This post was inspired by a recent post on r/FIREUK. The author had sadly lost a parent much younger than the state pension age. From the discussion that followed, I don’t think they phrased their question the way they’d intended it, but understandably mistakes happen in that kind of situation. I’ve written this post in response to what I think they meant to say.
I’m assuming that if you’re wondering about this, you’re OK with the idea of investing money in general
A common criticism of financial independence and the FIRE movement is that there’s an idea that if you’re not spending your full earning power, minus the bare minimum needed to survive old age, you’re suffering. I guess most of the world can’t imagine being happy unless every penny goes on toys? Whatever.
Importantly, I’m not going to address that logical fallacy in this post. I’ve written about how being frugal shouldn’t make you unhappy, so if you’re looking for a counter-argument to that kind of thing, maybe look there first. Go for it.
No. This is about investment vehicle choices, for refined individuals who already know that a little bit of equity/bond investing is generally a good thing.
Which means we’re talking about using a pension instead of another investing account.
Why pensions suck
I invest in a pension. I’m an employee, not investing in a pension means I would miss out on that sweet employer contribution, which is basically like giving myself a pay cut.
However, pensions aren’t necessarily awesome.
You’re age restricted from accessing the money
So if you find yourself in dire need of resources – there isn’t anything you can do to get that pension cash when you need it, is there?
There’s a scheme for you to do this if you’re critically ill – here’s the outline to it on MoneyHelper.org.uk. So, if you’ve been given a short time to live, there is a mechanism for you to access the pot, so it could help with your own care needs or any last-minute bucket list items.
However, if you finally find that golden business opportunity, you’re going to need to find some other way to fund it, unless you want to deal with the tax penalties for withdrawing it prematurely… assuming your provider lets you.
That age bracket is moving further away
Bragging time: where I’m living, we can draw down our pensions from age 50.
However, for most of the UK, pensions are a no-no before age 55. From 2028, that’s increasing to age 57. Given the recent press reports about government efforts to get early retirees back to work, this might be pushed back even further.
Great for compounding – bad for flexibility.
Tax benefits are getting reduced
Back in the heady days of 2015, the annual allowance for pensions was £1.25m. That’s right, if you held onto the pot and it had built up to just under £1.25m, you’d only take income tax charges on drawdown. Go over it and incur a tax charge on your surplus, which undermines the point of using pensions as an investment vehicle.
At the moment it’s £1.0731m. In numerical terms, completely excluding inflation, that’s a 14.32% haircut.
I used this inflation calculator based on historical data, provided by the Bank of England. It has told me that £1.25m in 2016 is worth over £1.573m at the time of writing – so in real terms that’s a 32% haircut.
“Big deal!” you say. “I’m not going to have over £1,000,000!”
Well, maybe you will. Given the high rate of inflation, it’s entirely possible that your investments and contributions (and hopefully your wages, but the last twenty years says otherwise) grow to the point that £1m by the time you retire isn’t such a big amount.
Remember that scene from Austin Powers?
“I want – one million dollars!“
“Sir, that’s not a lot of money anymore.”
Assuming that there’s no reduction in the lifetime allowance, it’s still not ideal. How bad will it be? Who knows – which is kind of the point.
*But* just because some things suck, doesn’t mean all pensions suck
The criticisms above are totally valid.
Access isn’t that big a deal
Thing is though, regardless of how much further away your pension pot gets pushed, no sane financial independence campaigner is going to put themselves in a position where they run out of capital before they croak.
It’s a possibility, sure, but it’s a slow car crash you can see coming and if you’re into this stuff you’re going to take evasive action if you need to.
This means that it’s kind of irrelevant that some of your capital gets locked away for a while, because there was always going to be a large amount you weren’t going to touch until much later anyway.
Balance is key
There’s a reasonable debate here about how much you want to lock up versus how much you’re going to want accessible and liquid. It’s a personal choice. For my part, I prefer having more of my investments outside of a pension than in – but my tax situation is a bit different and I’ll get into that later.
The point is that you should consider having a pension. There are some great advantages to them for UK and Channel Islands FI campaigners.
Why pensions rock
If you die, they don’t count for inheritance
It finally happens – a big red bus hits you in the street, like your gran always warned you would happen. Hopefully you were wearing clean underwear.
Inheritance tax in England is an odd beast, but basically your spouse can inherit tax free and there’s an allowance for other tax-free inheritance on your estate. It was about £325,000 at last check, but you should obviously see a professional if you’re worried about these things.
Cool thing: if your pension gets distributed to another pension – perhaps, for your kids – then there’s no tax due. No inheritance tax bills for your family, hurrah!
Decided to YOLO on a business venture? Your pension is protected
Bankruptcy happens.
Pensions can be broken into by a court to pay off your debts if you go bankrupt, but it’s exceptionally rare. As a general rule, if it’s in the pension pot, an English/Welsh court won’t take it.
This is really cool if you decide you want to take a bit of risk and start your own company up. Most businesses fail, it’s a fact of life, but with your pension pot protected you can at least just go back to work if it doesn’t work out.
Your employer pays in so you might as well
In England – and very soon the island I’m living on – part of your employment contract is your pension matching.
You could decline to accept it, but why would you willingly take a pay cut?
Most workplace schemes require you to contribute too. The thing is, your contributions are made before the tax is taken off.
When I lived in England, as a basic rate taxpayer £100 of pension contributions cost me £68 out of my pay for the month. Pretty appealing!
On top of that, my work added £100. So I would get £200 of investments for £68. Even if I had a portfolio of entirely cash deposits, government bonds and money market funds, that’s a solid instant return that could reasonably be expected to take 10-20 years to generate from £68 outside the pot.
Here’s how I see it
I now live somewhere with a flat tax rate of 20% plus a social security (national insurance equivalent) that puts me on about a 25% deduction. We also have not capital gains regime – but the tax benefits of an ISA are more effective than this for most people, so don’t get too upset.
Pension schemes here are also high in fees and are more restricted. I miss my old Vanguard SIPP.
I’m matching my employer contributions, but as the benefits of a pension scheme for me are lower my main focus is on building assets outside of pensions. I don’t think that investing in a pension beyond my employer match is worth the access restrictions based purely on my own situation.
We don’t have kids, but even if we did there’s no inheritance tax here anyway.
My plan before I left England was different!
When I was still working and living in England, I had a very different plan.
Having qualified as a solicitor, it was very likely that I’d be a higher rate taxpayer. Paying on salary sacrifice would have given me something like a 40% plus national insurance tax saving, meaning that £100 of investment was going to cost me something like £55 via salary sacrifice.
My plan was to match the employer contributions and then salary sacrifice or pay into my SIPP everything I could in the higher tax bracket, at least for the first few years to build up a decent pot, then reduce it to just matching the employer contributions. The rate of return was too good, the benefits suited and my cost of living was much lower.
My point is…
That pensions are just a tool that you should consider using in your financial independence campaign.
As with any tool, there is a point to using them – but you don’t have to use them for everything, one tool doesn’t solve all problems and you should ideally have a whole toolbox of good quality tools to use at different times.
I’ve shared my two different approaches so that you can see that different priorities and considerations have changed the way I look at pensions as a tool in my own campaign.
As with everything on this site, these are my own views and they’re not financial advice. Financial advice is personal to you and tailored to your specific circumstances, which aren’t the same as mine. Hopefully though if you’re unsure it’s good for thought.
