Explaining... pensions

Will Hodges explains why having a pension is important and examines how countries around the world are dealing with the effects of an ageing population

While at university, it's understandable for you not to give significant thought to your pension plan. After all, there are enough obstacles to overcome in early adulthood as it is - finding a job, paying off student loans, saving for a house - without also worrying about how to fund your retirement.

Yet, as far off as it seems, saving for a pension is an inevitable requirement of adult life, so much so that it has been cited by a recent national survey as the biggest financial regret among the UK's baby boomer generation. According to the survey, nearly one in seven adults said they wished they'd started saving for retirement earlier.

As Rob Morgan, a pensions and investment analyst at Charles Stanley Direct, points out: "The fact of the matter is, people care more about saving for holidays, a house deposit, and going to the pub. There needs to be more education about pensions from a young age than there is currently."

The age at which you begin your pension contributions can have a significant impact on the amount you receive post-retirement. According to pensions and investments firm Standard Life, an individual who begins paying £100 a month into a private pension scheme at age 25 will be entitled to an annual income of £3,570 a year once they hit 65. In comparison, someone who begins saving the same amount aged 40 will receive just £2,000 a year.

It's not just individuals who should be worrying. With labour forces shrinking and populations living longer, honouring state pension commitments is an increasing challenge for governments across the world.

As the baby boomer generation enters retirement age, many countries are struggling to fund the retirement of millions of citizens from a tax pool already depleted by high levels of unemployment.

The issue currently facing governments boils down to the fact that the percentage of people paying into the national pension pot is no longer big enough to support the growing raft of people drawing from it each month.

In the US, Forbes magazine has called the situation "the greatest retirement crisis in the history of the world", and the picture on this side of the pond isn't much rosier. At the end of 2010, the British government was reported to be liable for a total of £3.8 trillion in state pensions, equivalent to about 263 per cent of total GDP.

With two-thirds of men and three-quarters of women expected to live past 75, the average UK citizen will now spend 31 per cent of his or her life as a retiree. This compares with just nine per cent when the Old-Age Pensions Act was introduced in 1908. Simply put, it's an equation that no longer works.

The situation has forced Whitehall to take radical measures to try to alleviate the impact of pensions on public finances.

This February, it was revealed the Department for Work and Pensions (DWP) was considering a move to privatise the system for delivering state pensions and terminate the jobs of the 7,000 workers currently managing pensions provision.

Understanding the Pensions Act 2011

In 2011, the UK government made a number of long awaited reforms to the existing pension scheme. While the bill was on the whole well-received, it included a number of controversial measures.

Here are some of the advantages and disadvantages of the bill.

Positives

  • You'll receive more money

From 2017, individuals claiming a pension will receive a flat-rate sum of £144 a week rather than being assessed under the current two-tier system. The flat-rate amount is worth just under £7,500 a year in today's money with the value expected to increase to £155 per week by 2016.

  • Your employer will have to contribute

Changes to the existing legislation mean employees will be automatically entered into an occupational pension scheme whatever their profession. Employers are obligated by law to pay into the scheme the equivalent of at least 1 per cent of an individual's salary each month, with the contribution set to rise to 2 per cent from 2016 and 3 per cent from 2017.

  • You'll be able to take it with you

The new scheme protects your pension contributions meaning most of the money you pay in is protected if you decide to move jobs or careers. The new rules mean that small pension pots of less than £10,000 automatically follow workers when they join a new employee pension scheme after moving jobs.

Negatives

  • You'll have to work longer

By its own admission, the government's main reason for tweaking the existing scheme was the realisation that the existing retirement age for men (65) and women (60) is no longer viable. The new measures will see the women's state pension age increase to 65 from 2018 and the retirement age for both men and women rise to 66 by 2020 and 67 from 2026.

There are likely to be regular reviews to the state pension age thereafter to take into account rising life expectancies. This means the official retirement age for men and women is likely to have breached 70 by the time today's 20-somethings are able to call it a day.

  • The money comes out of your salary

Under the new legislation, employees will automatically pay at least 2 per cent of their earnings into their pensions pot. From October 2017, however, the minimum contribution will increase to 8 per cent. This means a graduate earning an annual salary of £25,000 in 2017 will be expected to put £132 a month towards their pension.

  • You could be left with nothing

To be eligible to draw a full state pension you will have to have worked for 35 years (previously 30 years) and have been making regular National Insurance contributions during this period. Individuals who've worked fewer years will receive a reduced amount, while those who've worked fewer than 10 years will receive nothing at all.

What are the different types of pension?

State pension

In the UK the state pension is the income paid to all pensioners who have participated in the workforce during their lifetime or who have made sufficient national insurance (N.I.) contributions. At present, retirees hoping to draw a full pension will have needed to have worked (or made N.I. contributions) for 35 years during their lifetime.

Occupational pension

An occupational or work-based pension allows an employee to build up a secondary pension pot that can provide an additional source of retirement income on top of their state allowance. Under the Pensions Act 2011, all employers are required to offer the scheme to their employees and they must pay a set amount into their workers' pension pot each month, while the employee also contributes a percentage of their earnings.

Personal Pension Scheme

Many individuals choose to set up a private pension scheme, which can provide another source of income following retirement. As well as building up a tidy nest egg, participants receive tax benefits, meaning the funds they pay in are offset against the amount of income tax they pay each month.

On retirement, participants can choose to withdraw their funds as a lump sum, or in the form of regular monthly payments. The only downside is that savers are often unable to withdraw any of the funds until they reach a minimum retirement age.

The pension crisis: a global conundrum

The UK is not alone in facing down a looming pensions crisis. As populations around the world benefit from improvements in medical care and living standards, the gap between retirement age and final life expectancy is rapidly increasing, the most dramatic example being in Japan, where men can expect to live an average of 21 years as retirees.

In Europe, meanwhile, the ongoing economic crisis has forced a number of governments - including those of Italy and Greece - to raise the minimum state pension age, a measure which has gone some way to reducing the public debt burden on the state.

Such measures have often proven to be extremely unpopular; France was crippled by weeks of strikes by public sector workers after former French president Nicolas Sarkozy raised the retirement age to 62. His successor Francois Hollande has since announced a partial reversal of the decision, with some citizens, such as mothers with three or more children, still able to claim their pension at age 60.

The pensions problem exists in the developing world too. In China, measures to control population growth, such as the now abolished one-child policy, have led to a shrinking work force that is no longer able to support a rapidly ageing population. As a result, the government is trying to push through controversial measures to raise the minimum age of retirement to 65 for both men and women (currently 60 and 50 respectively).

Other emerging market states are in a similar predicament as advances in living standards have brought life expectancies to a level comparable with those of Europe and the US.

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