How do pensions work? All you need to know
Good job, great friends and a family on its way. Life is good. But have you made provisions to keep you in the lifestyle you have come to expect? Today, we will focus briefly on how do pensions work.
Retirement and old age seems such a long way away to bother about, but the time will come when you’ll want to put up your feet and tend the cabbages. With no wage coming in how do you support yourself? There are a lot of products and services out there, which can seem daunting to the novice’s eye. Here is a basic breakdown of how do pensions work :
Overview of how do pensions work
The profile of pensions has seen a rise over the past few years. Scandals over the pension mishandling affairs and a certain fat bloke who got his comeuppance after tumbling over the side of a boat after treating people’s pension policies like a big fat wallet have made sure pensions are kept in the public eye.
The negative press dented many people’s confidence in getting a pension to see them through their twilight years, but the positive outcome has been that people are talking a lot more about it now.
Generally, there are two types of pensions available to people.
1.) State Pension
2.) Private Pension
How do pensions work? Please read below on State Pension
Everybody is entitled to a state pension but it is dependent upon your ability to keep your National Insurance contributions up to date, with the amount you are entitled to based on your qualifying years. Qualifying years is the total number of years you have built up before reaching the retirement age.
In order to qualify for a full pension, you must have built up 44 qualifying years as a man and 39 years as a woman. The retirement age for men is 65 and 60 for women. This will change in 2010 when the retirement age will be equal for both sexes at 65.
There can be many reasons for not building up enough qualifying years, such as earning income below the lower earnings limit, so for many people, the state pension barely covers their needs.
For this and for many other reasons, a lot of people are taking out additional private policies to top up their pension.
The basic state pension is the same for everyone, so whether you are on £10,000 a year or £100,000, the state pension will be identical for both people.
A State Earnings Related Pension Scheme (SERPS) was then introduced, where part of your National Insurance contributions would be used to boost your basic pension, by providing an additional pension which is related to earnings.
Therefore the more you earned the higher the pension you would be entitled to. You can also ‘opt-out’ of paying to SERPS and pay into a company or personal pension scheme.
How do pensions work? Please read below on Private Pensions
As the cost of living goes up and our wants and needs reach new heights, many have realised that the basic state pension will do little to afford extra luxuries. Therefore, Private pensions have become an increasingly popular way of topping up the basic state pension.
These products can be found at any high street financial organisation or on the other hand, your company may offer you a pension scheme as a perk. There is no fixed amount that you have to contribute but the investment depends upon you and your circumstances.
There are three basic provisions available to people:
- Occupational pensions
- Personal pensions
As the name suggests, this is a pension scheme set up by your employer. There are two types of occupational pension schemes:
Salary related schemes – these are based on the number of years you have been in the scheme as an employee and the amount of your last salary during the few years before retirement. The benefits are obvious, as people’s pay is higher towards the end of their employment than when they began. This scheme offers protection against inflation but can be an expensive scheme for employers and is less popular now.
Money purchase scheme – this is where regular contributions from you and your employer are put into the same pot until you retire. You can make regular deposits into this fund every month.
This money is then handed over to a company such as a life insurance company, as a lump sum, who will manage it for you and provide a monthly pension income as an annuity. This can be a good way of topping up your state pension but the amount of pension you will receive is not guaranteed.
For people not in company schemes or who wish to take out a separate scheme to that offered by their employer, a personal pension can be an effective way of building up a nest egg for when you retire.
There are many products available to people offered by high street financial institutions, such as banks, insurance companies, building societies, and other special investment companies.
It is usual to pay a regular monthly amount into a pension plan account and you can also get your employer to also contribute. The money can then be invested in two different ways:
This is when your money is pooled along with other investors’ funds into a big pot where returns can be maximised. A fund manager, who will oversee the investment of the account, manages this account.
Unit Linked Policy
This is a slightly riskier form of investment as the funds are invested in the stock market and are dependent upon the performance of the shares. If the funds are invested wisely the returns can be fairly high.
The government is to introduce a new scheme on 6 April 2001 in order to encourage more people to make provisions for the future.
The new Stakeholder pension is meant to be a low-cost option for those who don’t currently have a second pension provision on top of the state pension and who earn between £9,000 and £18,500 a year. You can save up to a maximum of £3,600 a year into a stakeholder pension, provided you don’t already pay into an occupational pension fund.
Companies that have five or more employees can provide this provision via a suitable pension provider. The employees can then contribute to the recognised provider or they can go and opt for a different one themselves.
Stakeholder pensions should be cheaper because the government has put a restriction on the fund charges with a maximum of 1%.
Previously, people could only contribute to pensions if they were in employment but the Stakeholder pension allows the unemployed, students, non-earning partners, or people in-between jobs to contribute therefore not losing out on the provisions for the future.
Even children can open a stakeholder pension, though they have to be set up by a parent or guardian. Regular monthly payments into a stakeholder scheme are then invested in a variety of ways including stocks and shares.
Pension contributions attract generous tax relief, so with a basic rate of tax at 22%, for every £100 you contribute, it will cost you £78 with the taxman topping up the rest.
For higher rate taxpayers at a rate of 40%, every £100 will cost you £60 with £40 from the taxman. Higher rate taxpayers can claim the relief through the Self-Assessment form at the end of the tax year.
With an ever-growing aging population, it is advisable to think about your future provision.
For more information on your pension options, visit the government’s pensions guide site.
For more advice click here to visit the Government’s Pension Guide. Thanks a lot for reading my article – How do pensions work? Hopefully, you read and enjoy it. Have a good day!