Step 43: Workplace Pensions

As we saw before, a workplace pension is often offered by your employer or work sector and contributions are usually made monthly directly from your paycheck. Although many of the characteristics discussed in step 42 on state pensions are also applicable to workplace pensions, the latter often have many additional advantages or characteristics, including some of the following:

Automatic

It is often (though not always!) automatic, meaning in many workplace pensions employees are automatically enrolled. If you don’t take action to opt-out you are systematically making monthly payments into your pension scheme.

Monthly contribution

You can determine your monthly contribution. There is usually both a minimum and maximum contribution you are allowed to make, and although many people might just pay the bare minimum, if you budget well and set aside enough money, you can obviously pay in more. The more you contribute (i.e. save) now, the more you’ll again have by the time you retire, not just from your monthly paymentsbut also from the compounded interest. 

Employer’s contribution

Your employer might further supplement your pension. This is a huge advantage that many workplace pensions offer that none of the other schemes have: The amount of the additional payment to your pension scheme made by your employer often depends on your own contribution. For example your employer might pay 50% of what you pay, so if you pay in 6% of your salary, your employer puts in another 3%. How much your employer pays varies enormously and normally has a maximum per month or per year.

This extra contribution is in essence free money that you can get and is not seen as a part of your income. So even if you get this extra money on top of your regular income, it isn’t counted as income and therefore won’t affect your taxes.

Tax advantage

Most pension plans offer tax advantages, and they usually give an advantage in one of two ways: a tax advantage when you pay in (this is usually more for workplace pension schemes) or a tax advantage when you withdraw (usually more applicable to individual pensions as the ones described in step 44).

• Tax advantage when you pay in – say that you earn $2.000 gross a month, pay 35% in income taxes, meaning you earn $1.300 a month and that you contribute 6% of your salary towards your pension. Instead of calculating the 6% of your net pay, this is calculated over your gross pay, so before you pay your income tax. The difference is 6% over $2.000 ($120) or over $1.300 ($78) that gets paid into your pension. You still get your $1.300 monthly pay however, so you don’t end up earning less, even though you put pre-taxed money away for your pension! In some instances this is calculated slightly differently but leads to the same result. Instead of saying you get to calculate it from your gross pay, you actually pay into your pension scheme from your net pay ($78) but then the state returns the 35% into your pension, in this case $42, which bring you back to the original $120. So in both cases you basically don’t pay income tax over this part of your income and get to keep it completely for your pension later on when you are retired. Examples of this include the traditional 401(k) schemes in the United States.
• Tax advantages upon withdrawing – this is a different type of scheme in which you don’t get any tax advantages when you pay into your scheme, meaning your income gets taxed first and then your contribution is calculated over your net pay, but you get a tax advantage when you withdraw the money. Pensions are seen as a type of income, so upon receiving your pension each month, you are required to pay taxes. So in the first example of a tax advantage when you pay in, by the time you start to draw a pension, you will be charged taxes. In the case of tax advantages upon withdrawing, you have already paid taxes when you paid your contribution, so you no longer get taxed when you start withdrawing from your pension.Example of these types of schemes include Roth IRAs and personal pensions (see step 44).
• Both options usually don’t tax investment growth, so your money can grow freely without being taxed, although if you pay taxes upon withdrawing you obviously still pay your taxes on the increases.

You might wonder what the difference is between these two types of tax reliefs. The main difference is that if you expect your tax rate to go up, because you think you might be earning a lot more in a few year’s time, or will have a big pension income by the time you retire, then the second option might be much more interesting. You either pay taxes now or when you retire. If by the time you retire your tax rate is a lot higher, you pay more taxes then, so it’s obviously better to take advantage of a lower tax rate now instead of paying the higher tax rate when you withdraw. Another difference between the two types of tax advantage pension funds include the maximum allowed yearly contribution.

Types of contribution

Traditionally occupational pensions offered a defined benefit scheme, although nowadays more are moving towards defined contribution plans. The difference between these two types are the following:

• Defined contribution – in this type of pension, your determined contribution into your pension is invested by your pension provider. By the time you retire and start withdrawing from your pension, the amount you have in your pension pot depends on how your investments have done over this time. You can usually decide how much you want to take out on a monthly basis, but you don’t know how much you will be able to take out, as that depends on how much is in it. All you know is how much you are paying in.
• Defined benefit – the amount you get when you retire is determined beforehand, and depends on your salary and how long you’ve worked for, not on how well your investments did. Regardless of the total amount you have in your pension pot, you will receive what was agreed from the beginning. Many pension providers use their own calculation for this to determine how much you’ll receive but two common ways of calculating your monthly pension in a defined benefit scheme is either based on your final salary, or on your average salary. These pensions are very expensive for employers and are therefore less common and almost disappearing.

Now that you know more about what workplace pensions entail, let’s look at your workplace pension options

Step 43 – Workplace Pensions – In Detail

• In step 41 you in theory requested details of your company’s workplace pension policy. You’ll want to double-check the following information and details:
  • How much you have contributed up to now;
  • The current value of your pension portfolio;
  • The maximum you can contribute (usually indicated on a yearly basis);
  • Whether your employer matches your contributions or how much the company pays in;
  • The tax advantages on the current set up of your pension scheme.
  • How much flexibility there is to choose what to do with your money and how to invest it.
  • Whether you are on a defined contribution or defined benefit plan.
• If needed, make sure to speak to the HR contact person in your company to find out more and to make sure you have all the information clear.

Workplace pension schemes offer a huge advantage over other pensions which is that often times your employer contributes to your pension free of charge for you. If however you are not entitled to any type of workplace pension, fear not and simply move on to step 44 where we look at personal pension options in greater detail.

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