Not wanting to be poor in your old age is the best reason I know for having a long-term savings plan. Most people don’t realise they need at least £150,000 to avoid the old age poverty trap.
The key point is that if - as now - you can only get a net return of 4% on your money, then a capital sum of £150,000 will produce an annual income of just £6,000 or £500 per month. Add that to what the government proposes as a flat rate OAP of £110 per week and you have a total annual income of just under £1,000 per month.
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Not giving up your capital costs you more
OK, if you are prepared to burn up all your capital by the time you die, you would need less capital to get the same income because you could buy an annuity. The cost in capital terms would depend on your age but right now, a 65-year-old man would still need to lay out £110,000 to guarantee him a net income of £6,000 a year for life from an annuity.
But most people would prefer not to give up all their capital - as you do with an annuity - and would like to pass some cash on to their family on their death. In which case, you need £150,000 to generate £6,000 a year.
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#1: Don’t wait to start your retirement plans off
What I’ve said so far is about the future, in line with the government’s recent White Paper on pension reforms. Right now we have an OAP and a complicated system of means testing that means it isn’t worth saving anything at all to support you in old age unless you have over £130,000. If you have less than that, the loss of means tested benefits pretty well eliminates the benefit from savings.
The White Paper proposes to link the OAP to earnings rather than prices, so it will gradually rise to the current level of the means-tested Minimum Income Guarantee (currently £110 for a single person).
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Stolen National Insurance contributions
The State Second Pension (S2P) will also gradually be converted from an earnings-related to a flat rate scheme. So essentially, in returnfor your National Insurance contributions the state will give you a flat-rate OAP that keeps a roof over your head and cheap food on the table - though whether it will pay the fuel bills looks questionable.
Under the proposed new system it’ll be up to you to save to generate more income for your retirement. Which is why you’ll need at least £150,000 of capital to provide a decent top-up to the state pension. And why you need to start now - because the reforms won’t start till 2012 at the earliest.
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Low-cost NPSS a partial solution
The White Paper proposes the introduction of a National Pension Savings Scheme. All employees would be automatically enrolled unless they were already members of a better employer’s scheme.
In the NPSS, the employer will contribute 4%, the employee 3% and the government (through tax relief) 1%, making a total of 8% of earnings. The scheme will offer a limited range of simple funds at very low costs- under 0.5% a year or a third of the current stakeholder pension charges.
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#2:Lower costs mean a bigger fund
This low-cost savings plan is part of the answer to the savings problem. Say you save £100 per month for 25 years and that the annual investment return is 7%. If stakeholder charges are deducted from this you get a net return of 5.5%.
Assume the NPSS charge and you get 6.5%. With a return of 5.5%, your fund would be worth £64,000 after 25 years; with 6.5%, £75,000. The additional capital gained as a result of getting an extra 1% a year is over a third of your total contributions of £30,000. So low charges are important and very worthwhile.
But low charges alone will not be enough to get people enthusiastic about pension savings. This comes back to the issue we started with: keeping control of your capital and generating an income from it from investments, or giving up your capital and getting a guaranteed lifetime income through an annuity, which is what you have to do with money saved in a pension plan.
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Annuities are a turn-off
As it stands, the system forces you to convert at least 75% of the money you save in a pension plan into an income by buying an annuity. So far, nobody has recommended radical change to this rule. Yet I’m absolutely sure it’s the biggest turn-off in the whole system.
Nobody seems to have clocked that if you do away with means testing and have a flat-rate OAP then the reason for annuities also vanishes. They only reason we have the current annuitisation rules is to stop people blowing all their pension savings in a spending binge and then living the rest of their lives at the taxpayer’s expense.
Until the clever-clogs in charge of the system get rid of annuitisation, nobody in their right minds - even those rich enough to be able to use the wrinkles in the rules to defer annuitisation until age 75 - will put the bulk of their long-term savings into pension plans.
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#3: Get your stock market savings started now
Apart from the annuity disincentive, I also believe most people are quite realistic about politicians’ abilities to break their promises, and intuitively understand that if the shish kebab hits the fan, politicians will find it a lot easier to change the rules to penalise people with money in officially-registered pension plans than to clobber savers whose money is under their own control.
What this means is that if your employer contributes to your pension plan, then you would be mad not to go along for what is effectively an almost free ride. And that will apply to the new NPSS - you should be happy to pay in 3% if the employer and government are paying in 4%. Or even happier if you are in an occupational scheme that is better than this.
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#4: Don’t simply assume a pension is best
But as for putting a large chunk of your own surplus money into pension plans, I am doubtful that this represents sound advice in your 20s and 30s unless you have pots of money to play with.
My own preference would be for saving in stock market funds inside the tax shelter of an ISA as your first long-term savings plan, though I also think there’s merit in Buy-to-Let as an investment for retirement. With money in an ISA, you can draw a tax-free income (whereas all the income you take out of a pension plan bears income tax) and keep control of the capital too.
The beauty about using the ISA for your pension savings now is that in future you can take lump sums out of it and put them into a pension plan if you want to in order to benefit from the tax relief. You’re allowed to contribute up to your gross annual earnings every year, and putting in a contribution of, say, £5,000 will result in another £1,410 (basic rate taxpayer) or £3,333 (higher rate taxpayer) being added to your fund.
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