The pension1 topic can sound a bit blunt and dreary, and if you’re not keen to understand how they work, you can be tempted to put it off.
When you’re young and energetic, you don’t think about things like retirement, it’s all about the YOLO lifestyle, and thus pensions see irrelevant and a long way off. With time, you start facing the challenges brought about by hitting your thirties and forties. Suddenly you encounter expenses, purchasing a home, raising your kids, and paying for your dream wedding becomes your priority – saving for retirement feels like the last thing on your ‘to-do’ list.
Since time waits for no one, the government suddenly requires your retirement papers, and you’re left regretting your choices.
Retirement might seem like millenniums to come, but when you make the most of your active life by saving for your pension, you get a chance to secure a decent income when you retire. A pension plan is your insurance policy that, if implemented correctly, can provide you with a financially comfortable retirement.
So, how do pensions work? Well, here’s a comprehensive guide on how pension plans work and how you can make the most out of it.
What is a Pension Plan?
Pensions are a retirement fund that you build up over your active years. It works by making regular contributions, and you typically invest the funds, intending to grow your savings over time. Unlike other long-term saving plans, pensions give you the added benefit of tax relief2.
They’re calculated based on three critical criteria:
- Your years of service in your organization or firm
- Your age
- Your annual compensation
In the UK financial market, there are several types of pension plans, and each works slightly different from the other. There’s the:
- Personal Pensions
- State Pensions3
- Workplace Pensions
There’s also a sub-category of these:
- Defined Contribution Pensions4
- Defined Benefits Pensions
Are you confused? Well, don’t worry, here’s a thorough guide on how pension plans work.
How Personal Pensions Work
Personal pensions are typically defined contribution pensions, meaning that the amount of cash you receive upon retirement depends on how much you’ve been paying into your pot and your investments’ performance.
There are various types of personal pensions, or private pensions, which range from the basic stakeholder pension that limits your investment options, and the self-invested personal pension, Sipp, that allows you to access various forms of investments.
Basically, in this pension plan, the pension fund manager invests your contributions into various platforms, which include shares, bonds, estates, and capital.
How Workplace Pensions Work
True to its name, the workplace pension is organized by your boss, and you can access it when you reach your retirement or pension age, which is currently set at 55years. Moreover, thanks to the fantastic Auto Enrolment5legislation, it’s now mandatory for all employers to set up a pension fund for their eligible staff and make minimum pension contributions in their employees’ pensions. They can do this through their pension plan, specialist pension providers, or through a government-backed scheme.
The government also contributes to your pension earnings by offering you tax relief. You also have to choose the amount to pay into your pension, and the lender will claim tax relief from the government and include it in your pot.
How State Pensions Work
The state pension is a necessary payment that you pay when you reach the state pension age. The amount of money you receive depends on your National Insurance Contributions6, with the government determining your state pension payments via the credits you’ve accumulated throughout your working life.
Well, considering how these three principal plans work, how do defined benefit and defined contribution pensions fit in?
How Defined Benefits Pensions Work
Defined benefits pensions, also known as final salary schemes, are a type of workplace pension that promises to pay you a set annual income in retirement, based on a specific percentage of your salary. They derive their name from the fact that the benefit you get is definite.
The amount you receive with these plans depends on the amount of time you’ve spent working for your firm and the amount you were earning when you left work. With the fast-paced nature of the global economy, these pension plans are now pretty rare since most companies can’t afford them. Most firms have opted to try out the less costly options – the defined contribution schemes.
How Defined Benefits Contributions Work
Defined benefits contributions schemes, also known as money purchase pensions, are a type of workplace and personal pension scheme, which you pay contributions into, mostly through your salary. Unlike their counterparts, don’t promise you any set payouts in retirement. Instead, you have to invest in building up your savings pots that your provider can ultimately use to offer you an income. The fund manager invests in the amount you put in through things like shares, property, finances, and bonds.
When you reach 55years of age, you have the option of using your defined contributions (DC) to purchase an annuity, which will offer you an income for the rest of your life.
Alternatively, you can always choose to take out your savings bit by bit.
Well, a pension annuity is an insurance contract that safeguards against living too long. In return for a cash lump sum, the capital you’ve saved in your pension pot, an insurance firm (the annuity provider) will offer you an annual income for the rest of your life.
When you use the cash from your pension pot to purchase an annuity, you can take up to a 25% of that amount as tax-free cash.
Most of the defined benefit pension schemes use a formula that calculates three key factors: your years of service in the organization, your final average salary, and the benefit multiplier – this is a percentage often ranging from 1% to 2.5%, that ultimately determines the size of the benefit amount.
Divorce does take a substantial emotional toll, but it can have a long time impact on your financial status. Separating your assets from those of your partner can be complicated if your pension plan is at risk. Typically, the pension you earn is considered a joint investment of both, meaning it’s subject to division in divorce.
Nonetheless, it’s up to the state divorce courts to figure out if and how the pension assets will be divided and if survivors benefits are payable. When the court makes a ruling on the division, then the couple will have to divide the pension at the time of divorce when other marital assets will be divided.
The court-approved property settlement that offers for a pension plan to make payments to a former spouse is called a domestic relations order.
How pensions work in the UK is slightly different from other states. First, you agree to pay a specific amount into your defined contribution pension scheme, say about 5% of your earnings. Your employer will then match this figure, so 10% of your income goes into the pension every month. When you decide to retire, you must then take your pot and purchase an income with it or draw on it.
If your boss is one of the rare employers that provide you with pension plans, then you’re lucky. However, you need to ensure you do your homework before jumping at the chance to enrol in a pension scheme – not every plan is equal, and your career choice can make it impractical to participate. If you, however, are willing to work at your firm long enough to reap the benefits, then taking the pension plan is a valuable perk. In any case, it’s never too late to invest, so start now!