Is it worth saving into a pension? Steve Webb replies

I was reading a question about pensions that you answered, and simply put I’ve never had a pension as I’ve always believed that they’re not worth the paper they are written on

My sister is pro pension and we had a heated discussion about the pros and cons, but I really believe that I can get a better deal by saving my money in a savings account rather than ‘let someone else invest’ my money. 

Am I right in thinking this?

SCROLL DOWN TO FIND OUT HOW TO ASK STEVE YOUR PENSION QUESTION     

Right or wrong? I’ve never had a pension because they’re not worth the paper they are written on

Steve Webb replies: When comparing different places to save, there are probably three main things to think about – how your savings are taxed, whether your employer will put money in, and what sort of investment return you can get on your money (after the deduction of any charges).

Let’s see how a pension and a savings account compare under each heading.

Tax advantages of a pension vs ordinary savings or investment account

Starting with tax, in most cases when you put money in a pension you benefit from ‘tax relief’ from the government.

Normally, when you earn money a slice is deducted for income tax and sent off to the Government.

But if you put money into a pension this tax amount goes into your pension pot instead. Although your final pension in years to come is subject to income tax, you can take a quarter out completely tax free.

Steve Webb: Find out how to ask the former Pensions Minister a question about your retirement savings in the box below

Steve Webb: Find out how to ask the former Pensions Minister a question about your retirement savings in the box below

If you decide instead to save in a savings account such as an Isa (Individual Savings Account), you do not get the same tax advantage.

The way an Isa works is that you contribute from your take-home pay – after the deduction of tax – and the only advantage of an Isa is that you don’t pay tax when you take money out.

But given that there are already various tax breaks on savings income and dividend income, there isn’t much of a tax advantage for most people from using an Isa.

Purely in terms of tax treatment therefore, a pension is much better.

In addition, the investments inside a pension can often be pretty similar to the investments inside an Isa – assuming you invest rather than use a low-interest cash Isa – but you are getting the tax advantages of a pension on top.

Free cash from employer into a pension vs none in savings or investment account

The second thing to think about is the role of your employer, assuming you are in work.

By law, provided you earn more than £10,000 per year, your employer is required to put you in a pension and to make a contribution.

The employer contribution is at a minimum rate of 3 per cent and applies to what are called ‘qualifying earnings’ which is anything you earn above a floor of about £6,000 a year.

This is however a legal minimum and many employers will put in a lot more than this. The crucial point is that if you choose to save in your own savings account instead of a workplace pension you are throwing away all the money your employer will put in.

STEVE WEBB ANSWERS YOUR PENSION QUESTIONS

       

The figures I have just given apply to ‘pot of money’ pensions but if your employer offers a ‘salary-related’ pension (including most of the public sector) then the value of the employer contribution is even greater.

For some public servants, the employer contribution is worth 20 per cent or more of their salary, so opting out can be a very bad idea.

Again, choosing a workplace pension over a savings account makes a lot of sense for this reason.

Potential return from a pension vs an ordinary savings account or your own investments

The final thing to think about is the return you can get on your own savings or investments. And it is certainly true that if you are good at investing then you could do well on your own, and you don’t have to pay anyone else to manage the money for you.

But there are several mistakes which individuals often make and which you would need to be careful about.

The first is that in general individuals tend to take too little risk. For example, they may put a lot of money in things like cash Isas where the returns are close to zero even before you take account of inflation.

In general, the more risk you are willing to take, the more return you are likely to get.

That doesn’t mean you should be reckless and take more risk than you can manage, but professional investors tend to be better at helping you pick the right level of risk.

The opposite problem is that individual investors are sometimes seduced by apparently impressive returns and end up getting scammed.

The second mistake that individual investors often make is that they don’t ‘diversify’ enough – in simple terms, they put all their eggs in one basket.

The classic example of this would be putting all your savings in a single buy-to-let property.

Whilst this can work out well, there are lots of situations in which it could go badly – a house price dip just when you want to sell, problems getting tenants, tenants not paying rent, tenants damaging the property, changes to government tax rules and so on.

Someone who invests money on your behalf will generally spread your money across different assets and different markets so that you can avoid the risk of a major drop in your funds if one investment performs badly.

A final mistake that individual investors often make is that they tend to over-react to short-term market movements.

For example, many investors saw the UK stock market crash earlier this year and reacted by selling up at once to avoid further losses.

What actually happened was that the market recovered significantly as the year went on, so those who over-reacted by selling at the bottom of the market lost out.

Professional investors tend to take a long-term view and can also do research to work out what the best long-term investments are likely to be.

What is the final verdict? 

In summary, when you think about tax advantages or about money from your employer, the case for choosing a pension rather than putting money in a savings account or investing yourself is overwhelming.

When it comes to investment returns, individuals can do well, but they need to know what they are doing and are prone to ‘biases’ which can lead to poor outcomes.

And to make up for the lack of tax breaks and the loss of an employer contribution, the investment return they achieve would have to be far higher.

The ‘eighth wonder of the world’ that could make or break your fortunes

How to unleash the ‘awesome power’ of compound interest… and calculate it. Tom Stevenson of Fidelity International explains here.

When you compare potential returns from saving into a pension to the interest you get on a savings account – where rates have been low for a very long time and are unlikely to recover in the near or even medium term – the disadvantage is even more stark.

The return – or interest – you get when saving or investing is crucial due to the massive power of compounding over long periods, and in this case we are talking about a whole working life.

Compounding simply means that when you add the return or interest to your sum of money, you make money on both thereafter, and when you do this repeatedly over many years you end up with an awesomely big figure.

One final thought. If you look at the people in retirement today who are enjoying a good standard of living, the large majority are those who went down the pension route.

I doubt that many of them now wish they had opted out of pensions and had a go at investing or simply left their money in a savings account instead.

Ask Steve Webb a pension question

Former Pensions Minister Steve Webb is This Is Money’s Agony Uncle.

He is ready to answer your questions, whether you are still saving, in the process of stopping work, or juggling your finances in retirement.

Steve left the Department of Work and Pensions after the May 2015 election. He is now a partner at actuary and consulting firm Lane Clark & Peacock.

If you would like to ask Steve a question about pensions, please email him at [email protected].

Steve will do his best to reply to your message in a forthcoming column, but he won’t be able to answer everyone or correspond privately with readers. Nothing in his replies constitutes regulated financial advice. Published questions are sometimes edited for brevity or other reasons.

Please include a daytime contact number with your message – this will be kept confidential and not used for marketing purposes.

If Steve is unable to answer your question, you can also contact The Pensions Advisory Service, a Government-backed organisation which gives free help to the public. TPAS can be found here and its number is 0800 011 3797.

Steve receives many questions about state pension forecasts and COPE – the Contracted Out Pension Equivalent. If you are writing to Steve on this topic, he responds to a typical reader question here. It includes links to Steve’s several earlier columns about state pension forecasts and contracting out, which might be helpful.  

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