Pension saving can beat inflation so keep up contributions

With the Bank of England forecasting that inflation could hit 11% around October, and stay above its 2% target rate for two years, it’s a struggle to find investments, never mind a savings account, that goes the distance in maintaining the real value of cash deposited.

However, the fact that savings into a pension come with what is effectively a gift of free cash from the State in the form of tax-relief, means this is one of the few options that will not just keep pace with but beat inflation. This obviously presupposes that the saver already has a cash savings buffer and does not need the monies saved into a pension until they reach pension access age (55, rising to 57 soon).

Tax relief means that all taxpayers’ pension contributions are immediately boosted by 25%, while higher rate taxpayers are effectively getting a 66.7% boost from tax relief before any investment growth.[1] Whether the tax relief is added to the pot or just banked, these assured cash boosters trounce any investment returns one is likely to get in an ISA and will beat inflation not just in the short term but in the long term.

Moreover, far from being a reason to reduce or avoid pension saving, periods of market volatility can be a boon for young and middle-aged investors as during these times their monthly contributions are picking up more fund units at lower prices.

Gary Smith, Director of Financial Planning at the Newcastle office of wealth manager Evelyn Partners[2], says: ‘With a tricky market environment at the moment it is tempting for savers who are nervous about volatility to take their foot off the pensions pedal – but these are exactly the times when regular pension saving will pick up cheaper investments and deliver even higher returns in years to come.

‘And younger workers tempted to cut back on pension saving as day-to-day financial pressures grow should remember that it is the earlier savings above all that turbo-charge a pension pot. And in fact this means it is much easier than you think to amass a pension pot of more than £1 million.

‘It doesn’t take stratospheric salaries, saving a huge percentage of one’s pay, big employer contributions, or above-average investment returns to get there. The power of compound returns applied to regular saving in one’s twenties and thirties will take up the slack to a surprising degree.

‘In fact, a young professional with salary progression through their career lifetime, who saves just 5% of their gross pay into a pension to start off with, will be setting themselves up to quite possibly break the £1 million barrier.’

In our example a young professional contributes via a net pay scheme 5% of her gross salary to her occupational pension for the first 11 years of her career, during which she earns on average £35,000. Thanks to tax relief that works out at 4% of her net income. Then she saves 8% for the next 11 years (from an increased salary of £45,000), 12% for the 11 years after that (from £55,000) and 15% for the final 12 years (from £65,000).

Her employer contributes 5% throughout and she achieves an average of 5% pa investment returns.

Smith says: ‘In this scenario her pension pot at age 68 would amount to £1,066,651, which is impressive given that the assumptions are reasonable. This is of course nudging very close to the current Lifetime Pensions Allowance of £1,073,100, where a tax charge is applied on any excess, but that is not something a young saver need bother themselves with. Judgements as to whether to continue growing a pension pot beyond the LPA can be made as the limit is approached, not least because any tax charges due to the LPA will only be levied when the pension is crystallised.

‘It’s by no means cut and dried that savers should avoid breaching the LPA, as it will depend on one’s financial situation, including plans for retirement and tax-efficient gifting. However, what this example does highlight is that middle and high earners who have been diligently saving into a pension for most of their career must be aware of the LPA and that it could come into play - and sooner than they might expect.’

The power of early saving is revealed if, in the example, our employee stops contributing to her work pension at the end of the first period, i.e., when she is 34, and merely lets the pot accrue at 5% pa for the following 34 years. By age 68 the pot would be a sizeable £335,062.57 - from personal contributions during those 11 years of just £15,400. That’s growth of 2,075%.

NOTES

[1] Tax relief is granted automatically at 20 per cent of the amount going into your pension, while higher-rate taxpayers can claim back an extra 20 per cent and additional rate taxpayers 25 per cent, whether that is through their annual self-assessment tax return or automatically in their workplace pension. In a net-pay arrangement – a system increasingly in use for workplace schemes – contributions are paid from gross pay, so higher and additional rate tax payers get their relief straight away and it goes straight into the pension pot.

Technicalities aside, if you pay £80 into a Self-Invested Personal Pension or workplace pension, that will be topped up to £100 whatever your marginal (or top) tax rate. Because £20 is the tax that a basic-rate payer would pay on £100, your pot is boosted by 25% by the 20% tax relief (£20 being a quarter of £80).

A higher-rate (40%) taxpayer could then claim back another £20, getting £100 in their pension pot for a net cost of £60 after the tax reliefs. That is effectively a 66.7% return before any investment growth. An additional-rate (45%) taxpayer could claim back a further £5.

Some higher-rate taxpayers in company pensions and the majority of SIPP holders will have to take steps to claim back their extra tax relief.

[2] Formerly Tilney Smith & Williamson.