Pensions explained without the jargon

Pensions are made to sound complicated, and the decisions that matter for most people reduce to a small number of straightforward points.

The two types

Which behave completely differently.

Defined benefit, which promises an income in retirement based on salary and service.

The employer carries the investment risk.

These are increasingly rare outside the public sector and are extremely valuable — transferring out of one is rarely advisable and requires regulated advice in many jurisdictions.

Defined contribution, which is a pot of money built from contributions and investment returns, converted to income at retirement.

You carry the investment risk.

This is what most people now have, and the outcome depends on contributions, time and returns.

The employer match

The single most important point.

Where an employer matches contributions, contributing enough to obtain the full match is generally the highest immediate return available in personal finance — frequently an instant substantial gain on the money contributed, before any investment return.

Declining it is declining part of your salary.

Which means finding out the matching structure and contributing at least to the maximum matched level should come before almost any other financial decision, including debt repayment in most cases.

Many people contribute at the automatic enrolment minimum without knowing that more is matched.

Tax relief

The second reason contributions are efficient.

Pension contributions typically receive tax relief in some form, meaning the cost to your take-home pay is less than the amount going in.

The mechanism differs by country and by scheme.

Salary sacrifice arrangements, where available, can also reduce social contributions, increasing the effect further — with implications for other calculations that are worth understanding.

Annual and lifetime limits apply in many jurisdictions and matter mainly to higher earners.

How much to contribute

Rules of thumb, with the caveat that they are rough.

Automatic enrolment minimums in several countries are widely considered insufficient for an adequate retirement.

One commonly cited heuristic is to contribute a percentage equal to half your age when you start, which produces uncomfortable numbers for late starters and reflects the arithmetic honestly.

Target replacement rates of around two-thirds of pre-retirement income are frequently used in planning.

Retirement income calculators published by regulators and pension bodies are more useful than any rule and take minutes.

And the most practical approach is to increase contributions with every pay rise, which captures increases before lifestyle absorbs them.

Where it is invested

The decision most people never make.

Most schemes have a default fund, which is where the large majority of members remain.

Defaults are generally reasonable and are designed for an average member, which you may not be.

Points worth checking: the charges, since a difference of a fraction of a per cent compounds enormously over decades; the asset allocation, since a fund that is too cautious for a young member costs a great deal in foregone growth; and the lifestyling approach, which shifts towards lower-risk assets approaching retirement and which assumes a retirement date and a way of taking the money that may not apply to you.

Reviewing these once takes an hour and can be worth a substantial sum.

Lost pensions

Extremely common.

People change jobs many times over a career and leave small pots behind, frequently at addresses they have moved from.

Tracing services exist in many countries, run by governments or industry bodies, and are free.

Consolidating small pots can reduce charges and simplify management, and should be checked carefully since some older schemes have valuable guarantees that would be lost.

Keeping a list of every scheme, with provider and reference, prevents the problem.

The state provision

Which underpins everything.

Most countries provide a state pension based on contribution or residence records.

Checking your record for gaps is worthwhile, since gaps reduce entitlement and can frequently be filled by voluntary contributions — which are among the best-value purchases available for anyone with a shortfall.

Periods of caring, unemployment or self-employment are the common causes of gaps.

And the age at which it becomes payable has risen in most countries and may rise further, which affects planning.

Taking the money

Where decisions are irreversible.

Options typically include an annuity providing guaranteed income, drawdown leaving the money invested and withdrawing flexibly, lump sums, or a combination.

Each has trade-offs between certainty, flexibility, investment risk and the risk of outliving the money.

Tax treatment of withdrawals varies and can be substantial.

Free guidance services exist in several countries and regulated advice is worth paying for at this point, since the decisions are large and generally cannot be undone.

And pension scams cluster around this moment, with unsolicited approaches offering early access or unusual investments being the classic pattern.

The single action

If you do one thing.

Find out your employer's matching structure and contribute enough to get all of it.

Then check the charges and the fund.

Then increase contributions with each pay rise.

Those three steps, done once, do more than most of what is written about retirement planning.

General information only, not financial advice. Pension rules vary enormously by country — consult a regulated financial adviser and use free government guidance services.