How young is too young to pay into a pension

Kelly’s Know-how’ – April 2021 edition

How young is ‘too young’ to pay into a pension?

I had an interesting meeting recently with a relatively young couple who wanted to look at ways to improve their financial situation. We talked about different ways to save for the future and the different tax treatments. I then suggested they save some of their disposable money into their pension, because they can get the associated tax relief.

Their answer: “I don’t want to tie my money up until retirement, I’d rather make overpayments on my mortgage to save interest and wait until I am 50/60 and then put all my money in a pension.”

Their answer struck me and made me realise how common their thinking is.

So in this month’s blog, I want discuss why the above strategy does not work and look at a better way to save for the future.

Pension allowances

Every year, you have an annual allowance for pension payments. You can carry forward up to 3 years, subject to your earnings. The main point here is that, by the time you want to put the money in the pension, you might not have enough allowance.

You should try to use your annual allowance whenever possible every tax year because once it’s gone, it’s gone!

Investing for longer

When you save for retirement, you are in the accumulation period. Meaning that you accumulate and don’t spend the money. When you are actually retired, you will be in the decumulation period, meaning that you start withdrawing money from the pension pot.

If you wait until you are 50/60 to start savings, you won’t have a long accumulation period for the pension pot to grow. And when it comes to investing, the key is the time you stay in the market. The long, the better.

With this in mind, you should start as early as possible, giving yourself a long accumulation period to benefit from capital growth.

Consistency and compounding

Why rush with a last minute pension contribution when you can make regular monthly contributions?

Planning for the future is not rocket science. They key is consistency, and there’s no better way of achieving this than by setting up regular contributions. Make it automated and it will be become the norm, and you will be surprised at the results you can achieve. In this way, you are also benefitting from compound interest, which is earning interest on interest already earned; as Albert Einstein reputedly said “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”

The images below show just how much difference it could make if you start saving and investing early – even if you put in the same amount in total as someone who starts much later.

In our hypothetical example, David starts investing £100 a month when he is 25; Mike invests £200 a month from the age of 45, so they both save the same £48,000 by retirement and reinvest the returns. Assuming a 5% annual return, the effect of compounding has longer to work on David’s investments, and so he ends up with almost twice as much as Mike.

 In summary, the key point is to plan ahead, make your contributions automated and take advantage of the tax relief! 

Paying off vs saving

The appeal of living debt-free, and the achievement of paying off a mortgage are really attractive, but especially with the current low interest rates, actually it might not be the best thing for your finances.

Suppose interest is at 3%, if you overpay your mortgage, you would only save 3%. 

What about paying it into your pension? You immediately get 20% tax relief (40% if you are a higher tax payer) plus the potential growth and the effects of compounding on your investment. Suddenly it becomes a bit of a ‘no brainer’!

 

If you’d like to discuss any of the above topics, for yourself or perhaps another member of your family who is starting to save for the future, please don’t hesitate to get in touch! 

See you next month!

Kelly