If you have debts and no pension savings, which should you prioritise? We look at both options and evaluate the benefits of certain pension schemes, to help you decide.
The case for pensions linked to salaries
If your employer provides a pension scheme, offering a percentage of either your final salary or your career-average salary when you retire, it will usually be worthwhile joining it – despite the fact many schemes have reduced the benefits recently.
The benefits of any contributions made to these so-called ‘defined-benefit pensions’ should be guaranteed – provided your employer, or the scheme, doesn't collapse.
Each year you contribute you get another portion of your salary in retirement.
You might want to contribute now while these schemes still accept new contributions, because many companies are closing them down to new employees to cut costs.
The case for pensions linked to investments
More and more pension savers are offered pensions linked to investments, rather than salaries. These are ‘defined-contribution pensions’.
Lots of employers offer to double your contributions, giving your investments a big starting leg up, and reforms are going to force almost all employers to contribute to your pension scheme. You can also buy these pensions individually.
The trick with these schemes is to start as early as possible, because they're like snowballs. You start off small, making just a few pounds of gains in the early years but in later years you could gain far more.
If you delay pension saving in order to pay off debts, it could cost you a lot in lost pension income in the end.
Reasons to pay down debt first
If you have existing debt hanging over you but also are keen to start a pension, it can be a tough financial decision. Despite the advantages of investing for retirement early, there is also a case for paying off debt first.
Paying debt off early brings a guaranteed return: you'll pay less to your lender in interest (provided there are no hefty penalties for making overpayments).
The more debts you have and the greater your debt repayments compared to your income, the more vulnerable you'll be in an emergency situation.. The higher your debt interest rate, the more likely it is you'll be better off paying down debt before starting a pension.
To give you some rough figures, if you have debts at the shockingly expensive standard credit card rates of 15 per cent APR or more, for example, it'd be a safe choice to pay that debt off quickly.
If you're paying debt interest at 10 per cent or more, you should still consider putting more towards your debts than your pension contributions.
At 6 per cent-8 per cent, the case becomes more finely balanced when weighted against the pension – particularly so if you could join a generous defined-benefit scheme, or if your employer contributes to your defined-contribution pension.
However, it probably still makes sense to split the money between paying off debts and contributing to a pension.
If you can switch your debt to something cheap, like 0 per cent credit card deals, and do so again in the future, you could tip the balance more in favour of retirement savings, but only if you're not overwhelmed with debt.
More rough rules
The ideal balance is down to your individual circumstances, but the guidance above should give you some approximate rules to work with.
Certainly the best thing we can all do is budget, so that we have more money to pay down debt, save for retirement, or both.
While I've been writing about pensions here as the standard way to save for life after work, investment ISAs and buying your own home, as well as whatever the government can afford to pay us in state pensions by the time we retire, could all be part of a balanced retirement savings plan.
