Step 42: State Pensions

Step 42 of the 100 steps mission to financial independence: State Pensions
Step 42 of the 100 steps mission: State Pensions

In the previous step we looked at the different types of pensions that exist. In this step we look at state pensions in detail, although many of the characteristics of state pensions also apply to other types of pensions. Pensions vary greatly from one country to the next, if they even exist at all, as not all countries offer state pensions, so make sure to do your homework well and read up on the details of the state pension for your country.

If you are entitled to a state pension this is normally regardless of the height of your salary and of any workplace or private pensions you might or might not have. Bear in mind that most state pensions tend to be far from generous and designed mainly to just provide for your basic needs. 

Now onto some some of the characteristics of state pensions.

Inflation

First of, as we have discussed on previous occasions, money loses its value over time due to inflation. So when a country or state raises money to pay pensions with, if they don’t use it in the moment, in a few years’ time it won’t be worth the same anymore as the original money that they collected. This means that any pension contributions or taxes that you pay, aren’t just sitting in a bank account waiting for you to start drawing your pension. As by the time you’d retire, that money isn’t worth much anymore.

There are two options in order to counter this problem to make sure that pension funds have enough money for the pensioners, by chosing between a funded or an unfunded pension scheme:

  • In funded pension plans, any tax contribution to pensions is actually used to pay current pensions. Younger generations pay the older generations’ pension, so (in theory) your own pension will be paid by future generations. In that way pensions are set based on the value of today’s money.
  • In unfunded pension plans, the tax contribution you pay is invested, with it hopefully growing enough over time to minimally beat inflation, but ideally do even better than that. For obvious reasons this option is slightly more risky  but therefore might also have better returns.

Inflation 2

A huge advantage of state pensions over other types of pension is that often times (although not always) they are corrected for inflation, regardless of how well investments did in unfunded pension plans. This doesn’t mean they alway keep up with inflation, but if inflation is 2% this year, you can reasonably expect the pensions to go up a little next year as well, although this might not always be 2%.

Changing demographics

A huge challenge for our pension schemes is that we are living longer and longer and whereas pensions were once implemented to support people for only a few years after retirement age, many today live for a lot longer, meaning pensions become more expensive as people receive money for a lot longer.

As we live longer, the relative percentage of people receiving a pension also increases compared to the number of people working to pay those pensions, so for especially funded pension schemes this can be a challenge, as there are fewer people working compared to the amount of people receiving a pension, meaning there are less contributions made and therefore there is less money available for an increasing part of the population.

Pension Age

Many countries are changing their state pension age in order to make sure that pensions can still be paid in the future. By increasing the state pension age, people work longer, thereby making contributions for longer and at the same time will draw pensions less long. You will likely need to work longer than your parents. Don’t count on retiring at 65 anymore and definitely don’t think you can retire before that time and still collect a generous pension. (You can of course retire and just not collect a state pension, in which case you need to have a lot of other funds available though!).

Years worked

In many countries you need to have worked a minimum amount of years in order to be entitled to the full state pension, think around 35 – 40 years at least. This is to avoid people receiving a pension without having contributed to it. If you don’t work for the minimum number of years, that often means that by the time your retire, there is a certain percentage per year that you didn’t work that gets deducted from your pension. For example it might that every year you didn’t work (and therefore didn’t pay pension taxes) costs you 2% of the maximum state pension. This means that if you are 10 years below the minimum number of years, instead of getting the full 100%, you get 10 times 2% less, so in this case 80% of the maximum state pension. In some countries and states, time out of work doesn’t get penalized if that was time you were looking after children younger than a certain age. Also some countries allow you to compensate with your partner’s pension, but all of this varies hugely across the world.

Deferring pensions

Some pensions allow you to defer you pension, which means that if you decide to take your pension later than at the state pension age, your annual payment once you start taking a pension actually increases. This is in essence the opposite of the previous point where you lose a certain percentage if you work less. Since you arent’s collecting a pension, and are still paying taxes on your wage for pensions, governments reward people defering their pension by increasing the percentage of pension you receive. Say that the legal pension age is 68 by the time you retire, but you decide to continue working until you’re 70. If the government pays 5% more by every year extra, you would in this case not receive 100% but 110% of the maximum state pension.

Step 42 – State pensions – in detail:

As mentioned before, state pensions vary hugely from one country to the next, if you are lucky enough to be entitled to one in the first place, so make sure you do your research well. Remember that if your pension is still a few decades away, many things can change between now and then, but that doesn’t mean you shouldn’t at least become aware of the current situation and use that as a base to plan from. Even if things change, they are unlikely to change 180º.

  • Find out what the current state pension is per month. Remember that pensions are taxed, just like a regular income.
  • Find out what the current state pension age is and whether this is changing over the next few year. I.e. many countries used to have 65 as the legal pension age, but the vast majority are increasing this to 67 or 68, and eventually might even go up to 70.
  • What is the minimum number of years you need to have worked for in order to be entitled to the full pension?
  • If you don’ get to the minimum number of years required, what are the consequences per year not worked?
  • Look into the current options of defering a pension: i.e. would you be paid more and how much extra per year. Check whether this is likely to change any time soon.

If you are eligible for a state pension, remember that even if it isn’t a great deal of money, it a good base to plan the rest of your pension tactics from.

Read more about my 100 steps mission to financial independence or simply decide to take control today and join us on our step-by-step quest on how to make your finances work for you, starting with step 1.

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