What is a Pension?
A pension is a way of saving for your retirement; you make tax free contributions into your pension each month, and in return, you get a regular income once you’ve retired.
Planning for retirement is one of the key financial objectives that people face with three types of pension available – state pension, workplace pension and personal pension.
When people reach their state pension age they will receive an income from the state as long as they have made sufficient National Insurance (NI) contributions throughout their working life.
The State Pension ages have been undergoing radical changes since April 2010. The changes will see the State pension age rise to 65 for women between 2010 and 2018, and then to 66, 67 and 68 for both men and women. There are plans to change State Pension ages further.
The new State Pension rose by 2.5% for 2017/18 meaning that pensioners entitled to it saw their payments increase from £155.65 to £159.55 per week; a total of £8,296.60 per year.
Those that receive the basic State Pension have seen their weekly payments increase from £119.30 to £122.30 since April 6th 2017; a total of £6,359.60 per year.
‘£890 buys you £1 a week at age 65, £25 a week costs £22,250, falling with age’
The number of qualifying years of NI contributions is 30 for the old State Pension; to qualify for the new full, flat rate pension 35 qualifying years of NI are required.
If you don’t have enough qualifying years, you can pay voluntary contributions; £890 buys you £1 a week at age 65, £25 a week costs £22,250, falling with age.
If you’re employed, you might also have built up a second state pension (S2P), previously known as SERPS which was based on your NI contributions and how much you get depends on your earnings.
For most the state pension will provide insufficient income for their retirement, so most have a pension with their employer as well.
Workplace pensions take contributions from you and your employer based upon a percentage of salary, topped up by the government, and invests them to provide you with a pension when you retire.
Your contributions are tax free and contributions from your employer are in effect an addition to your salary.
There are two types of workplace pension – defined benefit and defined contribution – by 2019 all employers in the UK will have to offer a workplace pension scheme under the Auto Enrolment scheme, with the National Employment Savings Trust (NEST) as the default investment option.
Defined Contribution (sometimes ‘money purchase’ or ‘DC’) schemes involve an employer selecting a pension provider to invest the money you pay in and you may be given options in terms of the risk profile of the various investment funds available; many offer a ‘glidepath’ to retirement by moving your money into lower-risk investments.
The amount you get at retirement will depend on:
- How much you’ve paid in
- How long you’ve paid in for
- The fees charged by the provider
- How well the investment has performed
Defined Benefit (sometimes ‘final salary’ or DB) schemes are highly prized but are being phased out in favour of DC schemes because they are expensive to the employer.
DB pensions guarantee you a certain amount when you retire, typically based upon your salary when you left the company or retired.
The amount you get at retirement will depend on:
- The level of personal contribution you chose to make
- The precise terms of the scheme
- Your salary – either aggregated over the period of your employment, or when you leave
Many DB schemes are currently in deficit and operators are offering extremely high multiples of the expected annual benefit to those agreeing to exit the scheme; this is something that can never be undertaken without professional financial advice. More here
Select a pension scheme from a provider into which you pay regular sums, in return for a lump sum at the end with which to fund your retirement.
Personal pensions are suitable for the self-employed or people who aren’t in work, who don’t have access to workplace pensions and like a workplace pension, the success of the scheme depends upon the performance of its investments.
Since pension reforms of April 2015 those reaching age 55 have been freed from the requirement to purchase an annuity with their pension pot, and have freedom to draw down income or reinvest as they choose.
However, those seeking certainty may still consider an annuity, and those in any doubt should not hesitate to take professional advice, as the consequences of making a wrong decision could literally stay with you for the rest of your life.
‘SIPPs give the DIY investor the widest choice of investment options and total freedom to manage their own affairs’
Personal pensions offer 20% tax relief which providers claim back and add to your pot; they also provide a 25% tax-free lump sum on retirement. They are more portable than company pensions, so you can build up a larger fund without having to transfer pots from previous employment, thereby potentially incurring additional fees.
However, personal pensions are just that, they don’t offer the extra ‘free money’ in the form of employer contributions that make workplace pensions relatively attractive and management charges may be higher than those levied by company schemes.
Ultimately the success of a personal pension will depend upon the amount you contribute and the duration of your contributions, the success of the investment strategy and the ‘drag’ of fees and charges; you will have some control over the investment strategy by selecting, for example, between ‘default’, ‘cautious’ and ‘adventurous’ portfolios.
Self Invested Personal Pensions (SIPPs) give the DIY investor the widest choice of investment options and total freedom to manage their own affairs in a cost-effective and tax-efficient wrapper.
An increasing number of automated investment platforms offer a SIPP wrapper in addition to their general investment and ISA accounts; in the accumulation phase this allows an investor to make regular contributions into a risk managed investment portfolio and in retirement can be used to deliver income whilst leaving the pension pot invested.
SIPPs are useful for people with commercial premises, as they can free up funds to be re-invested into a business and also deliver inheritance tax benefits.