Things they didn’t teach you in school Chapter 1 Pensions
What is a pension?
Germany in 1891 was the first country to introduce an age based pension provided by the government through general taxation. Pensions provide an income when you retire from working by investing money in to a long term savings plan, this is generally shares and/or bonds but can be other types of assets. The two types of pensions are Public or Private, this can be broken down into five subcategories:
- State pension — Pension payout determined by the tax payer’s regular contributions.
- Defined contribution — Pension payout determined by the amount paid in and the investment funds performance.
- Defined Benefit — Pension payout from an employer determined by final or average saraly.
- SIPP — Self-Invested personal pension; saver picks investments. This is generally used by the self-employed or company directors or smaller companies.
- Company Pension — Employee and employers make monthly payments into a fund managed by a pension company.
Public Pensions
In many countries Government pays retirees based on a public/state pension based on the tax payer contributions. Currently, in the UK when you earn over ~£9500 per year or around £183 per week, you must National insurance contribution which fund the state pension in the UK. This will only provided you with a very basic standard of living. To increase the amount income you have during retirement you will also need a private pension. The state pension will rise by a minimum of either 2.5%, the rate of inflation or average earnings growth, whichever is largest. This is known as the Triple Dead Lock.
National Insurance System UK (Extra Reading)
Unlike other countries the United Kingdom does not have a sovereign wealth fund. A Sovereign fund is a large investment portfolio owned by the government that is used for the pension/public spending, it made up of bonds or/and stocks and shares that compound in value. The UK could of opted to invest the it’s North Sea Oil money as Norway did and continues to do, however, instead this money was used to fund tax cuts and extra public spending. It funds it’s state pension via the National Insurance System, an extra tax that is exclusively for paying out state pensions. So this year National Insurance Payment are used to pay for this years State Pensions Payments, they are stored in a bank account that is managed by the Debt Managment Office and is topped up by the current going interest rates. There is currently a surplus in the account, i.e more people have been paying National Insurance than the amount required for state pensions.
This amount is failing year by year, this mainly due to the 2007–2008 financial crash, the averages have been failing in real terms for over 10 years and this means that employers and employees are contributing less and less into the fund. The Government predicts that without action the fund will be empty by 2035. Small steps have been taken to prevent this crisis, via increasing retirement age and enforce automatically enrolment into a private pensions by your employer.
Summary
- Public pension are funded by national insurance contributions
- The Government predicts by 2035 that the NI account will be empty, so building your private pension is essential for comfortable retirement.
Private Pensions
These are pensions that are not operated by the Government but are subject to tax relief of up to 100% of your income or £40,00 which ever comes first. They generally come in two forms either a company pension or a Self Invested Personal Pension. It is required by law that your company offers a workplace pension, you do have a right to opt-out. However, this is not recommended because your in effect turning down free money. The minimum contribution is currently 3% for employers and 5% for employees which makes up 8% of your gross salary, this is then used to by a pension company to buy investments to generate interest and will compound over time to create an income or a lump when you retire. There is a general rule that your pension contribution percentage should be half your age. The investments are normally done via a pension plan, which have different level of risk associated with them. Most companies by default will place you in either a low or medium risk, this will deliverer poor returns over the long term because they are generally invested in blended fund which is mainly made up of bonds. Providing that you are young and still have a lot of time to work left, you should always pick the highest risk in your pension plan, this will change the ratio of bonds and shares, giving a higher share ratio. Shares will always out perform bonds in the long term because share produce cash which is used either re-investing into the business to create more money or pay out dividends which in a pension will just be used to buy more shares.
Options for accessing your pension
Cash
Take 100 percent of the pension cash out to spend to invest. Only 25% of the pension pot can be taken out tax free, in the UK you can do this at the age of 55. The rest of cash will be taxed in the same way as any other earnings. There is a risk of running out of cash, unless it’s invested wisely.
Annuity
This is an insurance product that provides a fixed amount of cash every year for life. An annuity means the money won’t run out, but the rate income will be lower. They amount of income you will receive will depends on many factors including your health. You can calculate how much you could potentially get here:
Get a guaranteed income (annuity)
Income Draw down
Some pension plans offer the option of keeping money invested — and hopefully producing decent returns — with cash sums withdrawn as necessary. If too much cash is withdrawn, or the investments perform badly, however, then again there is a risk that the saver will run out of money. This is very common for who are Self employed that are generally going to be using a SIPP which normally will an well diversified index fund.
Pension consolidation
In the modern age people people will not have a job for life as their parents or grandparents may have, in fact the average person aged 30 or below will have around 12 jobs during their life time. Working all these different jobs over you life will result in many different pension plan that are different sizes, different conditions and mostly importantly fees and administration costs for each pension.
Combining all your pension into a single plan means they are easier to keep track of, while also being cheaper in the long run. When consolidating your pension plan the most important thing you should consider is the fees, as this can make a massive difference in the amount of money you will hold in your find as the interest compounds. For example if the average person with the median wage which is currently £31,461 if they save around 8% gross income this would be £209.74 per month. Now lets say they saved into a pension plan A which charge the average pension annual fee of 1.09 (UK average) they would have with annual growth of 7.75% which is the average return from the FTSE 100 from the last 100 years. Then they would have a pension fund worth around £334,699.14 after 35 years of working. However, if they invest in a ultra low index fund such Vanguard FTSE 100 index fund which as of writing has a fee of 0.30%, with the same parameters you could have pension fund value of £399,305.41. So that a massive £64,606.27, and of course if your pension potter is bigger the saving are also compounding bigger.
A word of warning, If you’ve got a pension with certain special benefits worth more than £30,000, you’ll have to seek independent financial advice before you can transfer it to a new provider.
Summary
- Always max out your company pension benefits it’s free money.
- Providing that your still young ask to move your pension plan to the higher risk so that you can greater returns on your investments.
- The earlier you start the bigger your pension pot will be due to compound interest.
References