One of the big announcements at last week's spending review was on the state pension age. It is to rise to 66 in 2020.
This shouldn't have come as too much of a surprise to anyone the retirement age was clearly far too low given therapid rises in life expectancy. So in that sense we should only be surprised that it has not been raised further. Note that in 1925 when the age at which men could start claiming a state pension was set at 65, life expectancy was 56. Now someone turning 65 has, on average, another 17 years to live.
The result? A financial package originally set up just to help the very few who survived well beyond what was considered an average life span at the time has become one that has to support millions of people for a couple of decades each. No wonder it has been one of the first targets of the 'cuts'.
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So what does this all mean for you? It should at the very least act as a reminder that you can't rely on the state pension to support you when you retire. Not only is it a mere £95.25 a week(so under £5,000 a year, an amount that doesn't fit with most people's retirement dreams), but as the comprehensive spending review made clear, you can't be sure when you'll get it. We wouldn't be particularly surprised to see the threshold ending up nearer 75 than 65 so you may find yourself out of work long before you qualify. So you need your own savings in place. Too many people never start saving on the basis that doing so via a pension is just too complicated. But it doesn't have to be.
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How much should I save?
Most people aim to have a retirement income of around two thirds what they earned when they were working. So with the average UK income currently £26,000, let's say you are aiming for a retirement income of £17,500 a year. To have that you need to have saved around £340,000 when you retire. That's a lot of money. But thanks to the joy that is compound interest it's easier to save than you think. Over the years you'll earn interest on top of interest creating a snowball effect so your money will grow faster and faster.
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All you need to do is start saving as soon as you can. For example, if you don't start saving for retirement until you are 40, you would need to save £850 a month in order to have a savings pot of £340,000 when you are 65 (assuming an annual growth rate of 5% and inflation of 2.5%).
But if you start saving at 25 you could save just £435 a month to have the same result. That may sound like a lot to be saving but the other option is always to save a percentage of your income so that you save more as your earnings increase and aren't financially crippled when you are earning less.
If you use the pension calculator available here you can put in your personal circumstances and get a more exact idea of what you need to save.
Where to put your savings
Saving for your retirement doesn't have to mean opening a pension. A pension is a very tax-efficient option and definitely worth doing if you are a higher rate taxpayer (more on this later).
But an individual savings account (Isa) is also a tax-efficient way to save. The returns on any money you put into an Isa are protected from income tax and capital gains tax. So start saving with an Isa and all the interest you earn over the next 30 years will be tax-free, helping your money grow more.
Isas are an attractive option because they are much simpler than a pension. You can just walk into a bank or visit a website and open a cash Isa. You can then deposit up to £5,100 a year into it so as long as you aren't planning on saving more than £425 a month this is the ideal option.
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Just make sure you shop around and find the best possible interest rate the higher the rate, the better your retirement will be. At the moment the interest rates on Isas aren't particularly impressive the best buy I would recommend would be Santander's Flexible Isa, which pays 2.85% for the first year.
But just because interest rates are low now doesn't mean you shouldn't put money into an Isa. Start saving now and then when interest rates improve you'll have a nice stash of money ring-fenced from tax that you can move to another Isa paying a better interest rate.
There are drawbacks to Isas compared to pensions, but for a straightforward, tax-efficient way of saving it's the best bet for basic-rate taxpayers (that's anyone earning under £43,875).
When a pension is a better option
There are some situations in which you are obviously better off paying into a pension than an ISA. The obvious one being if you are a higher rate tax payer. When you put money into an ISA you do so with already taxed income. So you pay your tax on the way in not the way out. With a pension it is the opposite.
When you invest money the government refund the income tax you paid on it. So if you pay income tax at 40% and you put £600 into your pension the taxman will add a further £400. However when you take income from the pension later you will pay tax on it. So you pay tax not on the way in but on the way out. So what matters is what level of tax you pay when. If you are a lower rate tax payer already you might as well take the hit now your tax rate isn;'t likely to go down. But if you are a higher rate tax payer and you expect to become a lower rate payer on retirement it might be wise to pay the tax later at a lower rate. That means a pension makes more sense.
The other main reason to opt for a pension is if your company operates a benefits system where they match your pension contributions up to a certain level. In this scenario you might pay £200 of your salary into your pension each month and your company will put in another £200. In which case, you are missing out on free money if you don't take them up on it. So check and find out if your employer offers any pension perks.
Finally, there is one aspect of pensions that might be a pro or a con. With a pension you can't acceess your funds until you are 55. Some people complain about this saying they can't access their cash in a crisis. But I think it's a good thing in general. Yes, if you are made redundant and scrabbling to find cash, having all that money sitting there that you can't touch would be infuriating. But at least you won't dip in to it for 'emergencies' like a much-needed holiday or new sofa, and whittle away your retirement money something you could do with an Isa.
Before you start saving for your retirement through a pension or an Isa, it's worth saving a decent emergency fund (about six months wages should do). That way, if you do need some cash in a hurry, you won't have to dip into your retirement Isas or gaze longingly at your pension statement.
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