Definition of a Pension and How it Works

A pension is a type of savings plan to help you set money aside for later in life, typically when you retire. And its tax efficiency makes it a more favorable option compared with many other types of savings.

Contents

1. A long-term savings plan ↴
2. How does a pension work? ↴
3. Why you should contribute to a pension ↴
4. Types of pensions ↴

A Long-term Savings Plan

A pension is a long-term savings plan that helps you save money to use when you’re older and no longer in active employment. Tax reliefs set by the government serve as an incentive to encourage you to prepare for retirement.

Depending on the type of plan you have, you, your employer, and any other person can contribute to your pension. You can choose to wait till retirement to access your accumulated benefits, or you can opt to access a portion of your money before retirement and the rest (lesser amount) after retirement.

How Does a Pension Work?

To understand how a pension works, think of it as a savings pot. Once you sign up for a plan, you pay regular contributions towards your pension during your active years of employment or income generation.

You don’t have to have a formal job to get a pension. You only need to be able to pay into and grow your pot, meaning self-employed people can have a plan too.

If you are formally employed, the law requires your employer to make regular contributions towards your pension. The government also plays a part. It offers tax reliefs and exemptions if you access your money after retirement.

What happens to the money in your pension?

Pension providers have elaborate investment strategies to put your accumulated funds into use. The money is invested in stocks, government bonds, and shares, to name a few, and the returns vested (added) onto your pension amount.

What happens to my pension if I die before taking my benefits?

If you die before receiving your pension benefits, your pension will pay death benefits to your nominated beneficiaries. Beneficiaries are the people who depend on you for financial security. These would include, among others, your spouse and children.

Ensure you specify your beneficiaries when signing up for a pension plan. You can update the list during your membership.

Why You Should Contribute to a Pension

It is a good idea to save money for when you need it later in life. Contributing to your pension plan helps you provide some level of financial protection when you get old and retire or when you start working less.

Define the lifestyle you want to lead when you retire and get a pension plan to help you achieve it. Don’t put the burden of taking care of your financial needs on your children. They’ll probably have their own goals and lives to take care of too.

Besides, with the government exempting your pension investments and payout from tax, you don’t have to worry about the taxman. However, you will pay taxes if you opt to access your pension before your retirement age. This tax works to discourage early withdrawals.

Is it too late to start contributing to a pension?

While it is best to start when young, it’s never too late to start saving. Consider getting a pension plan soon and put aside as much as you can. Besides the government tax incentives on pension savings, your employer also contributes to your retirement pot.

Types of Pension Plans

There are three main types of pension in Kenya: state pension, occupational pension, and personal pension.

State Pension

The government offers the state pension in Kenya through the National Social Security Fund (NSSF). Kenyans above the age of 18 can make contributions and access the money when they retire.

The amount you receive depends on how much you’ve contributed. In most cases, the amount of income you get from the state pension is never enough on itself to sustain the type of lifestyle you want. It’s advisable to complement it with another source of income like another pension plan.

Occupational Pension

The law requires your employer to enroll you in a pension and make regular contributions towards the same. This pension is also called a workplace pension or an occupational pension. You may, however, only be eligible for your workplace pension if you are a permanent employee.

Here is how it works: both you and your employer contribute at least the defined minimum portion of your monthly (3% for your employer and 5% for you) income towards your pension. The pension scheme you are in will have rules that govern its operations.

An occupational pension can be under a defined contribution (DC) scheme or a defined benefit (DB) scheme.

Defined contribution pension scheme – both you and your employer contribute a percentage of your salary to the pension. Your pension scheme invests the funds and vests the returns onto your retirement pot. What you get depends on your contributions and the scheme’s investment performance. The amount is not guaranteed.

Defined benefit pension scheme – from the name, you get a predefined amount of money when you retire. You make regular contributions towards your pension, and so does your employer. Your retirement pot depends on how long you’ve worked and your salary at retirement. As such, it’s often called the final salary pension scheme.

Check with your employer to understand the type of scheme in which you are enrolled. When leaving your employer, you can opt to transfer your benefits to a new pension scheme, retain your pension under the same provider, or withdraw your accumulated benefits.

You can withdraw up to 150% of your total accumulated benefits before retirement age – 100% of your contributions plus 50% of your employer’s contributions.

Personal Pension

Personal pension, also known as an individual pension, or a private pension, is a pension set by individuals. Since you decide whether to have it, you can have a personal pension in addition to your occupational or state pension.

You choose your pension provider, the amount and frequency of contribution, and, sometimes, your investment options. The government, as with occupational pension, offers tax reliefs.

Personal pension plans are administered as defined contribution pension schemes. The amount available at retirement depends on how much you have contributed and the scheme’s investment performance.

The three main types of personal pension are:

• Simple personal pension: you make regular payments to your pension, and a pension provider manages your pot. The provider usually offers different investment strategies to choose from based on your attitude towards risk and your circumstances.
• Stakeholder pension: operates more or less like the simple personal pension. It, however, comes with strict government regulations, through the Retirement Benefits Authority, on how it’s managed. This type of personal pension has few investment options, low minimum contribution limits, and caps on the fees your provider can charge you.
• Self-invested personal pension (SIPP): you are actively involved in how your pension contributions are invested. This option is ideal with high contribution amounts and may require you to have investment experience and know-how. It also involves hefty charges.

It is worth mentioning that in cases where your pension is not guaranteed, like with most defined contribution pension schemes, the value of your pension could go up or down. As such, you might end up with less than what you contributed to your retirement pot.