Where do you even start- you hear all these different names for pensions, auto enrolment, defined benefit, defined contribution, private pensions and more. All these different types of pension -what the hell do they all mean? And more importantly, what do they mean for you for both saving for your pension & when you actually retire.
You cannot take any money out of your pension, until you are pension age*. Ignore anybody or any company that tells you otherwise- its likely illegal and will cost you thousands- just don’t do it!. So, if you are wanting to retire before the UK pension age- currently 55, rising to 57 shortly (it’s set 10 years earlier than the state pension age current)- this is the age you will need to be before you can access your pension.
*There are a few exceptions to this- one is if you are terminally ill, and even then it might be best not to take it as it can affect your estate for inheritance tax reasons- seek professional advice
So a pension is useless if you want to retire early?
No! Not at all. The tax benefits of pensions (are currently) excellent, and everybody should be saving into a pension, whether or not you want to retire early or not. Just remember that you can pick whenever you want to retire, and it can be as early as you want. You cannot however take any of your pension benefits until you hit pension age. You will need to build a financial bridge to get you there!
Very broadly there are only really 2 different types of pension:
Defined Contributions (DC) Pension
Defined Benefit (DB) Pensions
Now, it maybe that you may have an older type of pension that no longer exists anymore- as the governments of the day have made multiple changes over the years. Usually old schemes are just “put on pause” so that new members can’t join them, but they stay open for the current membership (but sometimes stopping new contributions as well).
This is usually is what on offer by every employer in the UK now- it’s the default. In fact, by law, as long as you are an employee- your employer has to pay into your pension. This is called auto enrolment, and its discussed a bit further below.
The simplest way to describe how this pension works- is from it’s name “defined contribution”. Each month that you work for your employer- there is a defined amount of money that is paid into your pension. Some of this is directly from the employer, some of it is tax relief from the government and the rest is from you. Now, that doesn’t mean that you yourself needs to setup a direct debit/standing order to cover your part- your employer normally takes this straight out of your wages.
What defined contribution doesn’t tell you, or guarantee you- is the amount that you will have when you actually retire. Your pension provider should give you a yearly “prediction” of what they think might happen, but this contains a huge number of assumptions (the biggest one for people that are FIRE’ing, is that you will work till pension age of 65!).
So, you will need to keep a careful eye on this yourself, and either create your own assumptions or use other calculators that allow for contributions to stop at the age that you stop working. Do note, that just before you stop working, doesn’t mean that you have to stop your contributions to your pension- but the tax relief rules are such that it wouldn’t necessarily make sense to contribute over certain limits.
If you move jobs, then its likely that your new employer will use a different provider than the previous one. This isn’t a problem, you should look at the fees of both, and decide which offers best value for you (and some might only have certain funds available). Your current employer will probably only contribute the provider that they pick, so you might be slightly stuck here, but don’t let that put you off moving your old pensions so at least you only have 2- rather than say 10.
I say without much doubt that this type of pension is pretty much the dream. They were everywhere until the start of the millennium, where government changes made them more and more expensive to run, at which point they all but stopped. The only place you will likely find this type of pension now is in the public sector- councils & schools are still offering these for example.
How do they work & how are they different to defined contribution? Well, you still pay into them- it’s usually a set percentage of your pay, though this tends to be higher the more that you get paid. So it may start at 7%, but go to 12% and even higher as you get to the higher end bands. Hold on, this sounds more expensive than the defined contribution above? Well, yes, it does, but the benefits are HUGE- let me explain more.
Years ago (think 1960s/70s/80s) employees used amazing pensions- usually based on the number of years that they had worked + their final salary that they were on. This was an absolutely amazing deal, since your last salary tends to be the highest you have ever earned- since you have the maximum level of experience/responsibility etc.
Defined benefit works somewhat like this, but are no way near as good (but, probably the best pension type that still exists). You get a “amount of pension” for each year that you have worked- based on your salary that year.
Let’s use Cardiff Council as an example of how this could work for you (if you have a DB scheme). You have a salary of £20,000 & the Cardiff Council scheme is part of the wider Local Government Pension Scheme (LGPS). According to the current contrition calculator– you would pay 5.8% (do note, this can and does change yearly etc) of your yearly salary (it gets taken monthly from your salary). You also get margin tax relief of 20% on this amount as well, so the actual cost to you is about £77.34 a month (note: this maybe different if you aren’t on the standard tax code, 1250L or C1250)
So, what you get for your £77.34 a month- or £928.08 a year? Well, you get 1/49th of your pensionable pay as your pension- when you get there. What the hell does this actually mean? Well, following the same example, if you earnt £20,000 then 1/49th of this is £408~, so that means when you retire, you will get £408 paid you to at age 65 (or whatever the pension age is at that time. Hold on, I paid £928.08 and only got £408? Well, yes but no- you get this £408 EVERY YEAR you are retired, so, if you live to 85, then actually you would get £8,160 in total. The scheme also applies a cost of living increase each year as well- so this should grow with inflation too!.
How does this compare to a DC pension? It totally blows it out of the water, the DB pension is better in almost every single way. You don’t even have to worry about what fund its invested in, or the risks etc- the pension provider (LGPS in this case) does all of that for you!
Hopefully you have heard about auto enrolment- the government has done a massive information campaign over the past couple of years. This isn’t actually a pension type as such- its just new rules that mean that pretty much every employee has to be paid a pension, and by default you are automatically enrolled. Now, you do need to note that there are some exception that mean employers don’t have to set them up (mostly in regards to minimum amounts earnt/worked), but apart from that, everybody should now get offered a pension from their employer
These types of pensions are defined contribution- you know what you are putting in, but not what you will get out (see above). Do remember that you are more than doubling the money you put in- see my other post. Please do think about that if you are thinking of opting out of the pension.
Pensions can be insanely complicated- for most people they aren’t, your employer sets up the account and pays both your & their amounts in, and that’s it. It can get very complicated if you are near tax brackets, or have abnormal situations- such as tax resident in multiple countries etc. If this is the case for you, it’s best to get professional advice. This is one area you do not want to get wrong, as it maybe the error/mistake doesn’t get picked up for years- at which point it has compounded massively.
Nothing in this article is professional advice- please seek it elsewhere!