Pensions for dummies
Discussion
Right, I'm in my early twenties, and I guess I should really be looking at pensions, etc.
I really have very little knowledge, so you'll have to help me out.
So, starting from the basics, How does one work? What different kinds are there? Are there any other alternatives?
I'm between offices at the moment, so one through work may not be an option for another 2 years.
GO!
I really have very little knowledge, so you'll have to help me out.
So, starting from the basics, How does one work? What different kinds are there? Are there any other alternatives?
I'm between offices at the moment, so one through work may not be an option for another 2 years.
GO!
I'm surprised no one has given you a serious answer...
Anyhow, at the most basic level there are two types of pension schemes - final salary and money purchase.
Final Salary
This is the traditional (and for so long hugely successful) method. Your employer has set up a pension trust, managed by a board of trustees. It (and you) pay money into the scheme. Every year of emloyment you were (almost) guaranteed a pension value equal to a fraction of your final salary (when you retire or leave the company) - so each year you would have gained perhaps 1/50th of your final salary as a pension.
The fund could estimate how much liability ot was building up, secure appropriate contributions, and invest that money to maintain adequate reserves. When you retire after perhaps 20 years service, you would be entitled to 20/50th of your final salary (with corrections if you retired early). You would receive that pension every week/month for the rest of your life.
Obviously this was very popular with employees, as they carried very little risk. With good estimation of liabilities, long-view management, tax breaks and a healthy investment market, most schemes were very successful and built up huge surplusses (more value than predicted liabilities). As non-profit funds directly related to their owner/contributors they were also much more cautious - much like comparing building societies to retail banks. Problems were rare - mainly fraud as in the Maxwell/Mirror case.
However. Goverments (Major and particularly Blair/Brown) got envious and tax breaks were removed. Surplusses were capped (and at the worst time, when the markets were at a peak in a bubble). Companies & shareholders also got greedy - they took (over long) contributions holidays, and sought to extract funds as profits.
With markets down, many more schemes are now in a shortfall (e.g Royal Mail). Those already retired get first call on the funds, and those still working/paying are at risk. Many companies are withdrawing their final salary scheme.
However, if the offer is there, it is still the best & most secure option for employees, and very appealing.
Money Purchase
A money purchase scheme is much more personal. There are two stages.
First, whilst you are working, you put money into a fund. It's a simple monthly savings scheme. The money is invested over the years to build its value (as you get older the investment strategy gets more conservative to reduce your risk). Your employer may also make contributions. They may run their own scheme, or buy into a larger fund. Or you might run your own (if you are self-employed for example).
The second phase is the annuity. When you retire, you use your savings fund to purchase an annuity. An annuity is like a huge bet from the provider - they look at your lifestyle, estimate how long you will live, and promise to pay you a certain amount each year. Typically it might be 4% of your fund, but the rate varies on your circumstances and market conditions. So a £1m fund might give you a pension of £40,000pa.
If you die early, the annuity provider wins. If you live to 120, your quids in.
If you die before your retirement your fund should form part of your estate. But if you die on your first day of retirement, it's gone.
But you'll see that you are carrying much more risk yourself. Your investment performance affects you more directly. Annuity rates could be (and are) very poor at the moment you retire. The investment fund is run by people not directly involved with your company.
You can appreciate that anyone retiring at the moment (with even safe investments having dropped, and miserable annuity rates) must be cursing their decision not to retire two years ago. You can understand why some people have avoided traditional pension funds and invested the money themselves (Buy to let is often considered as getting rent to cover the mortgage, but the house itself is the pension fund to be sold when you retire).
An employer-funded money purchase scheme is generally worth being involved in - provided you expect to be there for some years, and indeed you expect the company to be around for some years.
From there, the extensions are fairly obvious:
- Widow's rights to your pension
- Bonuses
- The facility to make additional voluntary contributions (AVCs) now to bump up your pension in the future.
- The ability to move your pension fund from a poor investment fund to a safer or more effective one (this can even be done with a final salary scheme, where they calculate a transfer figure)
Anyhow, at the most basic level there are two types of pension schemes - final salary and money purchase.
Final Salary
This is the traditional (and for so long hugely successful) method. Your employer has set up a pension trust, managed by a board of trustees. It (and you) pay money into the scheme. Every year of emloyment you were (almost) guaranteed a pension value equal to a fraction of your final salary (when you retire or leave the company) - so each year you would have gained perhaps 1/50th of your final salary as a pension.
The fund could estimate how much liability ot was building up, secure appropriate contributions, and invest that money to maintain adequate reserves. When you retire after perhaps 20 years service, you would be entitled to 20/50th of your final salary (with corrections if you retired early). You would receive that pension every week/month for the rest of your life.
Obviously this was very popular with employees, as they carried very little risk. With good estimation of liabilities, long-view management, tax breaks and a healthy investment market, most schemes were very successful and built up huge surplusses (more value than predicted liabilities). As non-profit funds directly related to their owner/contributors they were also much more cautious - much like comparing building societies to retail banks. Problems were rare - mainly fraud as in the Maxwell/Mirror case.
However. Goverments (Major and particularly Blair/Brown) got envious and tax breaks were removed. Surplusses were capped (and at the worst time, when the markets were at a peak in a bubble). Companies & shareholders also got greedy - they took (over long) contributions holidays, and sought to extract funds as profits.
With markets down, many more schemes are now in a shortfall (e.g Royal Mail). Those already retired get first call on the funds, and those still working/paying are at risk. Many companies are withdrawing their final salary scheme.
However, if the offer is there, it is still the best & most secure option for employees, and very appealing.
Money Purchase
A money purchase scheme is much more personal. There are two stages.
First, whilst you are working, you put money into a fund. It's a simple monthly savings scheme. The money is invested over the years to build its value (as you get older the investment strategy gets more conservative to reduce your risk). Your employer may also make contributions. They may run their own scheme, or buy into a larger fund. Or you might run your own (if you are self-employed for example).
The second phase is the annuity. When you retire, you use your savings fund to purchase an annuity. An annuity is like a huge bet from the provider - they look at your lifestyle, estimate how long you will live, and promise to pay you a certain amount each year. Typically it might be 4% of your fund, but the rate varies on your circumstances and market conditions. So a £1m fund might give you a pension of £40,000pa.
If you die early, the annuity provider wins. If you live to 120, your quids in.
If you die before your retirement your fund should form part of your estate. But if you die on your first day of retirement, it's gone.
But you'll see that you are carrying much more risk yourself. Your investment performance affects you more directly. Annuity rates could be (and are) very poor at the moment you retire. The investment fund is run by people not directly involved with your company.
You can appreciate that anyone retiring at the moment (with even safe investments having dropped, and miserable annuity rates) must be cursing their decision not to retire two years ago. You can understand why some people have avoided traditional pension funds and invested the money themselves (Buy to let is often considered as getting rent to cover the mortgage, but the house itself is the pension fund to be sold when you retire).
An employer-funded money purchase scheme is generally worth being involved in - provided you expect to be there for some years, and indeed you expect the company to be around for some years.
From there, the extensions are fairly obvious:
- Widow's rights to your pension
- Bonuses
- The facility to make additional voluntary contributions (AVCs) now to bump up your pension in the future.
- The ability to move your pension fund from a poor investment fund to a safer or more effective one (this can even be done with a final salary scheme, where they calculate a transfer figure)
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