Once you have created an emergency fund, the next step to improve your finances is to create a private pension fund to protect your retirement.
Now? Yes!!! You may think you still have many years, if not decades, before your retirement, but it will arrive. And you will discover that you will be too tired to keep working, but you will still need money yo pay your expenses. And by having made your budget, you know approximately how much you spend; now multiply that by 20, the average number of years you will spend in retirement.
And it will be hard to save money then; so why not save them now? After all a dollar saved now is not the same of a dollar saved later. Why? Because of compounding interests! Any dollar that you save now will multiply over time due to interests; and that will be automatic. So it is an opportunity for free money you should not miss.
This is part of the first steps on how to improve your finances.
What about the public pension funds?
You may think you are covered since you know that part of the taxes you pay go to the public pension; let me crush your dreams: it will not be enough. Most national pension funds will give the retirees only few hundreds dollars/euro/etc. each month. That is because of several limitations, but mainly:
- the public pensions agencies have limits on how they can manage and invest those funds while you contribute to them; that means they will not grow too much in value during the years (often less than the inflation, so $100 you take out while in retirement is worth less than the $100 you contributed years before);
- the taxes you pay, while in theory recorded under your account, are not set aside for your pension. The taxes you pay are used to pay the pensions of the current retirees; and when you retire, the then currently working people will pay for the pension you earn. And in many countries older generations went into retirement with pensions laws that were more generous than the one covering your pension. That means that current retirees are costing the system a lot compared to the taxes you are paying; and that means that when you will go into retirement, the public funds will be well underfunded.
What are private pension funds
Since the public pension fund will not be enough, you need a private pension fund. Private pensions funds are funds managed by private financials institutions where you can deposit money at your discretion and then collect them during retirement. They do not compete with public funds, but instead integrate them; so you will be able to (and should) cash both of them simultaneously.
The first thing you need to do is to search for the appropriate name for those funds. They have different names in different nations; for example in the U.S. they are often called “401(k)“, in Switzerland “3rd pillar”, and in Italy “Individual pension plan” (Piano individuale pensionistico – PIP).
Select your private pension fund
The second step is to shop around for the best account; I cannot give you a direct answer, since it depend on national regulations and it will change overtime due to competition. But I can give you some general considerations:
- check the costs carefully; some bank may promise a great return, but then you will discover that the costs are so high that they will eat out most of the returns;
- check the conditions for an eventual early withdrawal (even a partial one) in case you encounter difficulties during your pre-retirement life. Hopefully this scenario will not happen, especially if you have a separate emergency fund, but you can never know. Please note that often the limits for withdrawal are not set by the financial institution, but by the government; for example you can withdraw some money only for specific medical expenses, restructuring your main home, or similar scenarios.
- check the flexibility in the contributions; the best strategy is to set a periodic (i.e. monthly) automatic contribution you are comfortable with and leave it be, but as above you never know if you encounter a period where you need to pause or reduce your contributions. Lets take for example the Italian “Individual pension plans”: there are 2 kinds of private pension funds – financial-based and insurance-based; with the financial-based you are free to change the contribution amount and periodicity (and therefore pause them), but with the insurance-based not; you can change the amount, but once you start with those, you need to pay every month until your retirement.
How much to contribute to your private pension fund
Once you have selected your private pension fund, it is time to decide how much money to put into it.
The most common wisdom here is to max out the allowed tax deduction every year. Yes, you have read it correctly: you can deduce the contributions to pensions funds from your taxes; so not only you will earn money from the fund over the years, but you will save some more from your taxes. A double win.
But of course, nations don’t like that so they impose limits on how much you can deduct each year. You are totally free to contribute to your private pension fund more than that, but beyond that limit you will not receive any tax benefits (but it will still generate more money via interests).
There is a reason why many suggest to limit the contributions to the maximum deductible and not more; often the maximum deductible is generous enough that, if maxed every year, it will give a sufficient pension when you retire; also it will be advantageous to diversify your investments (so if you have more money available than that limit, you should invest the difference elsewhere).