In the past, UK pensions were typically 'defined benefit' schemes. Here your employer was responsible for your retirement income, and there were no investment decisions for you to make.
But such schemes are being phased out.
Today most people put away money from their salaries – often, but not always, with a contribution from their employer – into so-called 'defined contribution' pension schemes.
This money is in turn invested into funds and other investments within the pension. Your defined contribution pension might be a workplace pension scheme, a personal pension, or a SIPP. You might even have multiple pensions!
Pension tax advantagesEven though most people must now save for their retirement out of their earnings, there is still a huge advantage to pensions for long-term savers. And that is you can get up to 45% tax relief on your own contributions. The government offers this incentive to encourage us to save for our retirement.
For example, to make a £1,000 pension contribution, a higher-rate tax payer would pay in just £800. The government adds the extra 20% via basic rate tax relief. Better yet, the higher rate taxpayer could claim back as much as £200 of their contribution via their annual tax return.
This means a £1,000 contribution could cost them only £600!
(The exact level of tax relief you will receive will depend on your personal tax rate and how much money you save.)
Under current legislation you can generally contribute 100% of your annual earnings before tax into your pension, up to an annual limit of £40,000 and a lifetime allowance of £1.25 million. Once money is inside the pension there is no capital gains tax or income tax liability as it grows over the years (although there is usually income tax to pay when you withdraw it).
New pension freedomsPensions are being made even more attractive from April 2015. As under the old rules, from the age of 55 you can take 25% of your pension as a tax-free lump sum if you want to.
But under the new rules, from 55 you will also be able to withdraw as much of the rest of your pension as you like, too, whenever you like (although this will be subject to income tax).
Hitherto you've eventually had to buy an annuity or been restricted with how much you can withdraw each year, which has put many people off pensions. Pensions and taxation are complicated, some rules are in consultation, and the benefits vary with individual circumstances, so seek financial advice if you need it.
SIPPs and ETFsSo where do SIPPs fit in?
A SIPP is a particularly flexible kind of personal pension where you're in control. A SIPP has the same tax advantages as other kinds of pensions, and your employer can contribute money into it. However with a SIPP you are responsible for how the money is invested, and you have a huge amount of choice.
This is a big contrast with most workplace pensions provided by employers, or with private pensions offered by insurance companies. With those you are usually only able to choose from a limited range of funds, and these funds are often expensive actively managed options.
But with a SIPP you can invest in stock market listed shares, as well as funds, investment trusts, unquoted companies, commercial property and many other things. This list includes ETFs, which is great for those wanting to create a diversified portfolio that covers different asset classes in a cost-effective and flexible way.
Because ETFs can be traded whenever you like, you can easily create a higher risk and potentially higher reward portfolio early in your working life, and then to protect your retirement income you can shift towards safer investments such as bond ETFs later in your career – or whenever you think the stock market is getting frothy.
You can even hold dividend-paying ETFs in your SIPP after you retire to generate the income you need.
The perfect pension for DIY investorsThe most sophisticated SIPPs can cost several hundred pounds to set up and run. However the good news for ETF investors is that low-cost SIPPs offered by the popular online brokers enable you to buy and hold ETFs. These SIPPs are usually free to setup, and there are just the normal dealing costs and annual platform charges to be paid.
In fact, an ETF portfolio in an online SIPP will usually cost about the same as if you'd invested in a shares ISA with the same broker. This means SIPPs are not just for the rich. With proper research and an ongoing proactive approach to your financial future, you can manage your own ETF portfolio for a fraction of the cost of expensive pension solutions – and the money you save could mean there's more for you to spend in your old age.
We think ETFs and SIPPs are a compelling option for retirement planning – and the tools on justETF will help you every step of the way.