How do pensions work?
A pension pot is similar in a lot of respects to a savings account. You pay into it on a regular basis during your working years and then use your pot at retirement to provide yourself with a monthly income until you pass away. Unlike a savings account however pensions don’t pay interest on the money you save. Instead you get a return from the investments that your pension provider makes on your behalf.
When it comes to pensions you can also claim an amount equal to 20% of your annual deposits from the tax man each year. So for example, if you deposit £1000 each year into your pension fund you can claim up to £200 from the tax man as well.
What happens to the money you deposit?
The money you deposit into you pension fund is invested by your pension provider over a number of years. You get to choose the amount of risk you want your pension provider to take with your money, but generally speaking the riskier the investment the better return you get in the long run. It should be pointed out though that high risk investments don’t always provide you with a bigger pension pot on retirement than low risk investments, and in some cases they can leave you with much less money than you actually pay in.
What happens at retirement?
When you reach retirement age you have two options available with regards to your pension pot. The first of these is to buy an annuity with the money. An annuity is designed to pay you a fixed amount each month for the rest of your life and is often worth purchasing.
So for example, let’s say you have a pension pot of £80,000 on retirement and after shopping around you manage to find an annuity that pays you £5000 per year until you die. Obviously if you end up living for another 16 years or more then you’ll get back more than you originally paid in to your pension. If however you only live for 5 or 10 years then not all of your £80,000 will be paid back to you in the form of annuity payments. Should you pass away earlier than expected it is sometimes possible to have your pension paid to relatives instead though.
The second option with regards to your pension pot is called income drawdown. This option allows you to keep your pension fund invested so that you still see annual returns but at the same time withdraw a fixed amount each year to use as an income. The amount you can withdraw is set by the government and not by your pension provider.
When to start saving
Ideally you should start saving for your retirement from the day you start working but this rarely happens. It’s hard enough figuring out how to budget your money without having to think about what you’re going to live on 50 years down the line. Remember though that the earlier you start your pension fund the more time it has to grow before you need it, and the better quality of life you’ll have when you finally decide to retire.
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