Planning For RetirementSee also: Long-Term Financial Planning
Retirement may seem like a long way off—or possibly an impossible dream, depending on where you live, and your financial circumstances. However, it is never too early to start planning financially for this event. Careful and early planning ensures that you have plenty of time to start saving, and build up a reasonable pot of money.
Even if you have left it fairly late, it is still worth thinking about and planning for retirement. Checking how much money you need to live the way you would like, compared with what you have available, and understanding the rules around pensions, could be time well spent. This page provides some advice and ideas to help you plan effectively for retirement.
What is a Pension?
A pension is a savings plan designed to help you save for retirement.
Pensions allow you to save money out of your income while you are working, to fund your retirement or when you stop working. There are several different sorts of pension, some run by employers, and some that you can set up by yourself (or with the help of a financial adviser).
Some countries have a ‘state pension’. This is paid by the government to everyone over a certain age who has worked and contributed taxes during their working life.
However, it is not usually a huge amount. In the UK, the current state pension amount is around £180 per week, which is not very much. Most people therefore need an additional income from a personal pension as well as the state pension.
There are many different alternatives if you want to save money. Our page on Loans and Savings explains some of them. So why do you need a specific option for retirement savings? Here are some reasons why you might want to consider a pension:
In many countries, pensions have tax advantages. For example, in the UK, you can pay into a pension from pre-tax income. In other words, you are not taxed on the income that you pay into a pension scheme. This is because the government wants people to save for retirement.
Many employers also pay into their employees’ pension schemes as part of the overall remuneration package. This means that you get extra (free) money saved for your retirement—and it really is effectively free, because you cannot choose to take it as salary instead. If you don’t have it paid into a pension, you will lose that benefit.
Pensions funds also have another advantage: the funds are invested and managed to help them to grow. Unlike a savings account that only pays a small amount of interest, your pensions fund is likely to be invested into stocks and shares and similar funds. It should therefore grow faster than inflation. This means that you should get back more than you paid into the fund.
Defined benefits or defined contributions?
There are two main types of pension scheme: defined benefits and defined contributions.
A defined benefits pension scheme pays out a fixed amount of benefit
These are also known as ‘final salary’ schemes because the benefit is usually based on your salary during your last few years of working. These schemes are now increasingly rare, because they are extremely expensive to operate. Few if any employers or pension managers wish to take the risk of the fund falling short of the necessary amount to pay all the obligations.
In a defined contributions scheme, you (and your employer) pay in a fixed amount each month
The size of your pension pot, and the amount that you can withdraw each month, then depends on the state of the pensions fund when you withdraw the money.
Starting to Save into a Pension
Many people start to save into a pension when they are first employed.
In the UK, at least, this is because employers are now obliged to offer a pension scheme, and to enrol their employees into it. You now have to opt out of an employer-provided pension scheme, rather than opt in.
If your employer offers a pension scheme, regardless of whether you have to opt in or opt out, it is a good idea to take up that offer.
Generally speaking, employer pension schemes offer reasonable value, especially if you have not already made alternative arrangements. However, if you are self-employed, or on a zero-hours contract, you may need to make your own pension arrangements.
It is a good idea to do this, even if you think retirement is a long way off. Every bit of money saved into a pension now will grow over time, and improve your eventual pension pot.
Choosing the Right Pension Scheme
There are a huge range of pension schemes available.
The best one for you will depend on various things, including:
Where you live, and the laws and rules about pensions in your country;
Your financial circumstances, including how old you are, how much you can afford to save, and when you want to retire. You can afford to take more risks with your money in pursuit of higher rewards when you are younger; and
Your investment priorities, for example, if you want to invest only in funds that are guaranteed to be ethical.
It is a good idea to get advice before choosing a pension, using an independent financial adviser.
Your contributions will also vary over time.
If you are paying into an employer pension, your contributions will be a fixed percentage of your income. However, you may be able to choose to pay in more if you want. Some people, for example, front-load their contributions by paying a bit more in before they start a family, so that they can afford to reduce their working hours, and therefore pay in a bit less, while their children are small.
WARNING! Check the Rules Where You Live!
If you are a high earner, it is worth checking the rules about maximum pension contributions.
Some countries have rules about the maximum amount that you can pay into a pension in a year, and over your working life. If you go above this maximum, you may have to pay tax on your contributions, or other penalties may apply.
If in doubt, consult a financial adviser well in advance of any problems.
Managing Your Pension(s) Over Time
The main reason to think about your contributions, and particularly to consider increasing them, is to ensure that your pension(s) will give you enough income to live the way you want once you have retired.
There are two aspects to this: the current size of your pot, and the extent to which it may grow over the time between now and your retirement. There are plenty of pension calculators about that can help you to work out the potential growth, based on projected stock market growth over the period and your planned retirement age. They usually offer a high, medium and low projection, so you can get a reasonable idea of how your pot is likely to perform.
It is worth using one of these calculators to see if you will have enough. If you won’t, you can either reduce your expectations of retirement, or try to save a bit more each month.
To do this, you will need to have a reasonable idea of your needs for income during retirement—and it is worth working these out sensibly, so that you know, rather than guess.
It is also worth redoing this exercise periodically—say, every 10 years when you are younger, and every 5 years once you reach your late 40s and early 50s. This will show whether you are on track to reach your planned retirement pot.
This is the main factor to consider in ‘managing’ your pension over time.
However, if you have a personal pension, rather than an employer pension, you may also want to consider aspects such as the administration costs, and the nature of your investments. Your views about risk may change over time, as may your opinion of ethical investments, or the performance of the funds in which you originally chose to invest. You should also consider whether you need to combine pension pots to minimise costs (see box).
There are further aspects to consider if you have a self-invested personal pension (available in the UK). These allow you to manage your own pension funds either personally or with the help of a fund manager, for example, by investing in property, or in the stock market. You can also vary the amount that you pay in, including by paying in lump sums.
Combining Pension Pots
Back in the day, most people expected to work for a single employer for most of their working life. Those days are now long gone.
However, pension rules have not entirely caught up with his change. Employer-provided pension pots mean that by the time you reach your 40s or 50s, you may have paid into four or five different pension pots, all for a period of just a few years. If you have had some periods of self-employment, you may also have a personal pension.
It may therefore be worth combining your pension pots into one. You can either bring them all together into a personal pension, or into your current employer’s pension. This will reduce any administration charges.
However, it is worth getting advice about the implications before you do any combining, because some pensions may offer better benefits than others.
Drawing Your Pension
It is worth giving some thought to what you plan to do with your pension. Some countries have rules about how you can take your pension to ensure that you don’t run out of money during retirement.
In particular, you should consider what is permitted by way of taking out a lump sum, monthly withdrawals, and any requirement to use some of the money to buy an annuity instead of simply withdrawing money.
The restrictions on these activities vary over time, and in different countries. The implications also vary. For example, you may only be able to withdraw a certain proportion as a lump sum without having to pay any tax on it.
Different people’s requirements will also vary. For example, some people want a bigger lump sum to buy a property for retirement, or decide to take an annuity because of the financial security that it offers. Some people also want to take a smaller pension earlier, but continue to work part-time to supplement it, whereas others want to stop work completely when they retire, but feel able to do so later in life.
Only you can decide what is best for you. However, you would be wise to take advice from an independent financial adviser before making any final decisions.
Other Savings for Retirement
A pension is a conventional—and tax-efficient—way to save for retirement. However, there are other ways to fund retirement. If you are a homeowner, for example, you could draw down some of the equity from your home. If you hold a life insurance policy in the US, you may be able to borrow against it if you need a lump sum.
There is more about these options in our guest post on top tips for money management during retirement.
An Important Take-Home Message
If you take only one thing from this page, it should be the importance of saving for retirement.
However, if you are willing to take two ideas away, the second should be the value of getting independent financial advice about saving for retirement—and preferably on an ongoing basis. Planning for retirement is not simple, and getting good advice could make all the difference to your comfort level in retirement.