How does a Pension Work?
20 Apr 2021
When it comes to all matters financial, there’s nothing that gets the average person’s eyes to glaze over than talk of a pension. We all know we should have one. We know the earlier you start the better. We’ve heard that there are tax benefits.
But how many of us actually have the faintest idea of how a pension actually works?
How a Pension Works
Let’s try to demystify how a pension works.
If you save into a retirement fund, typically with a deduction from your weekly or monthly salary, that money is invested. Where it is invested and how much risk you are prepared to accept is completely up to you. The aim is that when you finally decide to retire, you have enough set aside to live your life happily. So essentially, a pension is a way of saving for the long-term.
But there are a couple of key things which make saving into a pension a little bit different than sticking it under the mattress.
The first one is tax. When you save money into a pension, you may get tax relief on it. It’s one of the most compelling reasons to save through a pension. Other forms of savings, like a credit union or bank account, do not attract such generous incentives.
Every contribution you make to a pension plan receives tax relief based on the rate of income tax you pay (most of us pay income tax at a rate of either 20% or 40%). Zurich have a very nifty tax relief calculator which you can use to work out what your pension contribution may cost after tax relief. If, for example, you are paying tax at 40%, €1,000 invested in your pension may end up costing you just €600 tax relief is taken into account,
The second one is that the returns you make on the investment are reinvested again and again, obviously depending on how the pension funds performs. By reinvesting any surpluses, it means that even a small fund can grow substantially over a long number of years. And the earlier you start the pension plan, the more years there will be for the pension pot to grow.
How much do I need?
When it comes to determining how much money a person needs in retirement, the simple answer is that there’s no simple answer. No one knows exactly how long they will live for and therefore how long their pension will need to last. One thing we do know is that the sooner you start a pension, the bigger it should grow.
Most of us can now look forward to around 30 years in retirement. How you support yourself financially during those years and what lifestyle you expect to live are the key questions. It is important when planning your retirement to ensure you have built up a substantial pension fund by the time you retire.
The State Contributory Pension (ROI)
You can still have your own pension and also receive the State pension. However, there are a number of criteria which need to be met to qualify for the contributory State pension. You must have started paying social insurance before reaching 56 years of age and there are conditions in relation to the number of payments which you must make in order to quality. You can read more about the relevant conditions here.
The full State Pension (Contributory) is currently €248.30 per week, so although you may qualify for a state pension, it may well be lower than the income which you’re likely to need in your retirement.
While the benefits of starting a pension are clear, many of us have put this on the long finger. A nationally representative survey of 1,000 people carried out by Zurich in 2020 highlighted that nearly half of respondents were working, but do not have a pension.
Take the First Step
In order to help credit union members to plan for their financial future, a number of credit unions are collaborating with Zurich, one of Ireland’s most successful life and pension providers, to introduce a range of financial planning solutions to their members.
You can find out more about the initiative here.
Money on your Mind is a new series which aims to help you build your financial confidence. You’ll find insights, tips and suggestion to help you feel more knowledgeable about managing your money, as well as jargon free answers to some basic financial questions.
The content within this series is aimed to provide general guidance and information only. It does not represent financial advice. You should seek professional advice before making decisions regarding your financial future.