Retirement planning is critical to ensuring a pleasant and financially secure future. Pensions are essentially saving pots for retirement so understanding the fundamentals of pensions is a critical component of retirement planning.
In this blog, we will look at the fundamentals of pensions, such as their importance and types, among other things. Let’s dive into pensions and see how they might help you reach a worry-free retirement.
What is a Pension?
A pension is a retirement savings plan or arrangement that provides individuals with an income when they leave the workforce. It acts as a financial safety net, providing an income stream to sustain a living when one is no longer employed. The size of your pension and the pension arrangement may or may not provide you with sufficient income during retirement. This is why retirement planning is absolutely critical; no one wants to be 75 and out of money.
Pension Phases
Pensions have two main phases, accumulation and distribution. Individuals contribute to their pension fund during the accumulation phase, which grows over time through investments and compound interest. Retirees get regular payments or a lumpsum from their pension fund during the distribution period.
Types of Pension in the UK
State Pension
This is a regular payment from the government, and the amount is based on an individual’s National Insurance contributions. To qualify for the full state pension, individuals need to pay national insurance contributions for 35 years. However, payers qualify to a portion of their state pension after 10 years of paying national insurance contributions.
Currently, maximum state pension is set at £203 per week, or £812 a month. Although this does increase every year in line with inflation (minimum of 2.5%), it is obvious that this is not a lot of money. You will absolutely need to supplement this income during retirement.
Workplace Pension
These are employer-sponsored schemes designed to boost your savings for retirement during your working years. These plans vary in type as well:
- Defined Benefit (DB) Pensions: In a DB pension scheme, the amount you receive is based on your salary and the number of years you’ve been a member of the scheme. The employer takes on the investment risk, and the pension is typically a percentage of your final salary. These are not very common in the UK anymore.
- Defined Contribution (DC) Pensions: In a DC pension scheme, both the employer and employee contribute to a pension fund during the accumulation phase. The final pension amount is determined by the performance of the investments made with these contributions, which tend to be managed by the pension provider. The individual takes on the investment risk in this type of pension, so if the investments do not perform well, the retirees end up with less money. DC pensions are now the de facto pension schemes offered by most employers.
- Automatic Enrolment Pension: To encourage retirement savings, the government introduced automatic enrollment for workplace pensions. Eligible employees are automatically enrolled into a qualifying pension scheme, and both the employee and employer make contributions.
Whether your employer offers DB or DC pensions, you will be automatically enrolled unless you specifically request to opt-out. This is because the government introduced automatic enrolment for workplace pension to encourage saving for retirement. Even the government knows that £200 a week is not enough money to support retirement.
Private Pension
Individuals can also build private pensions by contributing to a personal retirement fund. There are vehicles designed specifically with the following retirement benefits in mind:
- SIPP: Self-Invested Pension Plans (SIPPs) are investment accounts that allow individuals to save and invest freely in a wide range of stocks, bonds and funds. Just like DC pensions, contributions are eligible for a tax relief. This means that you do not pay taxes on your retirement savings now, and you let your savings grow tax free.
- LISA: The LISA is another investment account designed for retirement savings. LISAs differ from SIPPs in one important aspect. Contributions made to a LISA are not eligible for tax relief. Instead, you can put away up to £4,000 and get 25% top-up from the government. This is an additional grand every year. Profits in a LISA are protected from dividend and capital gain taxes, but are subject to inheritance tax. Like a SIPP, stocks & shares LISAs allow individuals to invest this money in a wide range of financial assets. You need to be under the age of 39 to open a LISA and you can only make withdrawals after the age of 57.
FYI, LISAs can also be used towards the deposit of your first property (as long as it is less than £425,000).
Retirement Age and Withdrawals
Understanding the laws and processes for pension withdrawals and determining the right retirement age are critical components of retirement planning. Retirement age determines when people can begin claiming their pension benefits, while withdrawal rules govern how and when people can access their accrued pension savings. This is very important because many pension providers will not allow early withdrawals and if they do, there will be large penalties and charges associated with early withdrawal.
Normal Retirement Age
The age at which an individual becomes entitled to receive full pension benefits is referred to as the normal retirement age. The exact age varies according to the pension plan in the UK. In many countries, the normal retirement age is set around 65 or coincides with the age at which full state pension payments are available. However, as mentioned above, some plans allow withdrawal at an earlier age, such as LISA allowing withdrawals at the age of 57.
You should check with your pension provider the age when you can start making withdrawals. But even when you get to make withdrawals, think twice about how much you will withdraw because there may be tax implications.
Retiring Early? FIRE?
The FIRE movement (Financial Independence, Retire Early) movement has long preached for early retirement. Early retirement simply means calling it quits with work before (usually well before) the traditional retirement age of 65. But beware that every pension option mentioned here will probably not support early retirement. Early retirement is expected to be fully financed by personal investments in stocks and real estate, usually from living frugally and saving a large portion of your income, or from working in a high paying sector (e.g. banking or law) for 10-20 years.
Withdrawal Alternatives
To accommodate diverse retirement needs and financial situations, pension plans often offer a variety of withdrawal alternatives. Among the most prevalent withdrawal methods are:
- Lumpsum: Individuals may withdraw their whole pension balance as a lump sum. This allows you instant access to the accrued cash, but it will have tax implications and potential risks if not managed carefully. In the UK, you are allowed to withdraw 25% of your pension tax-free (up to a maximum of £268,275). Withdrawals in subsequent tax years will be subject to income tax and typical tax allowances.
- Annuity: An annuity payment option allows individuals to receive regular payments from their pension fund for a set amount of time or the rest of their lives. Annuities provide a steady stream of income, assuring financial security during retirement. It is always a good idea to combine state tax with an annuity to have a guaranteed minimum income on a regular basis during retirement.
- Combination: Some pension schemes allow for a combination of lump sum and annuity payouts. This technique allows retirees to receive a portion of their funds as a lump sum while converting the remainder into an annuity for ongoing income.
How much to withdraw going forward? and how to manage any outstanding funds in my pension in my early retirement days? These are advanced pension related questions that will be addressed in dedicated articles.
Consultation with a Financial Advisor
It is quite obvious that pensions are critical. Getting pensions wrong could lead to huge financial distress at old age. It is recommended that you meet with a skilled financial advisor at some point before retirement. They can advise you on your pension plan’s precise rules, withdrawal alternatives, and tax consequences, allowing you to make informed decisions that align with your financial objectives.
But please, do not wait till retirement to think about pensions. Book a free call with one of our financial coaches to talk money, retirement and more.
Conclusion
Pensions are critical in ensuring a financially secure retirement. Understanding the fundamentals of pensions, such as their types, contributions, and withdrawal restrictions, is necessary for effective retirement planning.
You can embark on a route to a worry-free and wealthy retirement by taking the time to understand these concepts and applying smart pension methods. Remember, there is always time to begin making plans for your future!
Also Read: How to Set Financial Goals
