Pensions: Why are they so important anyway?
So, what is a pension? It’s a special kind of scheme that encourages people to save for retirement. When you set one up, you will usually set up regular contributions that are invested so your money can grow as much as possible.
Any money that you contribute to a pension can’t be taken out until you reach retirement age, but in return you get to make big savings on tax. Plus, most employers will also ‘match’ your contributions, effectively meaning that any time you add money to your pension, your employer and the government will contribute too.
When you reach retirement, you’ll then have a pot of money that will help you live the rest of your life without having to work.
Why is a pension so important?
You’ll most likely have heard people say how important it is to set up a pension, and there’s good reasons for this.
The power of investing
When you contribute to a pension you are investing money, and that means the longer you can leave your investments to grow, the greater opportunity they have to grow. Even a few years difference can mean thousands of pounds more saved up by the time you reach retirement.
Get benefits only available to pensions
Whenever you contribute to a pension, you’ll get some tax relief from the government, boosting your savings quite significantly. If you’re a basic rate taxpayer, for every £100 you save into a pension, the Government will add £25. If you’re a higher rate taxpayer then their contribution is even higher.
Plus, if you contribute to a workplace pension then every time you contribute, your employer will contribute too (up to a set limit). In other words, you can earn extra money from your employer for saving for retirement! There are few cases in which it’s not worth taking advantage of this.
What are the different types of pension?
It can be confusing to get your head around the various pensions on offer. Here’s a quick overview of the main differences.
The world of pensions can be extremely difficult to navigate, with dozens of different types available. In general, there are three types you should know about.
The state pension is the pension you get from the government when you reach a certain age (currently 66). Unfortunately the state pension is not a huge amount and so you’re unlikely to be able to live off it alone.
To qualify for the full state pension, you must have paid National Insurance in the UK for at least 10 years in total.
Recent changes to the law mean that all employers will have to automatically enrol all their employees into a workplace pension scheme unless they specifically opt out. In a workplace pension, your employer will match your contributions to your pension (to a certain level).
This adds an additional incentive to contribute at least as much as your employer will match because it’s effectively free money!
Finally, a personal (or ‘private’) pension is a scheme that you can arrange on your own by going direct to a pension provider.
Defined Contribution vs Defined Benefit
Another important distinction to understand is between defined benefit and defined contribution. This is separate to the distinction between workplace and personal pensions mentioned above.
If you have a defined benefit scheme, when you reach retirement age you’ll start receiving a set amount of money each year for the rest of your life. The amount you get will be based on the length of time you worked for your employer and the size of your salary.
By contrast, a defined contribution scheme is where the amount you receive depends entirely on the size of the pot at the time you reach retirement. You’re not guaranteed to receive any specific amount after you have stopped working.
These days, the vast majority of pensions are defined contribution pensions.
How much should I be paying into a pension now?
How are you supposed to know whether you’re on track for a comfortable retirement?
One of the most difficult questions, is working out how much you should be contributing now in order to live comfortably in retirement.
The short answer is: you should contribute as much as you reasonably can, given your current circumstances and other goals.
The long answer is that there is no one right amount that every person should be putting into their pension each month. What is right for you depends on:
- How much you can afford to put away – for instance if you don’t have an emergency fund, you might want to build up some easily accessible savings before locking money away in a pension.
- What your financial goals are – If you would like to make a big purchase such as a house in the next couple of years then it might make sense to reduce the amount you put in your pension so you can make sure you have a large deposit and so have to borrow less.
- When you want to retire. – If you are close to retiring then you may need to prioritise your pension more than someone earlier in their career.
- What type of lifestyle you want to have in retirement. – You may be happy to live a relatively frugal life, or you may have visions of travelling the world on cruise ships.
- Your other assets – Pensions are usually a good way to save for retirement because of the great tax benefits, but it’s not the only way to do it. If you have other investments, savings or property that you can use to fund your retirement then your pension may be less of a priority.
Still have questions about Pensions? Why not book a free session with one of our friendly money coaches.