The Mystery of Pensions

      Okay, so this week the UK Chancellor of the Exchequer, George Osbourne, announced in his new budget that when you retire, you now have more choices about taking out some money from your pension pot as a lump sum. There was then some discussion on chat shows and daytime TV (the sort of programmes that you deny to friends ever watching) about being able to buy that sports car or luxury boat you have always wanted with money from your pension pot. Hmmmm. This needs some further thought. Here follows a simple guide to pensions.

     First, we need to know that there are two different kinds of pension. The first kind is called “Defined Benefit”. This guarantees that when you retire you will receive a certain percentage of your final salary. For life. So, if you been a teacher your whole working life and retire earning say £30,000, you might receive £15,000 every year for the rest of your life plus a £45,000 lump sum at the beginning. It will be index linked (which means if inflation goes up, so will your pension.) When you die, your spouse will get half of that. If you are lucky enough to have one of these pensions (and most companies do not now offer these, so really only government workers have them) then you are very fortunate. My advice is do not leave your job!

     However, most of us mere mortals will have what is called a “Defined Contribution” pension. (Yes, I know, very similar name. That is because financial people like to muddle us normal people. It makes them look clever. Really, they should be called “final salary pension” and “cross your fingers or pray hard pension.” That would be more accurate.) In this instance, when you retire, all the money you have paid in (plus any interest etc) is used to buy an annuity. An annuity is a financial product – you give in a lump sum, they then pay out an amount every month for the rest of your life. Some are index linked (goes up if inflation goes up), some are not.

     So, if you worked your whole life earning the same as a teacher, paying diligently into a pension fund, I estimate that you will retire with a pension pot worth £245,000. This would buy you an annuity (index linked and half for spouse on death) of £6,400 per year, with no lump sum. Pause for a moment. You have paid about £200 every month into a pension fund. That is a lot of money. You will receive about £6,000 a year to live on. That is not a lot of money. It will not allow for many ice-creams. Or even much bread.

     Now, the amount of money in your pension pot, the amount you have to buy an annuity, might have gone up or down depending on how the pension company has invested it. You need to keep an eye on it from time to time. Do not just trust it will “be enough”.

      The new rules that were announced in the budget apply to defined contribution pensions. These are what this article will be discussing.

     My first point is that if, when you retire, you take out a quarter of your pension as a lump sum, then your pension (what you receive each year for the rest of your life) will be a quarter less. This is not difficult maths! So, before you buy that yacht/ferrari/cruise/conservatory, check that when you are eighty you will still have enough money for food and heating.

     Secondly, do not over estimate how much you will receive. Pension companies are run by people who like numbers. They may wear glasses and polo shirts but they are not necessarily bad nor do they wave magic wands at things. You might work for forty years and pay (what feels like a lot) into a pension pot. You may then be retired for thirty years or more. The amount you have paid in, when spread over those retirement years may be a lot less than you think. You need to check now, before you retire and think about the numbers (brace yourself. This is your income for a long time. Force yourself to check.)You might want some chocolate when you have retired. You might even want electricity or some new clothes.

     Thirdly, when you retire, choose your next pension company – the one who will pay the annuity – carefully. It might be the same company who you have been saving with but it doesn’t have to be. Look at how much you have saved and then ‘shop around’, ask how much different companies will offer you each year that you are retired.

     Finally, think about how pension companies work. As I said before, they are maths people. When they are deciding what annuities to offer they consider things like life expectancy, stock market predictions and interest rates. Interest rates are very important. At the moment, March 2015, interest rates are at an all time low. This means annuities (remember, thats the amount you actually receive to live on) are also at an all time low. However, everyone who knows about these things, expects them to go up again. So, (big point, get ready) people about to retire should consider delaying buying their annuity. Got it? If you can work a couple of extra years or leave your pension in it’s pot for a while and not start the annuity, you might be a lot better off. Your income might be significantly higher for your whole retirement if you can wait until interest rates go up a bit.

     Some of these issues are uncomfortable to think about and if you do not enjoy numbers then they are a bit of an effort. However, think about how much you would like to receive every month when you have retired and then check how much you are likely to receive. Do not wait until it’s too late. Everyone needs chocolate, it’s a basic human right…..

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