Do you trust pensions?

by Adam on November 15, 2010

“I don’t trust pensions” exclaimed a colleague of mine the other day at work.

At that very moment I wanted to spit out my mouthful of water all over my desk.

She continued:

I’ve been missing out on 3% of my salary for all the time I’ve been here but I just don’t trust pensions”

I carefully swallowed my water before shaking my head in disbelief.

I was shaking at the gravity of this revelation. Well, maybe I wasn’t shaking but I was certainly fired up with evangelical zeal to get this woman to start saving in a retirement vehicle!

She was consciously and deliberately missing out on 3% of a good salary, and the potential growth of that money over the years…the numbers were simply mind-blowing.

We were having what quite possibly could have been a  £100 000+ discussion right here!

“I don’t trust pensions”

Her words haunted me for the rest of the day.

Why was it that she didn’t trust pensions?

I’m sure she’s not alone either.

Do you trust pensions?

Defined Benefit and Defined Contributions

To understand people’s misgivings about pensions we need to know about the difference between ‘defined benefit’ pensions and ‘defined contribution’ pensions.

In a sentence: the difference is a defined benefit pension promises you a certain amount of money when you retire, whereas a defined contribution pension gives you you a certain amount of money today to use when you retire.

Defined Benefit Trouble

With a defined benefit pension, otherwise known as a final salary pension, you contribute part of your salary into the scheme and then you are promised to be paid a percentage of your salary when you retire, depending on the number of years you’ve been working.

For example you might be promised a 40th of your salary for every year you work –work 40 years and retire and you continue to receive 100% of your current salary for the rest of the life. These kind of pensions sound pretty generous and they supposedly take the risk out retirement because it is the pension scheme’s responsibility to work out how they are able to afford to pay you your pension.

However, in recent years these generous pensions have been getting into trouble, particularly in times of economic uncertainty and plunging stock market valuations –some schemes simply run out of money and start racking up huge debts.

One famous example of a scheme in trouble is BT’s pension fund;

“BT’s pension scheme has been in the red since the 1990s, but went further under in the Noughties thanks to the double whammy of rising life expectancy and standards of living.” @Microscope

When companies have pension funds in trouble they may be tempted to change the rules of the pension. They change the contribution levels, lower pension benefits, stop new employees from joining the scheme and even have been known to reduce the salaries of employees close to retirement so that their ‘final salary’ pension is lower –changes that can dramatically effect the income of the soon-to-be retiree for the rest of their life.

It’s no wonder that some people don’t trust pensions.

They seem out of your control. Because they are.

And that’s the key: Whilst a defined benefit pension may seem generous, ultimately you are relying on those running the scheme to ensure you are going to be paid what you expect. They can change the rules when it suits them (a recent example). Hardly an empowering thought- your retirement is dependant on the actions of faceless administrators and in the case of public sector workers, politicians, perhaps many years into the future.

For more information on Final Salary pension schemes click here.

Defined Contribution Explosion

Whilst many people are rightly untrusting of these sorts of pensions, there is a relatively new form of retirement saving –the defined contribution pension.

(American readers: your 401k counts as a defined contribution pension)

Their popularity has surged in recent years as companies look for ways to move away from the risk of final salary pension schemes that leave them liable for coming up with the cash to pay generations of retired former employees.

With a defined contribution the employer chips in a contribution today and doesn’t have to worry about paying you a pension in the future. Some critics say they are less generous than the so-called ‘gold-plated’ final salary pensions but at least you know where you stand as you receive the money today, rather than just a generous promise for the future –as the saying goes: “A  bird in the hand is better than two in the bush.”

How a defined contribution pension works

Most private companies these days offer a defined contribution pension and it’s something you should be doing, especially if they offer what’s called a ‘match’ –where the company ‘matches’ what you put into the scheme up to a certain percentage of 3%.

Let’s give an example:

Say that you earn £20,000 a year and your company offers a 3% ‘match’.

This means that whatever you put into the pension account, the company will put in the same up to 3% of your salary. Therefore to get the most money from your company you need to put in at least what the maximum match is. In this example its 3% of £20,000  = 20k*0.03 = £600.

Put £600 of your own money into the scheme and you’ve just given yourself a £600 raise and you now have £1200 in the scheme! Result! You can actually put in as much as you want, up to 100% of your salary but your company won’t put in any more money into your account than the ‘match’ amount.

As you can see it’s worthwhile but its not the whole story –you need to consider how this money is going to grow and keep up with inflation. You do this by having your pension contributions invested automatically in various investment ‘funds’ –we’ll explore this in future posts in Magical Penny’s pension series.

Ultimately, pensions have a bit of a bad reputation given the ever changing rules about them and the failure of some pension schemes to be transparent in what you can expect to receive when it comes to retire. However, with a defined contribution pension you can receive free money today to help fund your future and be in more control than ever.

Get over your trust issues today by starting a pension and you’ll feel better about your financial future. And by doing so there will be one less person to come across to make me almost spit water all over my desk!

Subscribe to Magical Penny so you don’t miss a post as we show you how to start your pension and  invest in non-scary ways. Click here.

Other must-read posts in Magical Penny’s pension series:

{ 2 comments… read them below or add one }

John John

Adam, you state you can put up to 100% of your salary into a pension…are you sure? I thought there was an annual cap on this?

Thanks

Adam

Great point -technically yes but its very high so its a non-issue for all but a very very select minority:

The government has been making changes recently for the 2011/12 tax year too.

The maximum pension contribution limit will be reduced to £50,000 (down from £255,000). Still pretty high and why I wrote in the article that you could put 100% of your salary in.

There’s also been a change to the full lifetime allowance reducing to £1.5m, down from £1.8m. Whilst it won’t affect many, it’s a worthy goal don’t you think?!

Thanks for commenting John, to allow me to clarify.

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