Sole-trader pensions: will you be ready for a life free of work?
Among a freelancer’s priorities, saving for retirement probably doesn’t rank very high. Most of us focus on the short term, which is understandable to an extent because we don’t always know where our next pay cheque is coming from.
To make things worse, pensions are remarkably complicated. Earlier this year, Andy Haldane, the Bank of England’s chief economist, claimed that even though he considers himself ‘moderately financially literate’ (hopefully an understatement from someone in his position), he can’t ‘make the remotest sense of pensions’.
According to a report by Scottish Widows, nearly a quarter of the self- employed aren’t saving at all for retirement. I don’t have a pension, but a year-long contract with a bank – writing about personal finance and pensions – prompted me to look into one. I opted to open an investment ISA (Individual Savings Account) due to the flexibility it offers, although I’m missing out on some of the incentives the government uses to encourage people to contribute to a pension. More on this below.
Unlike paid employees, freelancers typically lack the support structure to guide us through the complexity of retirement saving. So we spoke to Romi Savova, founder and CEO of PensionBee, a platform that allows you to easily manage your pension online and on the go, to find out what advice she could offer about sole-trader pensions.
Why should you start saving for retirement?
The answer to this question is essentially the same for everyone – after working for around 40 years, you deserve to enjoy your retirement. For most people, this means maintaining a similar standard of living to the one they have while they’re working, without worrying about running out of money.
A life free of work probably appeals, but you may struggle to imagine what it would be like as it’s so far in the future. Savova suggests looking at your parents for inspiration. If they’re retired, what kind of lives are they living? Did they put enough away, or are they struggling to get by? Or if your parents are still working, do they feel financially prepared for retirement?
‘Freelancing tends to consume everything you do meaning you can lose track of your financial goals’ acknowledges Savova. ‘Freelancers need to be aware that as time marches on, the opportunity to save for retirement decreases’.
Savova’s advice is to start saving now: ‘In your 30s, 40s and even into your 50s, you’re in the prime of your working life. It’s important to save during this period, as you don’t know what your 60s and 70s will bring’.
This is especially the case if you’re fortunate enough to have excess cash sitting in a bank account.
‘The Money Advice Service suggests you shouldn’t hold more than three months’ worth of savings’ explains Savova. ‘Any amount over that is considered surplus cash that depreciates in value over time (due to inflation) and is not earning a return’. So with interest rates at historic lows, it’s worth considering other opportunities that may help your money grow, such as a pension. What’s more, one of the incentives to contribute to a pension is your money grows largely free of taxes.
How much will you need in retirement?
The general rule of thumb is to aim for 65% of your final annual salary. So if you’re earning £50,000 in your final year of employment, you should target an annual pension of £32,500. Of course, freelancers rarely know how much they’ll earn in a given year, never mind 20 or 30 years in the future, making this calculation slightly more complicated.
‘One figure people often tell me would allow them to live fairly comfortably is £30,000 per year’ says Savova. If this figure seems relatively low, don’t forget that by the time you retire, your outgoings will probably have fallen – you might have paid off your mortgage, and you may no longer need to support your children.
So how much must you save to secure retirement income of £30,000? Firstly, subtract the state pension which currently comes to around £8,000 per year – incidentally, not enough to survive on. There’s no way of knowing how much the state pension will pay in the future, but it’s our best estimate for now. This means you’ll need an additional £22,000. Supposing your pension pot will generate a return of 5% per year, you have to save a total of £440,000 (5% of £440,000 = £22,000).
‘Work through various scenarios to figure out how much you need to contribute’ suggests Savova. Try to come up with a budget based on the kind of lifestyle you’d like to live when you retire – for instance, if you fancy getting away to the sun a few times a year, £30,000 might not be enough.
For help with your calculations, try the Money Advice Service’s pension calculator.
How much should you save?
Another rule of thumb for pensions is to save a percentage of your salary equal to half your age. So if you’re 30 years old, you should aim to set aside 15%.
The crucial point though, as Savova made earlier, is to start saving as early as possible.
One of the main reasons is the power of compounding. As we’ll explain below, your savings are invested in the financial markets, either by your pension provider or by you. While there are no guarantees, 5% is a realistic expectation for how much your pot might grow each year. Compounding means you earn a return on your initial investment plus returns from previous years, so the longer your money is invested, the quicker it could grow.
To put this in perspective, if you contribute £550 per month for 30 years, allowing for 5% growth per year you’ll end up with a pension pot of just over £457,000. Your annual contribution would total £6,600 per year or 15% of a £44,000 salary.
You can plug your own figures into this calculation using the compounding calculator on This is Money.
If a monthly contribution of £550 feels onerous, then here’s another reason you should start saving sooner rather than later: the older you get, the higher the proportion of your earnings that you must put away. Imagine the impact on your finances if you have to save 25% or more of your salary when you’re in your 50s, still paying your mortgage and supporting your children.
‘Even if you can’t stretch to 15%’, advises Savova ‘putting aside whatever you can is still really beneficial’.
One aspect of pensions that may scare freelancers is the fact you can’t access your money until the age of 55 (rising to 57 in 2028). When you’ve no way of knowing what you’ll earn from month to month or year to year, locking your savings away can be a daunting prospect.
‘You have to think about the emergency scenarios that you could face and work out how much to set aside for them, perhaps in a cash ISA’ suggests Savova. However, if you face a serious emergency, such as a life – threatening illness, you can access your pension pot before the minimum retirement age.
Of course, there are other options to help protect against emergencies, like insurance, which allow you to continue saving for retirement at the same time.
What pension rules do you need to know about?
You should be aware of the rules governing pensions- some make retirement saving very attractive while others penalise you for exceeding certain limits.
One question Savova regularly gets asked is whether freelancers can take advantage of tax relief available to retirement savers. The good news is that you can, although you don’t benefit from the matched contributions an employer must make for their employees.
Nevertheless, tax relief is an attractive benefit. If you’re a basic rate taxpayer, your provider claims 20% tax relief on your pension contributions. So for every £80 you contribute, tax relief tops this up to £100. Higher rate and additional rate taxpayers can claim 40% and 45% respectively (usually through a self-assessment tax return).
Annual and lifetime limits
There are limits to the amount you can contribute each year and over the lifetime of your pension. The annual allowance is £40,000 or 100% of your salary, whichever is lower. If you’re lucky enough to earn over £150,000, this allowance can drop to as little as £10,000.
The lifetime allowance is £1 million, including all your various pension pots (such as previous workplace pensions) and any growth in your pot. You get taxed heavily on any amount above this allowance once you start drawing your pension. Bear in mind these figures are for the 2016-17 tax year and are subject to change in the future.
Carry forward is useful for freelancers who struggle with unpredictable income, or if you receive a financial windfall. It allows you to use any annual allowance you didn’t take up in the previous three tax years. However, you must have been enrolled in a pension scheme during that time and contribute the maximum allowable in the current tax year.
What are your options?
Freelancers can open what are known as defined contribution pensions, where you build up a pot of money over many years. The amount of retirement income you eventually receive depends on several factors including how much you contribute and the performance of the investments chosen by you or your provider.
You pick a provider, agree on a level of contributions and then your provider invests your money on your behalf. You may be presented with a limited choice of investment plans with varying degrees of risk, but otherwise a personal pension is a hands- off option.
A Self-Invested Personal Pension, commonly known as a SIPP, is a wrapper which holds investments until you reach the minimum retirement age, and you’re ready to start drawing an income. It’s subject to the same rules as other pensions, but you’ve much more flexibility when it comes to choosing investments like shares, funds and bonds. However, because you’re responsible for choosing and managing your investments, SIPPS are only suitable for experienced investors. If you decide to go with this option, remember the value of your investments can fall as well as rise, and you could lose some or all of your retirement savings.
A stakeholder pension is similar to a personal pension, but it must meet certain requirements set by the government such as accepting low minimum and flexible contributions, and capping fees. While a stakeholder pension may seem ideal for a freelancer, it’s not as widely available as the other types of pensions, according to Savova.
An ISA is a flexible alternative to a pension as you can access your money whenever you need it. There are several types of ISA including a cash ISA (which works like a savings account), an investment ISA (for holding shares, funds and other types of investments), and an innovative finance ISA (for P2P lending). However, contributions to an ISA don’t earn tax relief, so you miss out what is effectively free money.
Which one’s right for me?
When it comes to choosing the right option, there are a few key criteria, explains Savova: ‘Because a freelancer’s income is unpredictable, it can be hard to commit to a regular contribution, so make sure your provider can accommodate both regular and one- off contributions. Having this flexibility is critical’.
You also need to take into consideration who will be investing your money. ‘You want to choose a reputable provider and someone who manages lots of assets’ advises Savova. For example, PensionBee partners with BlackRock and State Street, two of the largest money managers in the world.
Also, fees eat into your returns, so keep an eye on what your provider charges. A little research should uncover personal and stakeholder pensions with competitive fees.
Still not sure?
Hopefully, this article takes some of the mystery out of sole- trader pensions. As highlighted earlier, this is one of the most complex aspects of personal finance so if you still have questions, you should speak to an Independent Financial Advisor (IFA). You can find an IFA at https://www.unbiased.co.uk/.
To learn more about PensionBee’s offering, visit https://www.pensionbee.com/.