Pensions

What are Pensions?

Pensions are possibly the most important investment made by individuals during their lifetime. Pensions provide individuals with an income following retirement.

How Pension Schemes Work

Employees make regular contributions into a pension scheme, usually direct from their salary. This way, the employee receives a tax benefit, since no tax is paid on the amount paid into the scheme.

The money paid into the pension scheme will be invested in a pension fund, to grow, and ultimately to be used to pay out your pension in retirement.

The pension fund is used to pay out an income to the individual following their retirement.

Types of Pensions

There are 2 main types of pension schemes:

Defined Beneift Schemes
Defined Contribution Schemes

Defined Benefit Pension Schemes

Under defined benefit arrangements, the amount received as a pension income in retirement will be calculated with reference the the salary you earned at the point of retirement.

For example, you may receive 1/60th of your final salary for each year of service. Therefore is you work for 20 years, and at the point of retirement your salary is £30,000, then you will receive £10,000 per year in retirement.

With defined benefit schemes, the risk lies with the employer, since any shortfall between the amount paid into the pension fund (and growth of the fund) and the amount requried to pay out the agreed pension income to the employee, must be made up by the employer.

This has been a common problem for many employers in recent years, and has resulted in many employers closing their defined benefit schemes to new employees.

Defined Contribution Pension Schemes

The amount paid out as a pension income in retirement will depend on the amount paid in during your working life, and the level of grow achieved from investing the money.

Under defiend contribution schemes, the employee carries the risk, since they will receive a smaller income in retirement if the pension fund does not perform well. Conversely, the individual will receive a higher income if the pension fund performs well and experiences a high level of growth.