Pensions can sound a bit dull and dreary and it can be very tempting to put off properly saving into them.
When you’re young it’s easy to dismiss them as irrelevant to you, as retirement seems a long way off.
When the expenses of life encountered in your thirties and forties arrive – such as buying a home, paying for a wedding and raising children – saving for retirement can feel a long way down the list of priorities.
Then in your fifties – with retirement approaching fast – it can be all too easy to decide that as you haven’t saved enough yet, there’s no point bothering now.
But making the most of a pension is your best chance of securing a decent income when you retire.
After you finish working you will still need to pay for bills, accommodation, food – and the occasional treat. How will you be able to afford to live if you don’t plan ahead?
What is a pension?
A pension is a financial product that you put money into so that you can build up a fund to use when you retire.
The idea is that a retirement pot is built up by investing over a number of years. The money that you save into a pension gets a boost from tax relief, so effectively you are saving out of untaxed earnings.
In retirement, you can then access your pension to buy yourself an income or draw on it. Alternatively, if you are lucky, you will have a defined benefit scheme – often known as final salary – where your employer promises you a set income in retirement for life and picks up the tab.
Most people usually start their pension through their workplace, but you can also set up and manage your own through a personal pension.
The two types of work pension you need to know about
There are two main types of pension that you will hear mentioned, defined contribution and defined benefit schemes.
These names sound like jargon, but simply describe how each pension works.
Defined benefit schemes pay you a set annual income in retirement. The name comes from the fact that the benefit you receive is defined.
These are often called final salary schemes, as they can pay an income based on your earnings at the end of your employment with a company. However, defined benefit pensions can also include career average schemes, or other methods of setting the income paid in retirement.
The crucial thing to remember about defined benefit pensions is that the employer has promised to pay out a certain amount of income every year on retirement and must take responsibility for funding that.
When you contribute to a final salary scheme your money goes into a pot with that of other members. The promises made to workers by defined benefit pensions have proved very expensive to fund and any shortfalls have to be made up by the employer. As a result these have become rare in private businesses and are now more commonly offered in the public sector.
Defined contribution schemes do not promise any set payouts in retirement. Instead you must invest to build up a savings pot that can eventually be used to provide an income. The name comes from the fact that it is your contributions that are defined.
With a work defined contribution pension, people are usually able to decide how much they want to pay in as a percentage of their salary and their employer will match some or all of the contributions.
The money saved into the pension is invested, typically into funds that hold shares or bonds, and grows over the years to deliver a retirement pot.
With these pensions it is your responsibility to build up the pot you need for retirement. You can track which investments your money is going into and how they are performing and change them if you wish.
Pensions don’t just come through work. You can also set up your own personal pension and invest through that too.
You can do this in addition to – or instead of – a work pension. There are different types of personal pension ranging from a cheap and basic stakeholder pension, which limits where you can invest, to what is known as a self invested personal pension, or Sipp, where you can access many different types of investment.
These are also defined contribution pensions – building up the pot is your responsibility.
When should I start a pension?
When it comes to saving for retirement, time is your friend.
The earlier you start investing the more you are likely to get when it comes to retirement.
Even starting with just a small amount at first can make a difference.
Investing £100 a month for 20 years with 5 per cent growth per year would deliver £41,000. Save for just ten years longer at the same rate and your pot will be worth more than twice as much at more than £83,000.
This is because your pot will have benefited from compounding, where your returns build up on returns that you have already received. It allows your retirement pot to grow like a snowball rolling down a hill, picking up extra little bits as it trundles along.
The other great advantage is that with time on your side, you have more breathing space to regain lost ground if your investments fall in value.
Over the short-term, this is likely to happen throughout your retirement saving lifetime.