There are several options and different factors to consider regarding self-employed pension plans. Maximising tax allowances and tax relief while investing your funds for long-term capital growth is important. As of May 2023, it is estimated that there were around 4.3 million people classified as self-employed in the UK. Consequently, many people consider self-employed pension plans as part of their long-term financial plans.

Retirement planning and the self-employed

Your working life as a self-employed person is very different from an employee’s; while the pension arrangements are similar, the source and amount of funding can vary. Whether self-employed or an employee, you need to look at a broader retirement plan with pension funding likely to be central.

The trend for self-employment in the UK

As we mentioned earlier, there are now around 4.3 million self-employed people in the UK. According to the Office for National Statistics (ONS), this peaked at 4.7 million (some sources put it closer to 5 million) towards the end of 2019.

Looking back, after hovering around the 2 million mark until 1980, it will be no surprise to learn that the 1980s saw a considerable increase to around 3.5 million. This was an era in which the stock market came into the public domain, entrepreneurship was surging and financial freedom became a reality for many people.

While progress has been more gradual of late, suffering a significant drop when the pandemic hit, interest in self-employment is growing again. This has created a very active sub-sector of the pension industry, pensions for the self-employed.

Pension challenges for the self-employed

While many established self-employed businesses may see less volatility in their income and expenses, it can be difficult to forecast in the early days. A recent survey by the Association for Independent Professionals and Self-Employed (IPSE) shed light on the challenges faced by those working for themselves. The survey found that:-

• 45% of freelancers are not saving in a pension plan
• 15% don’t currently have a pension plan
• 30% have a plan but aren’t making any contributions at the moment

The main reasons for not contributing to a pension plan include:-

• Other financial priorities (34%)
• Affordability (24%)
• Ceasing contributions after becoming self-employed (24%)

Unfortunately, the self-employed do not benefit from contributions by an employer. Due to volatile cash flow, they may need to suspend or cease pension contributions occasionally. While this is perfectly understandable, where possible, it is crucial to maintain a long-term strategy concerning your pension, even if you cut it back to a relatively small contribution.

Personal pensions for the self-employed

When looking at self-employed pension plans, there are three main options:-

• Standard personal pension

Often referred to as a personal pension plan, this tends to be invested in investment funds across a broad range of assets such as stocks and shares, property and fixed-interest investments. Whether an employee or self-employed, those looking for this type of personal pension are likely to take a hands-off approach to investment decisions. While seen as a lower risk than a SIPP, any investment still has a degree of risk.

• Self-Invested Personal Pension (SIPP)

Those who want to take an active role in the investment of their pension fund contributions will likely consider a SIPP. This type of plan gives you access to a broad range of investments, although this will depend to a certain extent on what your pension fund administrator offers. Many people use SIPPs to trade the stock market, looking at long-term capital appreciation for their pension fund.

• National Employment Savings Trust (Nest)

The Nest option is more associated with workplace pensions and relatively new auto-enrolment regulations brought in by the UK government. However, as a self-employed individual, you can set up an account with Nest, where pension funds tend to be managed across a diverse range of investments.

While the idea of self-managing your pension fund assets may attract those interested in the stock market, finding time as a self-employed person is not easy. Consequently, to ensure that your pension assets have the appropriate attention, it is essential to discuss the options with your financial adviser.

Self-Employed vs Employer-Sponsored Pensions

While the concept of pension investment is the same whether you are self-employed or part of an employer-sponsored scheme, there are some differences of which you should be aware. Most of these changes revolve around the level of contributions and the way in which your funds are managed. It is important to sculpt your pension plan and wider retirement strategy around your particular situation.

Pension contributions

The main difference is that with an employer-sponsored scheme, the employer contributes to the employee’s pension plan. Under the current legislation, the employer must contribute at least 3% of the 8% minimum gross amount. The additional funding will typically be 4% from the employee and 1% tax relief from the government.

Those who have looked at self-employed pension plans will know this is not the case for the self-employed. While you will receive tax relief on maximum contributions of £60,000 per annum (or 100% of your gross income, whichever is the lower), there are no additional payments.

Backdating tax relief on contributions

Many self-employed people will look at a monthly pension contribution and top up as and when additional funds are available. If your income is over £60,000, you can contribute additional funds but will not receive any tax relief on funds over the £60,000 annual limit. However, if you have unused pension contribution tax relief from the last three tax years (and you had an active pension fund), these could be brought forward to increase the element of tax relief.

Defined benefit and defined contribution

Due to the nature of workplace pension funds, they tend to be managed by third parties, whereas some self-employed people may take out a SIPP. This allows them to control how their pension funds are invested. In theory, an older workplace pension could also be a defined benefit (final salary) scheme where the pension is related to your years of service and final salary. This is not the case with self-employed pension plans, which are known as defined contribution (money purchase) plans.

Seeking advice

In reality, most employer pension funds are now defined contribution, due to the additional liabilities created by a defined benefit scheme. When looking at the variety of pension options available for employees and the self-employed, it can become a little complex, to say the least!

State pension for the self-employed

For some reason, many believe that self-employed people are not eligible for a state pension. In truth, it matters not whether you are self-employed or an employee; if you pay sufficient national insurance contributions, you will be entitled to a state pension in retirement. 

The following will give you an idea of entitlement to a state pension depending on years of national insurance contributions “marked as paid”:-

• Zero to nine years, no state pension
• 10 to 34 years, an element of the state pension
• 35 years plus, full state pension

To complicate matters, from time to time, the government will allow you to make up any shortfall in previous years’ national insurance contributions. The full state pension currently stands at £203.85 a week. However, to ensure that you pay the appropriate level of national insurance and know what to expect in retirement, it is crucial to take professional financial advice.

The role of a financial adviser

You have various protections and additional workplace pension contributions as an employee, but the situation is very different for the self-employed. When looking towards retirement, there are many issues to take into consideration, such as:-

• Personal pensions
• State pension
• Pension contributions
• Insurance policies
• Tax efficient investments
• Additional investments
• Savings
• Assets (such as your home)
• Inheritance tax

Due to the often varied cash flow from their business, self-employed people may need to be flexible about investments, pension contributions and the like. This means looking backwards to ensure that tax allowances have been utilised where applicable while also planning ahead concerning inheritance tax and retirement. Not easy!

When considering the above issues, they should be seen as pieces of a larger jigsaw. There will be ways to maximise investments and contributions while minimising tax liabilities. This should be part of your long-term financial planning; regular meetings with your financial adviser will help ensure you remain on track.

Conclusion

As we have covered above, some differences exist between self-employed pension plans and employee schemes. Aside from the additional contribution by an employer, the concept of pension contributions and saving for your retirement is broadly similar across the board. For self-employed people, it is more the potential variation of income and the lack of support from an employer, which can make pension and broader retirement planning more challenging. 

In recent years pension regulations have also changed, giving more freedom of choice to individuals but often making planning a little more complex. The role of a financial adviser is critical to the long-term success of pension plans, especially for the self-employed, who tend to be more focused on their business activities.