This is the main way that people need to save over the long term to provide an income when they retire. It mainly involves saving money when you first start work. If you work for an employer they may also pay some money into your retirement account.
There are two main types of pension defined benefit and defined contribution.
In a defined benefit scheme an employee usually pays into a company pension scheme a set amount of his salary. I return for this the company commits to providing a pension to the employee based on certain percentage of their salary based on every year that they pay into the company pension scheme. Now a days this type of pension is only available in some big multinational organisation or through local or national government.
In a defined contribution scheme the employee pays a certain amount of his salary into a pension scheme this is usually matched or added to by the employer. This money is then invested in a fund that over time should grow and provide a large fund so that an income can be bought.
In most countries there is usually some form of state or social pension these are usually created by the National Government to provide some minimal amount of income in retirement. This pension is usually made available via payment during a person’s working life from some form of tax depending on the contributions made would provide a certain amount of income. There is also usually some form of pension which is provided to people who cannot work, have never worked or have never earned enough money to contribute to a state pension. These pension usually provide a minimal amount of benefit to the claimant.
One of the main issues for pensions is trying to persuade people to save now to have an income provided in the future. This must be overcome so that people will have enough to live on in their old age. One of the ways governments sometimes help to convince people to pay into a pension is by providing a tax benefit on any of the income paid into a pension. This means that instead of the employee paying into the pension after tax it can be paid before tax and therefore a boost is given to the pension by not paying tax. The governments of the world would never be happy to lose income from these tax payers so the money that comes out of the pension when the person retirees and starts drawing their pension is taxed.
However the pension and other income would need to be over the person’s tax free allowance. The money may therefore be taxed at a lower tax rate when compared to the tax rate when the money was paid in.
In the future people may want to have flexibility in their savings so they can withdraw the money at any time rather than the money being locked up as in a pension.
We will look in to this more in a later post
The Normal Person