Concerns over how people will fund their retirements as life expectancy goes up has been growing and the government has introduced auto-enrolment as a way of addressing the problem.
The scheme, which began to be introduced this year to the biggest employers and will be gradually rolled-out to all buy the smallest employers over the next five years, automatically enrols employees into a company pension scheme.
Employers will be obligated to offer all employees a personal pension and employees will have to actively opt out if they don’t want to join the scheme.
Initially employees need to contribute 0.8 per cent of their salary. Employers add a further 1.0 per cent of the employees’ gross pay and a further 0.2 per cent will be added through tax relief taking the total contribution to two per cent. The government wants this minimum contribution to rise to a total of eight per cent over time. It would mean that out of every £1000 of earnings, the employee pays in £40, the employer contributes £30 and £10 is added through tax relief.
Saving for a pension
Pension savings work by an individual investing money into a personal pension. The total savings are put into a pension pot which is invested over time so that it grows and will provide an income for life when the individual is due to retire.
The most common way to purchase an income for life is through an annuity but for a variety of reasons annuity rates have fallen and this has contributed to the decline in the number of people opting to take out a personal pension.
Each year you will receive a projection of what your pension will pay out when you retire.
For example, if you pay in £2,000 for 30 years, the pension statement will project how much that may be worth by the time you are due to retire.
The projection will usually show how much the fund would be worth if the growth in your pension fund is low, four per cent, medium, six per cent or high at eight per cent. Using these growth estimates your pension statement could show that your total pension fund will be worth £100,000, £150,000 or £200,000. This would then provide an annual pension of £4,500, £8,000 or £14,000.
Buy-to-let investment as an alternative to a pension
Because of the poor performance of some pension investments and the rise of property values over the last 15 years, many people have chosen to invest in property either to supplement their pension income or as an alternative.
Rents are at a record high and there is a shortage of property to supply the increased demand that government schemes such as the Help to Buy scheme have brought to the property market.
This trend is likely to continue as the population grows and the areas available for new homes to be built declines. This makes investment property a good option for the long term.
A buy-to-let property offers potentially two income streams. You receive rent that should enable you to pay off the mortgage with a little left over and you also generate profit as the value of your property rises.
If an investor bought a two-bedroom flat for £150,000 with a deposit of £50,000 and the property went up by an average of four per cent a year for 25 years, it would be worth just under £400,000.
By comparison, £50,000 of savings would be worth around £150,000 over the same term at a rate of four per cent.
The difference comes because the rate of return is based on a higher figure for the property, at £150,000, compared to £50,000. The same principle applies when comparing the returns from a buy-to-let investment to growth in a private pension.
Benefits of pension saving
Many pension schemes come with the ability of being able to manage the funds that the pension fund is investing in.
A pension also provides a secure income for life because you can only access 25 per cent of the total value of the fund, the rest being paid out as a monthly income.
Pension fees are falling and can often be around one per cent of the total fund value. There will be pressure to ensure fees are capped by the government on auto-enrolment schemes, but so far the government has stopped short of introducing this rule.
Contributions made into a pension benefit from tax relief at an individual’s highest marginal rate of tax. So, for a basic rate tax payer a net contribution of £80 per month would result in £100 per month being invested; whilst for a high rate taxpayer an £80 per month net contribution would equate to £133.
However, the amount that you can save each year toward a pension from which you benefit from tax relief is subject to an annual allowance which has been reduced to £50,000 a year for the 2013-14.
Drawbacks of pension saving
There is no guarantee that your pension savings will grow as outlined. Because you are investing in stocks and shares, the value can go down as well as up.
Annuity rates are falling and the outlook is uncertain. Between 2008 and 2012 annuity rates fell by 18 per cent. This means the amount you get as an annual income reduces because the cost of buying an income for life goes up, so your £60,000 pension pot can buy less and less income.
There is also no guarantee that you will live long enough to enjoy your pension, so you may not get anything, so it is important to nominate your dependents as some schemes pay out a lump sum on your death and most will pay a pension for at least five years in the event of the death of the pension holder.
Benefits of a buy-to-let investment
A buy-to-let investment can provide two separate income streams. One from excess rental income after the mortgage has been paid and the other from the rise in property value over time.
The property can then be sold and the income used however you choose. This gives the opportunity to invest the money in whatever is the best investment at the time.
Mortgage interest and some expenses in running a buy to let property can be offset against the rental income received in order to reduce the amount of income tax which is payable.
Pitfalls of a buy-to-let investment
The only way you can realise your investment is by selling the property and you will have to pay capital gains tax on the proceeds of the sale, which, after all other allowances are used, is 28 per cent for 2012-13.
You will receive the whole amount when you sell the property, so you will then need to choose how you provide for your retirement with the proceeds. Whether you can generate an income that outpaces inflation will depend on the interest rates available and the rate of inflation at the time.
If you have researched the buy-to-let investment properly, you should be able to generate rental income to pay the mortgage but there are other costs to factor in which is why buy-to-let lenders expect to see returns of 125 per cent of the mortgage in rent.
This will help cover other costs for repair and maintenance, legal fees, rent arrears and for periods when the property is empty but they can eat into the potential returns of a buy-to-let investment.
There is also no guarantee that house prices will continue to rise. As with any investment, timing is key, which can be a problem if there is a market crash at the time you want to sell up.
What is the best option?
Both methods have their advantages and drawbacks and ideally a combination of both will help to reduce the risks that both have.
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