Is it worth investing in a pension in the UK?

A workplace pension sounds like a no brainer when you consider the money that your company contributes towards your pension. If you opt out of a pension, you're essentially taking a pay cut, aren't you?

I have always assumed that pensions are a good thing, but how good are they in comparison to other investment vehicles? Recently, I've also been wondering what the tax implications are. What would happen if I retire abroad? Would that mean I'd have to pay more tax on my pension earnings? Am I better off opting out of a pension and investing it directly in an ISA? I wasn't sure.

I wanted to try and answer all these questions in this article. It's also the first time I'm making use of Observable. Observable allows you to be an active reader and to interact with this document. I think it's pretty exciting. I hope you like it too.

• ROI at time of pension contribution
• ROI at time of withdrawal
• ROI assuming the investment doesn't grow
• ROI accounting for the growth of the initial investment
• Retiring abroad
• Appendix
• Calculating pension vs direct investment returns after investing in the stock market
• Setup

Let's say your salary is £30,000 and that your contribution to the pension is 4%. Your employer contributes 6%. If you're not happy with my default inputs, you can use the sliders below to change these inputs to your liking.

Note that the UK government requires the employer to contribute a minimum of 3%. However, your employer may contribute more than that depending on the pension scheme they offer.

At first glance, it seems like you're getting a 150% Return On Investment [ROI], but in fact, it's a bit better than that because you get tax relief on your pensions. Assuming a tax rate of 20% which is what anyone on the basic rate will be on, you get a tax relief of £240.

Now you might be thinking - what about National Insurance [NI] payments? Do you get a benefit there? Unfortunately, you don't, because NI contributions are calculated on your pay before pension contributions.

There are various options for taking your pension. You can take up to 25% of the money built up in your pension as a tax-free lump sum. The earliest you can do this is when you are 55, although this does depend on your pension provider. You’ll then have six months to start taking the remaining 75% which you’ll usually pay tax on.

Oh yes - there's no escape from the tax man. You do eventually end up paying income tax on the remaining 75% of your pot as income from pensions is still taxable income. The income tax rates are all the same as when you were paying into your pension.

How does this affect the ROI? Well, to make things simple, let's assume your total investment of £3,000 stays constant until it's time for you to make the withdrawal. You withdraw 25% of it, £750, tax free. You pay 20% tax, £450, on the remaining £2,250.

If you had to pay income tax on 75% of your pension pot your ROI would be reduced to 165.6%. That still sounds pretty amazing! See the plot below which compares your contribution to the initial and final values of your investment.

Additionally, bear in mind that you still have a personal allowance, and you only need to pay tax on any income exceeding your quota. You are also likely to be drawing a smaller income once you've retired, and you may fall below the threshold anyway and therefore not have to pay tax.

In the earlier calculation, we assumed that our total investment of £3,000 stays constant until it's time for you to make the withdrawal. However, that's generally not the case. Your investment is put into the stock market where it'll, hopefully, grow over time. How does this impact the tax?

Let's consider two different scenarios.

1. In the first scenario, the employee contributes to a pension.
2. In the second scenario, the employee contributes the same amount directly to an ISA.

It's fair to assume that the interest rate will be the same in both scenarios. Then, the two critical differences if you invest the money yourself are:

• The compound interest applies to a much smaller capital of £960 than £3,000.
• If you put the money into a Stocks and Shares ISA you won't have to pay any tax on your returns.

Using a little bit of math we can prove that the returns from the pension scenario are 165.6% more than the returns from the direct investment scenario, just the same as the simple ROI calculation assuming the investment doesn't grow. I've plotted a graph below to show how your investment value grows over time in both scenarios. Try playing around with the interest rate and see how significant an impact it has on your returns. Isn't compound interest just one of the most fascinating things about life :P

As you might expect, you can access your pension even if you move abroad. You still have to pay the UK government tax on your UK income living abroad.

Some key differences to bear in mind:

• You may be taxed on your UK income both by the UK and the country where you’re living unless the country you’re resident in has a double-taxation agreement with the UK.
• I'm not 100% sure about this, but I believe your 25% tax-free lump sum is still UK tax-free even if you live abroad, but it may be taxed by the country you're living in.
• You may not be eligible for a personal allowance unless you are an EEA citizen or the country you're living in is included in the double-taxation agreement.
• Watch out for those pesky bank charges and exchange rates as well.

So, what does all that mean? Say you're a British citizen and you retire in Spain, there is virtually no difference to your pension withdrawals compared to living in the UK. However, if you live in a country where you aren't eligible for the personal allowance or relief from double taxation - you might take a small hit. Oops!