How do pensions work?

Pensions are shrouded in mystery. They are like the Professor Snape in everyone's life. Skulking in the background, reminding us of getting old. But the mechanism behind them is surprisingly interesting.

Let's start with workplace pensions

You'll probably be paying something into your pension which comes out of your salary. That's automatic enrolment. The standard set-up is that you pay 5% of your salary, your company pays 3%. So that's 8% of your annual salary going towards your pension pot each year, normally. (If you're a freelancer like me, you can take that calculation and flush it down the toilet). What do they do with it?

Well, it will probably go to an institutional investor. Uuuuhhh... what the hell is that? Good question. It's like an investment firm on steroids. These guys don't deal in millions. They deal in hundreds and hundreds of billions... potentially trillions. They pool a lot of money together from a lot of organisations.

The kind of institutional investor your workplace pension money might go to could be Legal&General, Aviva, Nest, Fidelity, PensionBee, StandardLife.... There are lots!

How do pensions work for young people?

Pensions work around the number of years you have left until retirement. That's the main takeaway here. So if you are a young whippersnapper aged 21, and you have around 45 years until retirement, that's a really juicy wodge of time. It means that you can invest in companies that are teeny tiny right now, but by the time you retire, they will be huge.

For example. If you had invested $1,000 in Apple in 1980 and reinvested all the profits, you could be looking at $2.93 million today, 46 years later.

So when you have loads of time, your institutional investors will be looking for companies that are going to be very successful in around 30 to 50 years from now. The problem is, how do they KNOW if these companies are going to be successful? And the short answer is that they DON'T.

They could put $1,000 in Apple, wait 46 years and make their clients multi-millionaires. Or they could put $1,000 in Pets.com and lose everything in a spectacular crash shortly after.

Institutional investors have these really intense maths people (called Quants) that try to calculate it, and they have so many analysts trying to figure out the future. But as bankers love to say, (literally all the time), they don't have "a crystal ball" and they don't know what will happen. That's why these types of companies are called HIGH RISK. And you can only really invest in them if you have decades before you need the money. Because for every good one, there will probably be a bad one... and basically you need decades to figure out if it was good or bad, and to ride out some of the storms. In the end it should even-out.

This time in your pension is called GROWTH or ACCUMULATION. If you want to get to the point, you could be like "Speaking of accumulation phase..." and they would be like "oh shit, this person has all the lingo".

How do pensions work for middle-aged people?

Right. So as you get older, your institutional investor will slowly start to wind-down the risk. This means, less "we don't have a crystal ball" wildcard companies like Apple or Pets.com. And more reliable sources of income, such as very solid yawnfest firms which have been there since the dawn of time and government debt which is paid back using taxes (our money, in a wierd 360). At this point, your pension starts to get a little less exciting each year, and a little more predictable. Kind of like life.

You could think of your pension as getting all down and crazy in the club alongside you in your 20s, and then starting to do more bottomless bunches in your 30s, then winding down to nice hotels in your 40s, dinner parties in your 50s, then meeting your besties for lunch in your 60s. If you think of "risk" as alcohol, it's the journey from flaming sambucas every night in your 20s to the occasional tipple in your 60s.

The problem with less risky assets is that the returns are not going to be wild (in either direction). So you won't get an Apple moment. And again, that's like life. The kind of mad adventures you had in your 20s (I fainted out of a plane - it sucked), are probably going to be more crazy than when you go out in your 60s. (Although, here in Spain, I have seen some really intense grandads dancing, so that might be a bad analogy).

How do pensions work for people close to retirement?

When you have about 10 years left until you retire (so you're probably hitting your stride in your sixties or mid-fifties), the priority for your pension changes. Now institutional investors are now longer interested in growing your pension, instead they want to make sure that they don't lose it all. This means moving out of the ACCUMULATION phase and into the PRESERVATION phase.

At this point, nearly all the super risky investments that you had in your pension in your 20s should have matured into nice and reliable earners (like you!). And any losses should have been absorbed by the gains of others. This is thanks to DIVERSIFICATION, it means that by investing in a lot of different things, it's not the end of the world if one of them crashes, because the rest will prop it up over time.

So basically, you should have a healthy pension at this point. You could expect to have made at least 10% more than all the money you've been putting in over all this time. So, most people will have between around £50,000 in their pot at this stage (which to be honest, is not enough, because that money has to last you like 30 years. It's a crisis waiting to happen... and linked to why governments are worried about declining populations).

Annoyingly, on average men (£79,300) have more than women (£40,000) at this point. Which is called the "pension gap". It's because men get paid more, and women often have to take a career hit to have children. Sucks a lot.

During the preservation phase, institutional investors dial the risk right down. They're pretty much only investing in bluechips (which means really, really stable companies) and mostly government debt which they trust. You become kind of like a bank, lending money to countries like the UK or USA, and collecting interest along the way.

When do pensions start paying out?

Retirement time! Now we are in the DISTRIBUTION PHASE. This is where it really matters what kind of pension you have.

If you signed up for DEFINED BENEFIT pension, you will get paid a set amount every month until you die (sorry, but true). It doesn't matter if you amount of pension money you have runs out, your institutional investor will keep paying you (probably from other people's pensions, before they retire). This is the best one. It's the dream. If you have this, don't change it. I am not allowed to give investment advice to you on my blog. But I am strongly looking at you with crazy eyes right now and telling you without telling you, don't change it.

If you have a DEFINED CONTRIBUTION pension like most of us Millennials... umm... this one sucks a bit. Basically, when your money runs out, it runs out. Remember that £40k average pension pot for women? Yeahhhhh.... That has to be split up monthly, and become your salary for the rest of your life. This is why everyone says to invest as much as you can while you are young. Not just to add more to the pot, but more time = more potential returns as they compound.

Ok, so you might find yourself in a pickle at this point. Don't worry. Because you do also have the state pension.

The State Pension

There are three types of pension in total. Workplace pension, which we covered. Private pensions which are more or less the same as workplace pensions in the way they are managed. And then there's the State Pension.

Here's how it works: We pay our national insurance contributions for at least 10 years, and then we qualify for a pension. That money comes out of your paycheque if you're employed, so you are kind of paying for two pensions each month.

If you only pay your national insurance for 10 years, you'll get a very small pension. At the moment from what I can tell, its just £68.90 per week. Or just £275.60 per month. Which is obviously really shit if you are renting or do not have other income. If you pay for 35 years or more, it's a lot better at £241.30 per week or £965.20 a month.

Hopefully you should have a decent retirement income between your workplace and state pensions. But it is quite worrying because the cost-of-living, electricity and rent is just wild, especially for older people who don't have support networks.

The state pension is usually paid from the incoming national insurance contributions from the youngsters, so it kind of rotates. This is why governments are a bit nervous about declining populations, especially as people live so long and there are a lot more baby boomers than the rest of us!