A clear, easy-to-understand and helpful explanation of pensions
Photo by Micheile Henderson on Unsplash
Hello and welcome to the first piece in our financial empowerment section! We’ve been keen to launch this section since we began because we believe that financial knowledge and independence are a cornerstone of empowerment for everyone. To this end, each month we will cover different topics, beginning with the basics. To start off, we’ll give you the 101 on pensions because there is often much jargon thrown around that, at best, is misleading.
So what is a pension?
Simply put, it’s a pot of money you contribute to throughout the course of your life so that when it comes to retirement you have money to live off. Great, right? It is now a legal requirement in the UK for all employers to provide a workplace pension scheme and automatically enrol their employees into it. So if you work for an employer then you should already have a pension. This pension scheme is not run by your employer but by an external pension scheme business.
Why are you automatically enrolled?
Millions of people in previous generations didn’t save until much much later in their careers because they reasonably believed that they were too young to worry about retirement and had other more pressing uses for the money, like saving into an emergency fund or putting it towards a mortgage. Unfortunately though, when it came to retirement time, many found that they just didn’t have enough.
So, the government rightly decided to make it an opt-out requirement rather than opt-in one. This means that once you get hired, your employer automatically enrols you into their workplace pension scheme and if you don’t want to be in it then you have to specify that you want to opt out. It also means you don’t have to actively worry about it.
Photo by Fabian Blank on Unsplash
So how does it actually work?
Each month, a small amount (minimum 5%) is taken out of your salary and put into the workplace pension. It’s taken out of your salary before you are taxed which makes the amount you are taxed on smaller so the amount of tax you pay maybe reduced. This also means that you aren’t taxed on the money put into your pension. Win-win, right?
On top of that, your employer puts in a little bit (they may match how much you put in up till a certain amount) and if you pay tax, then the government will also put in a little bit. It’s like free money. And it’s all for your future.
If for whatever reason, you need to temporarily stop making contributions then you can stop and re-start whenever you are able to again. And if you leave your job then you can start a new pension pot in your new workplace whilst the money you put in your previous one continues to grow. You can have as many pension pots as you have workplaces.
How does your money grow?
It’s invested. So as you carry on with your life and grow in your career, your money is working hard and growing too. And it gets invested in a lot of things. Sure some of it is invested in the large money-making tobacco and coal organisations but it is also invested in infrastructure and helps build things like schools, is put towards developing drugs and vaccines for diseases like Covid-19 and creating new businesses and technologies of the future.
In some cases you can choose to have your money invested in ESG funds or Environmental, Social and Governance funds. These are funds that are invested in environmental businesses, green technologies and organisations that do social good. They are good long term investments as it can take time to return a profit on these investments.
So when can you access it?
From the age of 55, even if you continue working. There are many three ways to access your pension:
Drawn-down - take out a little bit at a time
Lump-sum - take it all out at once
Annuity - give it to an insurance company who will give it to you as a guaranteed income for the rest of your life.
With each of these options, you can take out a quarter of your pension beforehand and not be taxed on it. And this can be used for anything - you can spent it, save it or reinvest it.
With the first option - a draw-down - since you only take a little bit of money at a time, the rest of your money stays invested and therefore can continue to grow. However if it doesn’t grow and you live longer than expected, then the risk is that it can be difficult to determine if you’ll have enough money. But if you do have money left over then you can leave it to someone else.
With the second option, you run the risk of racking up a large tax bill. So alternatively, you can take it out in small lumps but if you’re relaying on this money to live off then it can be difficult to make it last as you don’t know how long you’ll live but you want to be able to enjoy your money too.
With the third option, the insurance company will predict how long you’re going to live for based on your health and lifestyle and will use your money to give you an income for the rest of your life but if you want to leave some to someone after you die, then be careful to choose one that allows you to do so.
You don’t just have to pick one option. You can choose two or all three if you like. But except for the first quarter of your pension which you can take out tax-free, you may have to pay tax on all the rest of your money but you won’t have to pay national insurance.
But don’t worry, all that national insurance you’ve been paying all your life will now come into good use when you take your pension.
What has my national insurance been doing?
Your national insurance has been contributing to your state pension which you are entitled to receive if you have been making national insurance contributions for 10 years. They don’t have to be consecutive years. You can make voluntary national insurance contributions too. Currently, the state pension is £179.60 per week but the actual amount you get depends on your National Insurance record.
To claim your state pension, you simply have to follow the instructions provided in the letter you will receive from the government two months before you reach your state pension age.
So do I really need a state and workplace pension?
The short answer is yes. The state pension is a minimal, keep-you-going kind of amount and depending on how much you’ve been able to contribute during the course of your life and baring in mind that the return from investments can go up and down, there’s really no guarantee of how much you’ll be able to get from your workplace pension(s) so keeping both options allows you to create the kind of later life you want.
Also, if at any stage you can, it’s worth investing into a personal pension too, also known as a SIP or Self Invested Personal pension. There’s a lot to explain about SIPs so we’ll save that for another article.
But really, the point of a pension is give you freedom and enjoyment in later life. Historically, when people hit ‘retirement age’ they simply took their pension and then stayed at home to tend to the garden and read books. And there’s nothing wrong with that. But that’s not all that’s open to you. You can travel, start a business, go part-time…do whatever you want really and a pension simply helps make that happen.
Photo by Aaron Burden on Unsplash
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