will be able to access the money tax-free.
A parent who started saving in a Junior ISA for a new-born child could build a tax-free pot of more than £240,000 by the time their child reaches 18, assuming they put the maximum in each year and it grows by 4% every year after charges.
LOOK AT THE CHARGES
If you’re picking your own investments, once you’ve established the appropriate level of risk it is crucial to keep your costs as low as possible. This is because even small differences in charges can compound over time to wipe thousands of pounds off the value of your pension.
In terms of cost, active funds tend to have higher charges than passive ones (although active managers say this charge is justified because they have the skill to deliver higher returns).
Once you’re happy with your attitude to risk and the investments you have chosen, there should be no need to do anything to your portfolio until you are around five to 10 years from retirement, apart from checking that nothing has changed to the investment case of each asset.
In fact, in most cases the last thing you want to do is trade too often as this will layer on extra costs with no guaranteed benefit.
Don’t miss next week’s pensions article, looking at what people in their 40s should do with saving for retirement.