Why a pension is not a savings plan

However you manage your money, confusing your savings with your pension plan can create difficulties in planning your financial strategy for the future. Because pensions and savings plans are often mentioned interchangeably, this can lead to a common misconception that they serve similar purposes.

While both aim to provide financial security in retirement, they are fundamentally different in nature, design, and purpose. Structurally, management and risk wise, they are different vehicles. Thinking your savings is akin to a fund for your retirement is as dangerous as thinking your pension can be drawn upon for general use.

Differences in structure and management

When working with a savings plan contributions are entirely voluntary and flexible, allowing adjustments according to personal wishes and circumstances. In contrast, a pension operates under a compulsory, structured contribution system. Employees and often employers, are required to contribute a predetermined percentage of the employee’s salary to the pension fund, which means individuals have no choice but to participate.

Another critical structural difference is that when choosing to invest money, you can make personal choices with your savings – you have the autonomy to invest your money wherever you like, be it in stocks, bonds, real estate, or other assets. While the level of control over investments is in your hands, you have to be prepared to navigate the market risks and take responsibility for investment strategies. Pension funds on the other hand, are managed by professional fund managers or trustees. These experts make investment decisions on your behalf, aiming to generate returns while managing risk.

Risk factors

Obviously, when you do your own investments with your savings, you take on the risks yourself, and therefore it is safer to know what you’re doing. You need to make choices regarding asset allocation, which is influenced by your risk tolerance, financial knowledge, and varying market conditions. Consequently, the returns on a savings plan can vary widely and may even result in financial losses. Pension funds, however, spread investment risk across a broader pool of contributors. Professional fund managers diversify investments to minimise risk, striving for consistent returns over the long term. This risk-sharing mechanism is a crucial aspect that distinguishes pensions from savings plans.

Longevity risk is something many people forget to factor into their calculations. It relates to the uncertainty of how long an individual will live in retirement. Savings plans do not provide any protection against longevity risk. Once the funds in a savings plan are depleted, there is no further financial support. The difference with a pension is that it is designed to mitigate this longevity risk. Geared to provide a stream of income for life, a pension ensures that retirees will have financial support for as long as they live. This is an important aspect in today’s world where people are concerned about living longer, and outliving their savings.

Different purposes of savings and pension

• The primary purpose of a pension is to serve as a retirement income replacement tool, specifically designed to replace a portion of an individual’s pre-retirement income in order to maintain a reasonable standard of living in retirement. In this way, a pension helps to ensure retirees do not face severe financial hardship in old age. Savings plans, on the other hand, do not have a specific income replacement goal. They are more general-purpose savings vehicles that can be used for various financial goals, including retirement.
• Governments often play a role in regulating and overseeing pension systems to ensure that retirees have a minimum level of income security. In many countries, pension plans are legally required, and governments may even contribute to, or provide a basic pension for citizens. Savings plans, while they can be valuable, do not have the same level of social safety net purpose. Savings are purely reliant on individual initiative, which means that some people can find themselves without adequate retirement savings as a result of unfortunate circumstances, poor planning and lack of discipline.
• Pension systems are important investment mechanisms for the market. They channel long-term investment into productive investments with the focus on growth over time, contributing to a buoyant and more stable market. This can have a positive impact on a nation’s economy, fostering economic development and job creation. Savings plans remain more privately dynamic and have less impact on economic stability.
• Both pensions and savings plans have unique advantages and limitations, but in essence serve different roles in the complex landscape of retirement planning. It’s important to understand the differences, so that when crafting retirement income, you can make wise and informed choices.

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