Pensions : The Box in the Attic

pandoras box

Open the box, banish the demons

When someone mentions pensions what comes into your head?

For those of us under the age of, say, 50 it will likely be a range of images or responses.  I’m just guessing that none of them involve champagne, laughter, dancing on a beach in Thailand or anything fun at all.  Most people’s reaction will be one of mild unease with a slight tightening of the chest and a vague feeling of apprehension or fear.

Most people treat their pension arrangements like a box in the attic containing a dead rat.  They know its there and needs to be dealt with.  There is a vague odour starting to float down from the roof.  But dealing with this involves going up to the attic in the dark, brushing past the mental cobwebs and spiders and looking at the imagined horrors inside the box.

The Escape Artist understands this and wants to help you.  Some tough love is required here.  We must  confront the issue, take control and look inside the black box labelled “pensions”. It’s not that scary and no actual rats are involved.

To illustrate, lets invent an imaginary friend and call her Sarah.

Sarah was always hard working at school. When she was 6, she wrote “What I Did In My Holidays” in neat, joined up handwriting and got an A* from her teacher.  Sarah was well behaved and loved the direct correlation between school work and positive feedback. As the years passed, she turned into a bit of a Hermione Granger.  She’s not entirely sure why she chose to study law at University and become a lawyer but suspects her middle class background had something to do with it.  At lunch parties, her parents and their friends would make vague but positive references to becoming a lawyer. After all, none of them could recall stepping over a homeless lawyer outside Waterloo station.

After university, Sarah trained as a lawyer at a large law firm in London.  This started out being fun, almost an extension of college but with more money.  But work gradually got more serious. She noticed that her peers and partners at her law firm seemed stressed and knackered most of the time. She is now 32 and has just moved job to be an in house counsel at a company.  She is smart, hard-working and ambitious but decided to go in-house because she may want to have kids in a few years time, the work will be interesting and the hours will be more sane.  The Escape Artist can only admire this level of awareness in a 32 year old – at that age I was still an idiot with no real idea what made me happy.

Sarah earns good money. Actually she earns great money – it just sometimes doesn’t feel that great living in London surrounded by people (both real people and shiny people in adverts) who are fronting and maxxing, pretending they have more money than they really do. But Sarah has a flat, is paying down the mortgage, and has her shit together in life.

The new job has forced Sarah to think about pensions. She has just had an email from HR containing 12 pdf attachments containing a load of bumf, blood curdling health warnings and investment jargon.  What should she do here?

Step 1: Do not ignore this

Being a lawyer, and therefore having developed a tolerance for reading boring shit, Sarah does not make like an ostrich and bury her head in the sand. She understands that money compounds over time so she does not delay.  She prints the attachments and reads them all – even though much of it she only skim reads to know what’s there.

Step 2: Understand the key features of “the deal”

OK, now Sarah has skim read the bumf, has she understood it?  What are the key elements of the deal?  A good test of this is: could she explain it to a 14 year old?

Sarah can see that, like most pensions now, this is a defined contribution scheme i.e. you know what goes in, you just don’t know what you’ll get out at the end.  The key is how much is the employer firm contributing and how much is Sarah contributing?  Sarah looks carefully for any element of match funding (i.e. the employer matches your contributions) as in this scenario its crazy not to contribute the maximum she can.

Understand the key tax benefits, even if only at a high level. What Sarah needs to know is this – as a 40% tax payer, if she pays in £6,000 per year, the government will make this up to £10,000. This is £4,000 of free money. This £4,000 is obtained partly by a direct reclaim of cash into the pension scheme (no paperwork required from Sarah) and partly via the tax return at the end of the year (for which Sarah needs to complete her tax return).

Step 3:  Consider a SIPP

Will your employer allow you to pay contributions into a self invested pension plan (SIPP)? These can be significantly cheaper (in terms of lower fees) and provide better choices versus a corporate scheme. However you should never leave a corporate scheme for a SIPP if the employer will not pay its contributions into a SIPP. Never leave free money on the table.

Don’t be fooled by a % of assets that may sound small, fees can add up to a million pounds over time. If you use the right platform and tracker funds, a SIPP can mean significantly lower annual costs and so a greater stash.  At work, I was able to move my pension pot from the employer provided scheme to a SIPP which meant I was able to reduce by 50% the fees paid.

Having a SIPP in addition to a corporate scheme is also an option. You can then use the SIPP for squirrelling away any annual bonuses etc.

A SIPP also allows you to consolidate pension pots from prior jobs.  This is often a smart move because 1) the fees on those schemes may be disgustingly high 2) you regain control over investment choices and 3) having everything in one place reduces admin and simplifies planning.

You can use this handy Monevator table to help you choose a SIPP provider.

Step 4: Make an asset allocation choice

Sarah is investing for the rest of her life. Pension money will be locked up for at least 22 years so Sarah should invest for long term returns, ignoring short term volatility.  This means being 100% equity invested.

She should look for broad geographical diversification – ideally via a single All World Equity Fund which includes the USA, Europe, Asia-Pacific and Emerging Markets.

Step 5: Make a fund choice

The key choice is active versus passive management.  An intelligent beginner recently pointed out to me that passive sounds “bad” or lazy.  But active is expensive and consistently underperforms passive after the impact of fees.  If you are still struggling to accept that most active funds under-perform the market after fees, read Winning the Losers Game.

Sarah vaguely knew a guy at university called Hugo who became a fund manager.  Sarah finds Hugo annoying. She knows he is paid a lot of money and has an extravagant lifestyle. Sarah does not want to subsidise his SUV, his ski chalet in Chamonix or his trips to strip clubs.  If you feel sorry for active fund managers, go passive and you can always take a suitcase of the cash saved and hand out cash “bricks” by Bank tube.  Just be aware that there are more worthy causes out there.

Sarah is smart so she uses passive index trackers. She pays the lowest costs and achieves the superior returns that the equity market provides over the long term. She looks for a low cost broad equity index tracker from Vanguard (who are run for her benefit).  She picks the Vanguard All World ETF (total expense ratio 0.25%).

Sarah (and not The Man) is now the Boss. She owns the entire capitalist system – right across the world.  Globalisation is working for her and her 7 billion employees.

Step 6: How much to contribute

People will tell you that pensions are very complicated.  But you don’t need to understand everything. You just need to follow the 80:20 rule and understand the 20% of information that provides 80% of the value.

Some schemes set the contributions (e.g. employer 10% of salary, employee 5% of salary).  This removes the choice from Sarah and at least provides simplicity.

If you have more flexibility to vary your contributions then in broad terms you can contribute an amount up to your earnings each year…in general Sarah should invest as much as she can afford, subject to the constraint that it will then be locked up until she’s 55. For money that she can’t lock-up that long, mortgage paydown or an equity ISA is a more appropriate tax efficient vehicle.

The beauty of monthly contributions to a pension from salary is cost averaging, meaning that your investment cost is spread over time and over different market conditions. This means Sarah will achieve a representative and acceptable market return over time. People think far too much about beating the market. The truth is that Sarah does not need to “beat” the market.  With the right saving rate and with low fees, the market return over time should be plenty good enough.

That’s it. Sarah is now good to go. The paperwork is all capable of being completed in an afternoon. The box can then be put back in the attic and safely ignored.

7 comments

  1. Paullypips · · Reply

    Excellent pension advice, simply explained. You really cannot go wrong with Vanguard ETFs, plus they have recently announced a reduction in their already tiny charges.

    1. PP – thanks for the comment (and the typo spot, now corrected!)

  2. Great article as always.

    I’d like to debate the merit of a pension vs. tax free savings.

    You say that if you put £6,000 the government will make this up to £10,000. Yes, the printed value of the pot does go up but as soon as you retire, the taxman takes it back again. All a pension scheme does is kindly shelter you from double taxation.

    Aren’t we all just government’s unpaid pension fund managers – “Dear Sarah, please invest our £4,000 for us. When you retire we’ll be back to take money then. Invest wisely. Love, The Govt.”

    The alternative is an ISA where you take the tax hit today but don’t pay tax again upon withdrawal.

    The choice of pension vs tax free saving is mathematically the same, all other things being equal.

    I’d therefore argue that the choice of pension vs tax free savings is down to personal circumstances and outlook.

    Case for Pension
    – Additional contribution from Employer
    – 25% tax free withdrawal upon retirement

    Case for ISA
    – Taxes always go up so it’s cheaper to pay today
    – It’s your money and you can touch it. Pensions are locked away and can be raided by the governments. Who’s going to pay for the spiralling government debt?
    – You can hand it to down to your kids. Conversely Pension annuities die with you – all your life saving’s have gone.

    If I were Sarah I may be swayed by the employer contribution.

    However, being self-employed, I won’t be touching a pension plan with a barge pole.

    Would love to hear if my understanding and/or logic is wrong.

    1. Thanks for the comment. I use both a pension and ISAs to shelter as much as possible. If someone like Sarah had to chose you’re right that, where her employer makes contributions, a pension is the right choice. Not joining is leaving free money on the table for her.

      For a self-employed dude, I’d recommend working the maths thru for each individual on a spreadsheet which takes into account the compounding effect & time value of money, the timing of the upfront 40% tax refund on pension contributions and the potential tax free withdrawal of 25% of the fund at retirement plus the expected rate of tax likely to be paid in retirement (see Sheldon’s comment below).

      Also, UK pensions are being freed up so there’s no need to take an annuity anymore.

  3. MB you are also ignoring the fact that most taxpayers who paying the 40% rate while working, will be 20% rate taxpayers as pensioners. In retirement you keep half the tax rebate (more if you take the 25% tax free lump sum) plus, as TEA says, all the compound growth.

    I fall into this category exactly. By contributing to a SIPP I get all my 40% tax back (about £4k per year). But once I have recovered all that tax then I put any remaining savings in an ISA.

    I don’t think its a case either ISA or SIPP – I use both. Don’t leave money on the table whether from an employer or the taxman.

  4. Hi Sheldon

    I agree if you are a 40% tax payer on the way in, but a 20% tax payer on the way out then you do gain through a pension so good on you. Once your pension pot gets significant enough to make you a higher rate pensioner, the upside diminishes.

    The 25% rebate definitely makes pensions more attractive but I personally can’t see this perk lasting the decade. Many politicians open state this is easy money to be had. Milliband’s current policy is to limit it to £36k!

    The compound growth of the government rebate is however a fallacy. You just end up with a compounded tax liability too. You’re just a temporary caretaker of the governments money.

    I think the case for ISA vs SIPP primarily depends upon age. A pension is held by government lock & key. If I was young and wouldn’t trust 30 years of government to keep my money safe. If I was 54 I’d probably be ramming my pension reasonably confident that I’d get the 25% tax free return before the perk is pulled.

  5. Hey MB

    To pay 40% tax in retirement you would need a £41k + pension. That’s a huge retirement income given you should be done with mortgages and child expenses – the average UK salary is only £26k. You would need a pot of over £700k to generate £41k – I’m expecting to have a £450k pot – so I will get to keep all of the compounded growth and very useful it will be.

    I’m not sure what you mean by “I wouldn’t trust the Govt to keep my money safe”. Compay and personal pensions are held and invested by financial institutions. The ‘lock and key’ consists of tax rules that mean you have to payback the tax relief if you access the pension before pensionable age.

    I take your point about future left-wing Government mounting raids on pension tax shelters – but then this equally applies to money held in ISAs.

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