Pensions Explained For Dummies

Do you know how much is in your pension?

Do you know what assets your pension is invested in?

Do you have a target pension pot you’re saving for?

If you answered YES to all three questions, you’re in the minority.

If you’re in your 20’s or 30’s and could answer all those questions, you’re a super freak.

But seriously, most people – especially millennials – are clueless about pensions. It’s not because they’re stupid. Far from it.

It’s because the financial industry does a poor job of explaining pensions.

They make pensions so difficult to understand that you either need to pay for advice, or you’re put off from ever starting one.

Yes, pensions and retirement planning can be tricky subjects to get your head around.

BUT…

The basics – which are all you really need to secure your financial future – aren’t hard to learn.

In this post, I’ll provide everything you need to know about pensions to enjoy a comfortable retirement.

And, I’ll explain it in a way that even a dummy (like me) can understand.

So, let’s get into it…

What is a Pension?

A pension is simply a long-term savings account that is used for one thing… to fund your retirement.

The idea is that you save a little of each wage so that you have money to live off of when you can no longer work.

If you didn’t have a pension, then you’d have to work till you die or rely on younger family members to support you, which still happens in some countries.

The money you save into a pension is invested into a portfolio of shares, bonds, property, cash, and other assets.

The exact assets you hold and how much of each asset you own will depend on the fund(s) you invest in.

There are also different types of pensions (don’t worry, I’ll explain later), but they all serve the same purpose – accumulating a pot of savings that will pay for your living costs when you’ve exited the workforce.

Why Pensions Are Important?

Without a pension, you’d have to work until the day you dropped or rely on someone else for financial support.

In the U.K., that someone else is usually the government. And the government’s support is… eh, how shall we say… not that generous.

In the 2020/21 tax year, the full state pension is £175.20 per week (and it could be less for some)! That’s only £9,110.40 annually.

If you don’t make saving for retirement a priority, you could end up being one of the roughly one million pensioners living in poverty in the U.K.

I don’t know about you, but I don’t want to spend my last days barely scraping by.

The thought of counting pennies to see whether I have enough to buy jam to go with my bread and butter sandwich is enough to give me a kick up the arse and get saving for retirement.

So, now you get why pensions are such a big deal, let’s look at some of their advantages.

The Benefits of Pensions

If you want to avoid being a penniless pensioner, then you’ve got to build a private pension to supplement your state pension.

The government encourages you to save for your retirement by providing pension accounts with fantastic benefits.

Let’s have a look at some:

1. Auto Enrolment

If you’ve got a job, you’re over 22, and earn over £10k per year, you’ll be automatically enrolled into your workplace pension.

Thanks to legislation that came into effect in 2019, 5% of your gross salary will be automatically deducted and added to your workplace pension.

And I say “thanks”, because auto-enrolment really is doing you a favour.

Skimming 5% off your wages may seem unfair – I mean, who are the government to decide how you spend your money? – but it means you’re automatically putting something aside for your retirement each payday (and that’s smart).

By paying yourself first, you’re eliminating the temptation to blow your wages on nights out, clothes, gadgets, and other stuff you don’t really need.

2. Employer Contributions

If you’re still miffed about being “forced” to save for retirement, here’s a deal sweetener: In addition to your 5% contribution, your employer must also contribute 3% of your salary.

This 3% contribution doesn’t count as part of your salary, so in effect, it’s FREE MONEY!

Cha-ching!

Besides free tea and coffee and possibly a uniform, most workers don’t get many freebies from the J.O.B. – so, count yourself lucky and graciously accept your employer’s pension contributions.

Note: NEVER opt out of your workplace pension unless you’re experiencing real financial hardship.

A 3% top-up may not seem much now, but it adds up over the course of your career.

3. Tax Relief

And the third major benefit of pensions is tax relief.

An easy way to think about how pensions accounts are taxed is that you don’t pay tax on the way in, but you pay it on the way out.

That means contributions to your pension are made with your gross salary.

So, a £100 contribution to your pension actually only costs you £80 – if you’re a basic rate taxpayer.

And if you’re a higher or additional rate taxpayer, a £100 contribution will only cost you £60 or £55, respectively.

If you had taken your salary as a wage instead of putting the money into your pension, then you’d have to pay £20 in tax.

But the government lets you keep the £20 to incentivise you to save for your retirement.

And it gets better; any income from investments or capital gains aren’t taxed while the money is held within your pension – this is shaping up to be a pretty sweet deal, right?

But…

You can’t avoid paying tax completely.

You will eventually have to pay income tax at your marginal tax rate when it comes time to withdraw your pension.

But by that time your pension pot will have benefitted from years of growth on your gross wage contributions.

You get to put in more money to begin with giving compound interest a larger starting pot to work its magic.

Different Types Of Pensions

Having several different types of pensions makes them all that more bamboozling.

But the good news is that most people will have a workplace pension which their employer sets up for them.

Workplace pensions can be two different types: defined contribution and defined benefit.

What is a Defined Contribution Pension Plan?

The vast majority of people will have a defined contribution pension.

With defined contribution pensions, your pension pot is determined by how much you (and your employer) contribute to your pension over your working life.

When you reach age 55 (rising to age 57 in 2028), you have a variety of options for accessing your pension:

• Take a 25% tax-free lump sum.
• Withdraw the remaining 75% immediately and pay income tax at your marginal rate.
• Leave the 75% invested with your pension provider and withdraw it whenever it suits.
• Buy an annuity with the 75% – which is a financial product that provides a guaranteed set income for the rest of your life.

You could also combine all of the above options to suit you, i.e. take a lump sum to treat yourself, buy an annuity so you have a regular income, and leave the remainder of your pension invested.

The pension freedoms act provides flexibility over how you access your pension, but it also requires you to be sensible and ensure your savings last for the rest of your life.

What is a Defined Benefit Pension Plan?

A defined benefit or final salary pension is a different kind of workplace pension where you get a set benefit at the end of your career.

You’ll receive a guaranteed income in retirement based on how long you were a member of the scheme and the salary you earned during your career.

Defined benefit pensions are rare, and most employers provide a defined contribution pension scheme.

However, certain public sector jobs still provide defined benefit pensions – emergency services, care workers, and council staff.

Workplace Pension Need To Know Facts

• There is no maximum amount you can invest in your pension. But if you contribute more than the lifetime allowance – which is £1,073,100 for the 2020-21 tax year – there can be hefty penalties.
• Although there is no maximum amount you can pay into your pension each year, you only receive tax relief on £40,000.
• If you’ve changed jobs several times in your career, then you’ll likely have multiple private pensions. Combining them makes your pension easier to manage, but make sure you don’t give up any benefits tied up to a pension.
• You can transfer your defined benefit pension to a defined contribution pension to take advantage of the pension freedoms act if you wish.

What is a SIPP?

SIPP stands for Self-invested Personal Pension.

If you’re self-employed or don’t qualify for your workplace pension (earn under £10k or you’re on a zero-hours contract), then a SIPP still allows you to save for retirement in tax-advantaged accounts.

You also receive the same tax advantages as those saving into a workplace pension i.e. £100 paid into your pension only costs you £80 (for basic rate taxpayers). But the big downside to SIPPs is the lack of employer contributions.

So, if you’re already in a workplace pension scheme, keep investing there before you decide to invest in a SIPP. Don’t say no to free money.

But if you have a retirement income goal and you need to up your contributions to reach it, having a SIPP running in tandem with your workplace pension could help.

And if you’re an investing nerd (like me), SIPPS are awesome as they allow you to choose what you invest in (unlike workplace pensions).

You also have more flexibility in how you invest – you can contribute regularly or pay in a lump sum whenever you have the cash.

If you want to find out more about using a SIPP to save for retirement, I have written an extensive article on the pros and cons versus the Lifetime ISA. 

What is a SSAS?

The least well-known type of pension is the SSAS (small self-administered pension scheme).

It‘s usually set up by a small number of company directors or key staff. The SSAS is run by trustees, which are usually contributing members.

Each member doesn’t have a pot per se, but owns a percentage of the SSAS’s assets.

The benefit of a SSAS is that it has many more investment options available.

For example, a SSAS can buy the trading premises of the business and lease it back to the business.

A SSAS can also borrow money, so it could use a mortgage to purchase the premises, therefore benefiting from leverage.

State Pension

And last but not least is the state pension.

As I already mentioned, you don’t want to rely on the state pension alone, but it can form part of your retirement income.

You can claim the state pension from age 66, although that age is rising to 67 between 2026-2028 and to 68 between 2044-2046

To receive the full state pension, you need to have 35 years of qualifying national insurance (N.I.) contributions.

To receive any state pension, you must have at least ten years of N.I. contributions. The full state pension is currently £175.20 per week, or £9,110.40 a year (for 2020/21).

State Pension Need To Know Facts

• You receive the state pension from the day you’re eligible until the day you die.
• The government “triple lock” safeguards pensioners against the rising cost of living. Every April, the state pension will rise by at least 2.5%, the inflation rate, or average earnings growth (whichever is greater).
• It’s possible to increase your state pension by working beyond retirement age or making voluntary N.I. contributions. For every nine weeks, you work beyond retirement age, your state pension will increase by 1%. If you deferred taking your state pension until 66, you’d receive 6% more.

Wrapping It Up

Although I’ve named this post “pensions explained for dummies”, you’re certainly not stupid if you don’t understand pensions – there’s a lot to take in.

Hopefully, this post has provided clarity on what is often a confusing subject.

At the very least, I hope it’s highlighted how important saving for your retirement is.

Don’t delay starting your pension or contributing more because you’re not sure what to do.

The sooner you start, the better. And it’s never too late to start building your pension.