What the hell is a pension anyway?!
A pension by definition is a pot of money that you are entitled to draw down from (i.e. take from) after you reach the retirement age.
Defined Contribution vs Defined Benefit
It used to be common practice that every pension was a ‘defined benefit’ pension but since they are more costly to the Government, they have now rolled out ‘defined contribution’ pensions instead………which is not such great news for us.
According to the GOV.UK website:
- “Defined benefit – usually a workplace pension based on your salary and how long you’ve worked for your employer
- Defined contribution – a pension pot based on how much is paid in”
The best pensions left out there come from the NHS and MOD.
For example, the MOD provides a non-contributory pension – meaning you do not actually contribute towards your pension each month, only the MOD does.
If you find yourself in either of these 2 pension schemes then stick with them, as they are the best in town.
Types of Pensions
There are 3 types of pensions:
State pension – a baseline amount the Government pays you after you retire.
Occupational/Workplace pension – contributions from your salary during your working life.
Private pension – also known as a SIPP (self invested personal pension) – additional contributions you make from either your salary, savings, gifts or investments.
The reason you have different types of pensions is because for most, living off the state pension contributions from the government is not sufficient.
Therefore, by law every employer has to provide its employees with a pension and contribute to it as well.
Employees are automatically enrolled into it but if, for some strange reason, you don’t want to have an occupational pension that you have to manually opt-out.
(Most IFA – independent financial advisers – will advise against this because you’re missing out on free money)
Free money, you say?! We all know there is no such thing as a free lunch, surely?!
Well, actually there is. The Government always incentivises its people to save so provides tax reliefs for those who do.
According to Investopaedia a tax relief is: “any government policy initiative designed to reduce the amount of taxes paid by individuals or businesses”.
How tax relief works
I like to be spoon fed information so love examples that simplify a concept:
Whichever bracket your salary falls into will determine how much you are taxed.
Personal allowance = you can have up to £12,500 tax-free (0%)
Basic rate tax payer = £12,571 to £50,270 (20%)
Higher rate taxpayer = £50,271 to £150,000 (40%)
Additional rate = salaries over > £150,000 (45%)
Now, let’s say you want to contribute £100 a month into your pension pot (we shall ignore different types of pension at this stage, as I just want to outline the benefits of tax relief)
If you are a basic rate tax payer you will only have to pay in £80 as the Government will provide tax relief of 20% and pay in £20 (20% of 100 = £20).
So £100 is still going into your pension pot but the Government is paying 20% of it.
If you are a higher rate taxpayer, in order to put £100 into your pension pot you only need to contribute £60 because the Government will top it up with £40 (40%).
This is why pensions are so great.
The only caveat is that you can only access this pot of money when you reach the retirement age.
Even MORE free money
It gets better.
With workplace pensions your employer is also obliged to contribute as well.
The Government stipulates that at least 8% of the employee’s salary should be contributed to the occupational pension.
Of that 8% the employer must contribute as a minimum of 3% – so the employee is only in fact contributing 5%.
I’m terrible at math so let’s keep it easy for me and stick with a nice, friendly round number of £1000.
You are paid £1000 per month by your employer (before tax).
Your workplace pension scheme specifies that 8% of that £1000 (i.e. £80) per month goes towards your occupational pension pot.
Your employer has to contribute a minimum of 3% (£30) per month from their bank account.
That leaves you only needing to pay 5% (£50) per month from your salary.
In summary, your future self is getting a free £30 each month from your employer.
Matched or Unmatched
The minimum contribution towards your occupational pension is a total of 8%:
3% (employer) + 5% (employee)
Note this is the minimum.
Some employers offer to match what you are contributing so ask your HR department if this is the case with your employer….and then jump on it.
If you are contributing 5% then your employer will then increase their contributions to 5% – more free money!
The more you increase your contributions per month into your future money pot, the greater your salary in the present will be sacrificed (no pain, no gain!) but it is worth it.
Ideally, you want to increase your monthly contributions to the highest you can personally tolerate and then ask your employer to match it.
Financial advisers suggest that in order for you to live comfortably in retirement you need to contribute 15% of your gross salary per year into your pension pot.
So if you’re currently contributing the minimum of 8%, you need to increase it by another 7%.
This can either be done by increasing your work place pension contributions (and getting your employer to then match it) or via a SIPP to top it up personally.
My personal example
My employer unfortunately does not abide by a ‘matched policy’ and will only contribute a maximum of 4%.
The work place pension I have been automatically enrolled into has me contributing 5% monthly.
That takes me to 9% total…….short by 6%.
I’ve then set up a SIPP (private pension) and contribute an extra 6% into my pension pot each month.
Self-Invested Personal Pension (SIPP)
There are many providers out there that offer a SIPP.
To name a few: Hargreaves Lansdown, Legal & General, AJ Bell, Vanguard etc.
They all offer different funds and fees that your money will be invested into while you are etching closer to your retirement age.
SIPPs are not compulsory but just another way you can increase your pension contributions.
Phone up your pensions or HR department and find out the following things:
What % is your employer contributing to your pension?
What % are you contributing to your pension?
Does your employer offer to match your contributions?
If so, ask them to increase your personal contribution % and get your employer to match it.
The closer you get to that golden number of 15% the better.
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This blog is for educational purposes only and should not be construed as financial advice. It is purely opinion-based.