A Simple Guide to Private Pensions
All of us hope to retire at some point in our lives. Retirement is that time of life when one gets to relax and enjoy the benefits of years of hard work. However, in order to retire successfully, one must also guarantee income is coming in to pay the bills. This can be accomplished through saving, investing, or a combination of both. One of the best tools for creating income retirement is the private pension.
Private pensions can be established through your employer or through a third party provider that you work with on your own. There are different kinds of private pensions, each with its own advantages and disadvantages. The first question to ask yourself is this: are you currently enrolled in a private pension or are you going to depend on the state pension to provide the majority of your retirement income?
Difference between State and Private Pensions
Some confusion persists regarding the differences between state and private pensions, despite an aggressive effort by the government to clear it up. It is important for you to know the difference so that you can make wise investment decisions.
The state pension is a guaranteed amount of retirement income that you will receive as long as you have at least ten qualifying years of full or part-time work during which you contributed to National Insurance (NI). In order to get the full amount, workers need 30 years of qualifying work and NI contributions. The state pension applies to nearly every worker in the UK. Having said that, state pension payments are not very generous.
Under pension reform, state pension payments are calculated by combining the total number of qualifying years worked with NI contributions, plus additional years worked after the elimination of the state second pension in 2016. Pension savers who contributed to the state second pension prior to its elimination, and retired on or before 16 April 2016, receive payments based on the old calculation.
A private pension is completely separate from the state pension. It is a pension that workers invest in by either having money deducted from their pay or by making direct contributions. The two biggest differences between the state and private pensions are as follows:
- Performance – Payments from the state system never change beyond cost-of-living increases linked to inflation. Payments from a private pension are different. These rise or fall based on the performance of individual investments.
- Retirement Income – The state pension will not provide most workers any more than £115 per week, in base payments, for the foreseeable future. It is not possible to live on that amount. A private pension is capable of providing so much more, especially if invested wisely.
The difference in payments received is one reason the government has been encouraging people to invest in private pensions. They know the state pension will be insufficient, so they want workers to take charge of their retirements by investing as early in their careers as possible.
How to Establish a Private Pension
Workers wishing to establish private pensions have three basic options: workplace pensions, stakeholder pensions, and SIPPs. All three options are fairly easy to exercise for the average worker. Below is a brief explanation of each:
- Workplace Pension – The workplace pension is a pension scheme offered through an employer. Auto-enrolment rules guarantee that nearly every UK worker will be invited to join the workplace pension by 2018. If you are not sure what your employer offers, check with the human resource department. They will have all of the information you need.
- Stakeholder Pension – The stakeholder pension is a private pension offered by an insurance company, bank, or another financial services provider. Members purchase pensions on their own, making regular contributions as per the pension agreement. The administrator handles investment transactions on behalf of the member.
- SIPP – Also known as the self-invested personal pension (SIPP), the SIPP is established by the pension saver through a third-party provider. The investor is ultimately responsible for the performance of his or her fund, utilising the help and advice of the administrator as needed.
Depending on what your employer has already established, your choice of workplace pensions may be limited. However, private pensions established as either stakeholder or SIPP schemes offer a lot more choices. You may want to opt out of your employer's plan if you believe you can get something better through one of the other options. Another possibility is to participate in your workplace plan at a minimal level and invest any remaining money in a stakeholder pension or SIPP.
Benefits of Private Pensions
You might be wondering why it is that financial advisors encourage investing in private pensions. After all, it may seem safer to put your money into savings or bonds with the goal of later combining it with state pension payments to provide income. Rest assured there are benefits to private pensions you cannot get from savings and bonds.
First and foremost is what is known as return on investment (ROI). Private pensions offer the potential of a significantly greater ROI than both savings and bonds. Where savings are concerned, you know interest rates have been at historic lows for years. Until those interest rates climb substantially, most pension savers will actually lose money – in real terms – by leaving money in savings. As for bonds, their interest rates are usually not competitive, despite being safe.
Other benefits of investing in private pensions include:
- larger selection of investment options
- investment options based on risk aversion
- flexibility when accessing funds
- government tax relief
- more income at retirement.
Another significant benefit of private pensions, at least compared to state pensions, is that savers can begin accessing their funds from the age of 55. An investor with multiple pensions might want to cash out one or two for the purposes of investing in something else. Property comes to mind as an example.
Let us assume you have your current workplace pension in addition to two inactive pensions from previous employers. At age 55, you could cash in the two inactive pensions in order to buy several rental properties while leaving your current workplace pension intact. This would give you the dual benefit of continued pension investment and rental property that could provide income for decades.
When a Private Pension Is Right for You
When the definition of private pensions includes workplace pension schemes, it becomes clear that they are right for everyone. A basic workplace pension is the fundamental starting point for any retirement plan. There are only a small number of legitimate reasons for not investing in a workplace pension in the absence of other options.
As for stakeholder pensions and SIPPs, these are good options for pension investors who want more control over their retirement funds. A stakeholder pension provides a little more freedom but with the assurance that the pension provider still takes an active role in protecting investments. The SIPP is the right option for the pension investor who wants complete control over everything.
Please understand that private pensions are your best bet for ensuring you have enough income in retirement. If you are relying solely on the state pension to pay your bills, you are going to find yourself in trouble once you stop working. We encourage you not to do that. Start looking into private pensions today if you are not already participating. You are never too old to begin investing in a private pension.
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