A Guide to Understanding the Different Kinds of Pensions So You Don't Die in Poverty

You might not care about pensions yet, but you really should.

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Oct 28 2016, 9:26am

Illustration by Sophie Castle

The list of things young people have to worry about is long. And pensions are far, far down at the bottom of that list – right behind getting a stable job, dealing with £50,000 worth of student debt or finding somewhere to live that isn't a mould-filled box.

But while young people deal with more immediate concerns, politicians and employers are busy making major changes to the pension system that could leave younger generations massively worse off, both now and in the future.

The average 20-something knows about tuition fees tripling and EMA being scrapped. But they might not know how pension changes affect their take home pay, right now. Or that three-quarters of 20-year-olds will be £19,000 poorer over the course of their retirement. Or that younger people may well end up with less money as pensioners than their parents.

"Young people naturally don't think much about retirement or pensions, and politicians have ruthlessly exploited this fact to undermine the position of the younger generation," says Angus Hanton, co-founder of the Intergenerational Foundation.

At some point your work may well ask you what percentage of your salary you'd like to put in a pension pot. When they do, it's worth knowing the basics of how pensions work. If, like most, you don't have a clue what's happening to pensions, here's a simple breakdown of how it works and why you're losing out.

STATE PENSIONS

As long as you're paying national insurance, you'll get a state pension. But don't get too excited. "If people rely just on the state pension, they'll live in poverty," says Guy Anker, managing editor of Money Saving Expert.

In today's terms it's worth £8,000 a year, and its future doesn't look great. This is mostly because people are living longer and there's not enough cash to go around. The government has also made things worse by promising old people guaranteed rises in the state pension, which experts say just isn't unsustainable.

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In April there was also a big shake-up of the state pensions system, which has left young people in a worse position. Under the old system, people are able to claim money from two state pension pots, the second one (known as Serps) is based on National Insurance contributions. Younger workers have now been told that they won't get a second state pension, even though they will still be paying full NI contributions. It's thought that three-quarters of 20-somethings will lose a notional £19,000 over the course of their retirement because of the changes.

Obviously this figure is only an estimate, but it's unlikely the state pension will get better, says Anker. "If you're a 30-year-old right now, you're talking 38 or so years minimum until you get to claim a pension. Who knows where we'll be in 38 years – there might not be a state pension, for all we know. I'm sure there'll be something, but we just don't know."

No one knows when you'll actually be able to claim your state pension, either. The state pension age is already set to rise to 68 by 2044. There's a government review going on at the moment that will probably accelerate this further.

Basically, don't expect much from your state pension, and don't expect to claim it until you're really, really old.

WORKPLACE PENSIONS

Alongside your state pension, you'll probably have a pension through your workplace. The government recently changed the rules on this so that if you're aged 22 or over and earn more than £10,000 you'll be automatically entered into a workplace pension. You can opt out if you want to, but most experts say it's the best way to save – your employer will also contribute and you'll get tax relief.

This sounds alright, but it's nowhere near as generous as the pensions enjoyed by older generations. Research by the Intergenerational Foundation found that companies spend 20 times more on the pensions of older workers than younger workers – basically because baby boomers are far more likely to be on final salary pensions. These types of pensions promise a fixed annual income throughout retirement (a figure that's based on your final salary and the number of years you've worked at a company). But because they're expensive for employers to run, most young people in the private sector won't stand a chance of getting one.

Instead, young people are being enrolled on pensions where there's no guarantee of the amount they'll receive once they retire. You put money in and hope for the best. If the investments underperform or you don't have enough money to contribute – perhaps because you're trying to pay off debt or save for a deposit on a house – that's your problem. Plus, most experts say the minimum amount that people should contribute – which, in a few years' time will rise to 8 percent, with 3 percent coming from your employer – is not enough to ensure a decent standard of living in retirement.

But this isn't the only reason young people are getting ripped off. Some argue that the final salary schemes enjoyed by baby boomers now entering retirement means companies are less likely to raise younger workers' pay or hire more young employees. The money has to come from somewhere, and it's unlikely to be taken away from shareholders or big bosses. Paul Johnson, Director of the Institute of Fiscal Studies, has called them "a burden on the young who can't hope to enjoy them".

FREELANCERS DON'T EVEN GET ME STARTED

If you're self-employed – and a growing number of people are – and you also happen to be young, then you're in an even worse position. "You're not eligible for a workplace pension with employer pension contributions, so there's a certain amount of 'you're on your own'," says Tim Pike, head of modelling at the Pensions Policy Institute. You need to shop around for a private pension and start saving.

A lot of freelancers will move in and out of jobs at various points, which means there is some back up – but, equally, having lots of small pots is nowhere near as effective as having one main pension. This is a problem for all young people, who are far less likely to have a job for life.

The government has designed something called a Lifetime ISA, which allows young people to save money either for a pension or to take money out earlier if they want to buy a house. This was designed with self-employed people in mind, who aren't benefiting from employer contributions. Unlike with pensions, though, savings here are taxed at the source.

Hanton is sceptical and argues that Lifetime ISAs don't come near to dealing with the real problem facing young people. "Unless we fix the housing and cost of living crisis for the young, we cannot expect them to save for their own retirement, let alone to pay for older generations' pensions."

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So that's basically it. Not exactly pretty reading. Most experts agree that the gap between generations is far too wide. Young people are suffering on all fronts, says Tom McPhail, Head of Pensions Research at Hargreaves Lansdown, an investment service. "Everything is against young people. The state pension age has gone up, the tax breaks are being progressively cut back, they're coming into the workforce with student debt in a lot of cases, the contribution rates that employers pay into work-based pensions have declined."

But while old people, who care a lot about how they'll be spending the next 30 years, turn out in their hordes to vote, pensions didn't make it into the top issues important to first-time votes in the last election.

"There is a sense among young people that it'll work itself out in the end and everything will be OK", says Hanton. But unless you're in line to inherit vast sums of money or property, this just isn't the case. "Young people tend not to be interested in the pension bill; they assume 'their turn will come'," he says. "The sad truth is that their time might not come if they cannot afford to save towards their own pensions."

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