Pension Savings

Video lesson3 worked examples

Theory

A pension is a long-term savings plan designed to provide a person with a regular income during their retirement, when they are no longer working.

1. Types of Pensions

State Pension: A regular payment from the government. To receive this, an individual must have paid sufficient National Insurance contributions over their working life.
Workplace / Private Pensions: These act very much like standard savings accounts. A person pays a percentage of their salary into the fund each month, and often, their employer will also pay an additional percentage into the same fund. The total fund earns compound interest over time until retirement.

2. The Lifetime ISA (LISA)

Qualifications Scotland frequently uses the government's Lifetime ISA scheme as an exam context for retirement or first-time buyer savings. You must be familiar with its specific rules:

You can save up to £4,000 a year, and the government will add a 25% bonus to your new deposits every month.
Once added, this bonus becomes part of your overall savings and begins to earn interest.
The Penalty Trap: If you withdraw money for an unauthorised reason (i.e., anything other than buying a first home, turning 60, or terminal illness), you face a 25% withdrawal charge on the total amount withdrawn.
(Note: A 25% charge on a balance that includes interest means you will actually lose money overall compared to what you put in!)

3. Retirement Drawdown (Living Costs)

Financial planners use spreadsheets to estimate if a person's pension pot will be large enough to last their entire retirement.

This involves a "drawdown" calculation: tracking a large starting balance that earns interest, whilst simultaneously subtracting regular withdrawals to cover monthly living costs.
Often, these living costs must be adjusted to increase over time to account for inflation.

Worked examples

Example 1

Example 1: Employer & Employee Contributions

Greg earns a gross annual salary of £36,000. He contributes 5% of his gross monthly pay into his workplace pension. His employer contributes an additional 7% of his gross monthly pay. The pension fund earns an effective rate of interest of 0.4% per month.

Assuming Greg's pension fund starts at £0, calculate the value of his pension fund immediately after his second monthly contribution is made.

Calculate the total monthly deposit:

Gross monthly pay: £36,000 ÷ 12 = £3,000.
Greg's contribution: 0.05 × £3,000 = £150.
Employer's contribution: 0.07 × £3,000 = £210.
Total monthly deposit: £150 + £210 = £360.

Track the balance chronologically (Method 1):

Month 1 Deposit: £360.
Month 1 Interest: $\text{\pounds}360 \times 1.004 = \text{\pounds}361.44$ .
Month 2 Deposit: $\text{\pounds}361.44 + \text{\pounds}360 = \text{\pounds}721.44$ .

The value of the fund after the second contribution is £721.44.

Example 2

Example 2: The Lifetime ISA (Bonus and Penalty)

Nina opens a Lifetime ISA to save for her retirement. On 1 March, she deposits £300. The government immediately applies the 25% bonus to her deposit. At the end of March, the account earns an effective rate of interest of 0.5% per month.

On 1 April, Nina decides to withdraw the entire balance of the account to pay for a holiday. Because this is an unauthorised withdrawal, the provider applies a 25% withdrawal charge.

(a) Calculate the balance of Nina's account at the end of March, after the bonus and interest have been applied.

(b) Calculate the final amount of cash Nina receives after the withdrawal charge is deducted.

Solution (a):

Add the bonus: $\text{\pounds}300 + (0.25 \times \text{\pounds}300) = \text{\pounds}300 + \text{\pounds}75 = \text{\pounds}375$ .
Add the interest: $\text{\pounds}375 \times 1.005 = \text{\pounds}376.88$ (rounded from £376.875).

Solution (b):

Calculate the 25% penalty on the total balance: $0.25 \times \text{\pounds}376.88 = \text{\pounds}94.22$ .
Subtract the penalty: $\text{\pounds}376.88 - \text{\pounds}94.22 = \text{\pounds}282.66$ .

(Notice that because the 25% penalty is taken from the larger, post-bonus balance, Nina gets back less than her original £300 deposit!)

Example 3

Example 3: Retirement Drawdown

David retires on his 65th birthday with a private pension pot of £240,000. The account pays an effective rate of interest of 0.2% per month.

At the very start of each month, David withdraws £1,450 to cover his living costs. Interest is then calculated and added to the remaining balance at the end of the month.

Calculate the exact balance of David's pension pot at the end of Month 2.

We must carefully step through the timeline, subtracting the living costs before calculating the interest. The multiplier is 1.002.

Month 1:

Start balance: £240,000.
Subtract living costs: $\text{\pounds}240,000 - \text{\pounds}1,450 = \text{\pounds}238,550$ .
Add interest: $\text{\pounds}238,550 \times 1.002 = \text{\pounds}239,027.10$ .

Month 2:

Subtract living costs: $\text{\pounds}239,027.10 - \text{\pounds}1,450 = \text{\pounds}237,577.10$ .
Add interest: $\text{\pounds}237,577.10 \times 1.002 = \text{\pounds}238,052.25$ .

Ready to practise?

5 Pension Savings questions with answers and video solutions