How do UK pensions work – (simple guide)

What is a pension? 

Quite simply, a pension is a tax-efficient way of saving money for your later retirement.

There are different types of pensions in the UK. As a result of previous actions, it does confuse a lot of people. Mainly because the rules keep changing and also because we don’t teach people how they work, so for most people it’s complete inertia or may appear confusing and complete.

But the world of UK pensions and how they operate shouldn’t have to be that way !

In simple terms, your contributions are invested in the stock markets, bonds and other asset classes by fund managers and pension providers. With aim of growing in value over numerous years, as pensions are considered a long term investment vehicle.

Your contributions paid by you and an employer are boosted by tax-relief. So it’s seen as a very tax efficient savings product, which grows over time through annual compounding.

So what types of pensions are there !

They are normally split into 2 types being DB or DC. So how they are different !

Defined Benefits (DB)

This type of pension will normally paid a guaranteed or defined benefit at a set age in future, normally called the scheme’s normal retirement date (NRD). In that a employee will pay a % of their annual salary through monthly payroll and it will provide defined pension at an agreed ate in future. It based on salary, accrual rate and the length of service.

In simple terms, the better your salary and the longer you work for an employer the better as it pay out a larger pension in retirement. These types of schemes were normally provided by large employers, or local authority (LGPS), Teachers, Police, NHS etc.

But most employers except the public funded have been closed down in recent years. As the risk to honour pensions payable to members or employees was at the risk of the employer. In recent times they have become unaffordable to most employers to still run at great expense.

As they will normally pay an income for life. Once in payment, the sum paid will increase every year to keep up with inflation. Plus most schemes will also provide a spouse’s pension, equal to 50% of members original benefits.

These types of schemes are run by Trustee boards that act in the best interests of the members to ensure they can be fully funded and benefits can be paid for many years in future.

Most employers will now offer its members a defined contribution scheme instead.

Defined Contribution (DC)

A defined contribution is simply a pot of money that is invested that goes up and down on a daily basis. Dependant upon the types of assets the funds are invested in. So your pot will move on a daily basis and isn’t guaranteed and the risk is borne by the member.

So let’ break DC pensions into different types !

Personal pension: can be offered by most pension providers, offering you a ranged of investment and assets that you pick yourself. It’s a simple arrangement between you and the respective pension provider.

Stakeholder pension: whereby you pay in a minimal amount each month, you can stop and start contributions when you like at a very low cost. You are usually limited to selected funds. Charges are normally capped to 0.75% since the introduction of Auto Enrolment.

Self-invested Personal Pension (SIPP): This type of product will give you more investments across numerous different sectors or asset classes. Whereby an individual can pick their own investments if you wish.

But for most people, they will shun this type of product as most people don’t feel comfortable or confident picking their own investments.

Employers will offer pensions called ” Group Personal Pension” or “Group Stakeholder Plan”

So why have a pension at all !

Most people don’t want to work all their lives, they would like some form of enjoyment in later years once they finish working. So unless you can survive on the UK pension, receive an inheritance or make other savings and investments. You have to find a way to fund these later years if you do stop working.

So who can have a pension !

• Self-employed
• anybody in employment, automatically enrolled through Auto-Enrolment.
• Non-workers (although you contributions are limited)
• Children or grandchildren (but they cannot unless until MPA currently 57 as per April 2028)

How do DC pensions work !

No matter what type of DC pension you have, you will have to invest your regular or annual contributions in assets. Which should hopefully grow and compound over time to provide a substantial amount of time at the time of access.

You can make contributions on a monthly or annual basis, and you can choose the amount of contributions that you make. It could be via DD or standing on the 1st of the month, or every payday. You can change the amount you contribute and it comes down to affordability.

You will normally be given tax-relief on your savings and this will be added into your pot. This will be done automatically by your pension provider. Then all investments within the pension wrapper will grow tax-free in future years.

Simple example: If you are a basic rate tax-payer and you contribute £ 100 on the 1st of each month, your provider will normally add £ 25 (tax-relief) by the middle of the following month.

Your funds will then be invested into your selected or allocated funds that you have chosen. Then when you retire the size of your accumulated pension pot will be based on the following:

• the amount of time you have saved for
• how much you have contributed over the years
• how well your investments have performed
• less any fees and charges payable to your provider.

What about my investment options !

Most pension providers will offer a simple range of investment funds across numerous different asset classes. It could be

• individual shares or stocks,
• government bonds or gilts
• specific funds based on geographical country (i.e USA / UK / Emerging Markets / Europe)
• growth or income funds (covering numerous companies in a particular sector)
• low risk ETF’s (i.e passive funds that tracker the market)
• lifestyle funded or target date fund (that will become less riskier the nearer to retirement)

Ultimately, when you join a pension plan you should complete a simple risk allocation form ahead of investing any money into a specific range of funds. You may be low, medium or high risk.

What charges should I pay !

Like any investment product, you will have to pay annual management fees to your provider to manage the funds on your behalf. The charges should be divulged when you open your plan. It may be a % of your total portfolio. It is normally payable on a monthly basis, this will be done automatically by your provider.

Be aware, a fund with higher charges doesn’t mean it will outperform its peers or the market. Can the funds be justified, and are competitive to other providers.

Also remember, if you are using a Financial Adviser to help you, they will also apply their own fees on top as well.

How can I track my pensions !

Your pension provider should provide you with an annual statement on regular basis. Which will provide you with an update about how it is performing. It should highlight:

• Starting value and year end valuation,
• details of any contributions made into your plan,
• where were your contributions invested
• annual or monthly fees payable
• assumptions or illustrations for future value at specific dates for future
• if pot has any special features or benefits (such as w/profits bonus or guarantees)
• should also highlighted selected retirement date, when it ends or can be accessed)

If you have any missing pensions, you can track them by using free government service being http://www.gov.uk/find-pension-contact-details (The Pension Tracing Service).

So how much should you save into a pension !

It all comes down to affordable and what sort of income you require in the later years, so you can enjoy an adequate or lavish retirement.

How much you save depends on some major factors:

• what level of contributions can you afford
• the level of contributions  any employer may add
• what are your investment returns whilst invested
• do you have a low or risk attitude to investments

A simple start may be to do some budget calculations. What do you spend your income on now and what are you likely to spend it on future. It is cars, holidays, travel, socialising, spending quality time with family or grandchildren.

At present any money you save into your pension can be accessed at age 55 being MPA, although this is being increased to age 57 with effect from April 2028. Unless you can access your pot early through ill-health or having a protected age.

There are simple lifestyle tools to help you such as the “retirement living standards survey” (https://www.retirementlivingstandards.org.uk/ which shows how much income somebody or a couple may need for certain lifestyles:

• minimum lifestyle – some money to live on, plus basic holidays and entertainment
• moderate lifestyle – some extra security and peace of ind for better holidays, social life
• comfortable lifestyle – having enough money to do most of what you want to achieve.

So how much in total can I pay into my pension !

At present, everybody has an annual allowance up to £60,000 per tax year. Or if you are earning a lower salary say £ 30,000 you can contribute up to that amount. This will cover salary, bonuses, overtime and commission. It doesn’t relate to dividends or rental income. This will cover your contribution and tax-relief aded by your employer or the UK government.

You can also carry forward any unused allowances from previous 3 years.

You can still contribute into a pension if you have no earnings, but your contributions are limited to £ 2,880 net per annum. The government can then top it up to £ 3,600 per annum by adding tax-relief on your behalf, which they will claim and add into your pension.

If you have income over £ 260,000 per annum, your annual allowance will be reduced by £ 1 for every £ 2 above that amount. Until the minimum tapered annual allowance of £ 10,000 is then reached. So it affects a minority of people earning over £ 360,000.

Suppose you are unlucky to exceed the annual allowance, you would have to pay back any tax relief your have received over that limit or threshold. This is known as the “annual allowance tax charge”

What about financial advice !

That all depends if you are happy and confident in making your own decisions, or do you need somebody to help you.

If you need a IFA to help you, compare 2 to 3 in your local area, or ask for recommendations from friends or colleagues. Do you get a feel or trust for them, what about reviews from other clients. What network do they use, and who are they affiliated to. What fees and charges apply and do your background checks and due diligence on their website etc.

Some advisers may charge a fixed fee, or % of pot value say 1 to 2%, some may offer free initial consultation.

You can use the “Pensions Advice Allowance” whereby you can take £ 500 each tax-free from a pensioner 3 years to cover the cost of advice, up to £ 1,500 in total. It may now cover the cost or be offered by all providers but most people don’t know it is available – or they may be put off buy the actual cost of regulated financial advice.

All advisers should be authorised and regulated on the FCA register, so that you are fully protected.

Use the following to find a reputable IFA: https://register.fca.org.uk/s/ or http://money helper.org.uk/retirement-adviser-directory

At present, there is no requirement to use an Financial adviser, unless you have a pot over 30K with special features, guaranteed benefits that you are transferring or cashing in completely. Or a DB pension with CETV (cash equivalent Transfer value over 30K) going to new provider.

Remember, as with any investment the value of your pension and any income may fall as well as rise and is not guaranteed.

So what happens when you start drawing a pension !

When you reach age 55 or age 57 from April 2028 you now have numerous options through the introduction of pensions freedom in 2015. You can do any of the following:

• leave the pot untouched and it remains invested
• buy an annuity to receive a regular guaranteed income
• access on a flexible basis via drawdown until the pot is empty
• take a number of lump sums
• cash the pot in completely
• or you could mix your options and do a combination of the above. (may be beneficial if you have several pots or a large pot)

You can take advantage of a free and impartial service called Pension Wise, which is available aged over 50 with a DC pension. Or under 50 if you have an inherited pension. On the following link: http://moneyhelper.org.uk/pensionwise, or by calling 0800 139 3944.

Remember:

If you found this blog post useful and informative, then check out my other posts on savings, pensions, investing and investment books that I recommend on https://moneyminted.co.uk. So you can improve your investing and finance knowledge to reach your financial goals and dreams.

It’s not a get rich quick journey, but you will get their in the end, if you create a plan and think long term !