Understanding pensions (UK) - easier than you think.

Understanding how pensions can work for you is easier than you think. In this video, I share a few principles that I find helpful to understand when planning to invest in a pension. Ideally, you learn these principles before you start investing in a pension and so are conceptually clear about the why and how to plan for your financial independence.

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My 6-year-old nephew innocently assumes I am a ‘YouTube Star’. I hope this video takes me higher in his estimations.

Transcript

Introduction

I want to share my main tips & principles for investing in a pension plan, so you feel naturally motivated to start or increase your contributions, to build your financially independent future. I am a London-based financial adviser who enjoys the teaching aspect of financial literacy. If you want to learn more about why being engaged about your pensions is important, then keep on watching.

Before I spill all the beans, I am highly regulated and so must add my disclaimer that nothing in this video constitutes financial advice.

Compounding is key

Principle no. 1. Compounding is key. Let me show you by example. From this example, you can see, that the quicker you start, the more time you have on your side for compounding to do the work. There are many rules of thumb that suggest you should pay half your age to get 2/3rds of your final salary, etc. However, with this compounding logic, it makes sense to max out as much as you can when you are older, so you can go easy on contributions when you are older and let compounding do all the hard work for you.

Wrapper not rapper

That word pension can sometimes muddy the waters and confuse. All a pension or a retirement plan is - is a tax-efficient wrapper. Not a rapper like Cardi B:). A Wrapper.

Think of a pillowcase. Now, an ISA is also a wrapper. You can stuff the same feathers inside both wrappers - an ISA and a pension - so the same kind of investments like mutual funds or stocks or Investment Trusts. So, a pension or an ISA is nothing but a way to hold those investments. So, why use the wrapper word then? It determines the tax treatment.

Tax-efficiency

Now, I don’t want to get too technical but pensions are a lot more tax efficient than ISA’s. You get tax relief on your contributions at the highest rate of tax that you pay. There is no tax relief on an ISA. Think of a snowball coming down a mountain. The bigger the snowball at the start, the quicker it can grow. A pension is a bigger snowball than the ISA - if you get 20% tax relief or higher like 40% you can just imagine. You cannot access your pensions until age 55 although you need to check with your individual provider if it is a work scheme... and while you can access a 25% tax free amount, the remaining 75% is taxed as PAYE - that means at source.

Access to your funds

You also need to consider if you need accessibility therefore to your investments and you could use both wrappers to plan for financial independence. It’s just that pensions are more tax efficient!

Foxes and chickens

Now, my third tip talks about tax and inflation at retirement. There are 2 foxes that can steal the chickens from your garden when you retire. These are tax and inflation.

With tax and pensions, there isn’t much you can do to mitigate tax at retirement although with drawdown, you have some flexibility about when and what amounts you access so there is some control. You could invest in ISAs and the first ISA millionaire in the UK was John Lee who often writes for the Financial Times. He has a great book called ‘ How to make a million slowly’.

You could easily take 3.5% or 4% out of your ISA’s at retirement and there would be no tax to pay. Same with your pensions of course...but there will be tax to pay on your pension. The inflation fox is taken care of if you stay invested while accessing your pension funds. If you have some decent equity exposure, then it is likely that your investment growth will more than take care of inflation for you.

Not everyone is utilitarian with fees. Cheapest way is passive. Range can be 0.1 to 1% for mutual funds so give attention to this area. As much as you reasonably can, especially if you are young. You can work backwards roughly with a good shortcut called 4% rule. Now, this is a quick shortcut and if you want to be more conservative, you can tweak it to 3 or 3.5% in which case you may have to pick a different multiplier between 20 & 30.

The 4% rule

I will stick with 4% for this example. It is simple to work out. Work out the gross amount you could live on, risk-adjusted for inflation is more conservative - for example, you may have more medical expenses and travel but less work related expenses- and be realistic. It is easier for most to save more than to earn more so being realistic helps. Then, multiply that by 25. So, that is how you find the target amount you need in your pension pot. A £20,000 spender like me for example, needs £450,000 Also, the higher your savings rate, the less years you will have to work till financial independence. So, why 25? That is simply how the maths works.

If you have your retirement savings invested in stocks or other assets, they grow via dividends and capital growth at a total rate of 7% per year, after fees and before inflation. Inflation eats 3% on average, leaving you with 4% to spend on.

A great blog to read on this is the 4% rule by Mr. Money Mustache. The simplicity of it is what I love. And if you want more complicated models, they are out there if you want to use them.

Flight path can change

If you are only 30 years old and plan to keep working till let's say 50...your life may change radically from now until 50...your needs may change. If you think of a pilot with a flight plan from London Heathrow to New York but then the plan changes to let's say, Mumbai, then he may need more fuel, a stop, etc.

So also, you can just keep adjusting your pension contributions, your expenses and your expectations accordingly by reviewing what kind of a lifestyle you want. Some people like being really minimalistic and some want a fancier retirement - nothing to judge, it is just that the amounts change and as long as there is a plan for this, it’s all good.

We start with a rough plan but not a perfect, foolproof plan...the plan can be adjusted and that is a good metaphor to explain we do not have to have the perfect plan right at the start. We review, we adjust.

Review your pensions regularly

My final tip is look at your pensions. Look at the funds you are investing in. Know what the fees are. Know the other investment choices your pension fund offers - whether they be ethical, active, passive. Most people don’t look at their pension statements enough. How will you know if you are on course for financial independence if you don’t? I have a great Conscious Money newsletter if you want to subscribe, I will leave the link below. If you liked this video, do give me a thumbs up, leave a comment and subscribe for more content on freedom and clarity with money and life. Thank you.