What is a pension?

Before heading into this topic, it’s important to establish a key definition.

What is a pension?

In the simplest terms possible, a pension is a savings fund that you can use when you retire.

Easy.

Building a pension is another area of personal finance that can raise a lot of unnecessary complexity and scaremongering. I hope this will break down some barriers and simplify things.

State Pension or Private Pension?

The most common misconceptions around Pensions is to do with State Pensions and Private Pensions.

They are pretty different and have some key differences which I’ll break down for you.

State Pension

A state pension (sometimes referred to as an “old age pension”), is money provided by a government to elderly people over a certain age, who meet certain criteria. A state pension is a form of welfare and isn’t provided by every country.

It’s also important to remember that state pension rules and structure can be changed whenever a government sees fit to do so. In the UK, the age eligibility to receive a state pension has been increasing higher and higher due to increased life expectancy. I’d argue that our obsession with fast food, sugar, and lack of exercise will lead to a lower than predicted life expectancy. But that’s a different discussion altogether.

Although a state pension can be a useful supplement, it’s a bad idea to be wholly reliant on this. Who knows what the rules will be by the time you retire and government’s can use “austerity” as a blanket excuse to ruin your retirement plans. Greece was a country that had a generous public pension system. Many were reliant upon these payments for retirement, and then the 2008 financial crisis completely splattered the nation’s pension payment expectations.

Private Pension

A private pension on the other hand can comes in lots of different formats. Essentially, it is a retirement fund that is to some extent managed by you or a private company and not the government.

The ability to nominate how much you choose to add to a private pension does give you a certain degree of control. In some countries, companies may match your pensions contributions as a benefit of being employed there.

Because a private pension can be controlled by you (to a certain extent), this is the type of pension you should be focusing your attention on.

The number one rule of building a pension

The number one rule when building a pension is simple. Start building it. NOW.

Two of the most common mistakes people make when it comes to building their pension fund are:

  1. They don’t pay anything into their pension fund.
  2. They spend too much time deliberating on the right fund or the amount they want to put in the fund.

Both these mistakes can be costly in the long term. Above all else, you need to put money in if you want the best chance of building a pension worthy of the retirement you deserve.

Tax efficiency

Most pension set-ups will allow you to save into your pension pot with at least some tax advantages. What this usually means is that you can build and grow your pension without incurring a tax bill.

In most cases, you pay income tax when you beginning drawing your pension, as if it were a salary. So it’s important to maximise any tax benefits early on to help build and grow your pension.

The tax structure of pensions are usually organised so that any contributions to your pension will come straight from your gross pay, before the government has clawed away at it to pay for horrible institutions like schools, healthcare, and welfare programs.

Tax isn’t cheap in most developed countries, and so tax efficiency alone can be a great reason to utilise any allowances to build your pension. It is worth remembering however that the tax rules in play today, may not be in effect in 30,40, or 50 years time. So although tax advantages from pensions are great, I wouldn’t bet my whole future that laws won’t change.

Changes introduced to pensions by governments can be small, but they can also be devastating. That being said, most government’s want you to be as self-reliant as possible in your old, frail age. So in recent years, there has been a strong push towards a better public understanding around private pensions (even though these aren’t as generous as they used to be).

Common pension schemes

The setup and structure of pensions will vary depending on where you are based.

  • In Australia you have a Superannuation Fund (where your employer pays 10% of your gross salary into a pension fund of your choice).undefined
  • In America you have a 401(k) offered by many workplaces as part of your renumeration package benefits and there is also a Roth IRA, which is an individual retirement account.

Researching your pension

As you can see from the examples above, most pension schemes are quite similar in their format and structure. They are usually tax efficient. They are also designed to be long-term saving accounts and therefore have restrictions to prevent early access. So you can’t use them before you’re old enough to be sitting on the beach drinking Pina Coladas at 3pm in your robe and slippers.

Your best bet is doing a bit of research into the pension options available in your country, and then deciding how you think you should proceed.

“Doing a bit of research” literally means just that. Do not get yourself down a rabbit hole of pension investment that leaves you confused and frightened.

Research into building your personal pension doesn’t need to take longer than a few days. Simply find out what is the most tax-efficient pension option in your country, choose how you’d like your money to be invested (where possible), and pay in as much as you can afford to do so. Simple.

Automatic pension contributions

Like with any savings, automating your pension contributions is the best and most painless way to set aside some money for the future.

In some cases you’re essentially forced to automate your pension contributions if it comes out of your gross pay. So you never even see the money. It just diverts away from your greedy hands before you even get a chance to smell it.

It’s hard to stay disciplined for a year, let alone most of your life. Automating your pension payments in whatever way possible removes the chance of human error. We all like to think of ourselves as highly disciplined creatures of habit. But how many times has a new year begun and you’ve told yourself that this is the year you’re going to get fit and healthy? Then by the time December rolls around, family members are having to dig you out from a cave built of chocolate wrappers. It takes way less energy to just remove your ego from the decision making process and let the machines do the work. Instead of willing yourself to put aside money each month for a retirement that seems like a lifetime away, just automate the process and let it happen.

It will make your life and retirement a hell of a lot easier.

See you on the beach for a Pina Colada in 2050!