Many people believe that a pension is to provide someone with an income for when they retire. When talking about pensions there are three types, state pensions, defined benefit pension and defined contribution pension. We will go more in depth into all of these types of pensions. Information correct as of June 2020.
Within the UK, most people will receive a state pension. This lasts for life and currently increases by the rate of inflation each year. Your state pension is built up by your national insurance contributions during your lifetime. Currently in the UK you will need to working/making NI contributions for at least 35 years to be eligible for the full state pension and 10 years for a part state pension.
Defined Benefit Pension
You may receive this type of pension if you work for the public sector or for a large corporation. The value of this type of pension is related to the salary you received in your working life and will pay out for life and increases each year, typically with inflation. The other factor to determine the value of the pension is the period you have work for the respective company/sector.
Defined Contribution Pension (also known as Personal Pension).
As within the name this pension’s value is dependent on the amount you contribute to the ‘pot’. There are also other factors that affect the value of this pension is the performance of the underlying investments made, the contributions you and your employer make to the pot and the charges that may be applicable depending on the provider. Defined Contribution pensions can also be referred to as workplace, personal and stakeholder pensions. In addition, with this type of pension, you are currently able to withdraw 25% tax free of the lump sum, however you have to be at least 55 to be able to withdraw any funds.
Self-Invested Personal Pension (SIPP)
A SIPP is a type of pension ‘wrapper’ offered by insurance companies. Wrapper means consolidating an investment or investment portfolio during financial planning. SIPP work very similar to personal pensions (defined contribution pension) with the main difference is in the control you have over the investments that are made within the pension. These are typically only used for high net worth individuals and more experienced investors. Using a SIPP will allow you to invest in a wide range of securities like shares, bonds, cash and commercial property. The type of underlying investment will depend on the provider of the SIPP and like with personal pensions there are fees and charges. However, with SIPPS these are typically higher as they are designed for larger funds and investments. To access any funds within the pot, like with a personal pension you need to be at least 55 and the same risk principals will apply.
Small Self-Administered Scheme (SSAS)
SSAS are similar to SIPPs in terms that they allow more control over the underlying investments that may not be available in other pension provisions. Just like SIPPS, they are offered by insurance companies but unlike SIPPs, this type of pension scheme is mainly for directors or key personnel of companies. It can also include employees and even members of their families even if they do not work for them. However, they are usually limited to 11 members. Depending on the provider, this limit will differ. As this is designed for directors of companies, this can be used to purchase the company’s office, warehouse etc. and then leased back to the company. In addition, SSAS can borrow money, within the terms of the SSAS, to purchase other assets or buy shares into funds. Just like with most pension provisions, you can normally start to draw money from the pot from the age of 55 and the value will depend on the value of the underlying investments, the amount of contributions and level of charges by the chosen provider.
Additional Voluntary Contributions (AVCs)
AVC are for people who are part of their existing workplace pension scheme who has some extra disposal income which they wish to contribute to their pension pot. It is a tax-efficient way to boost your pension as the contributions are deducted from your income before tax.
Free-Standing Additional Contributions (FSAVC).
With FSAVC, this is similar to AVC but is not connect to a workplace pension as they are free standing. They are usually found in personal pension plans with providers. Over the years these have become less popular but are still options for people who want to contribute more to a pension. It is important to note that the FSAVC have to be within the £40,000 annual allowance to be eligible for the tax relief. Please be aware that new FSAVC are not available.
Contributions to a Pension
To start building a pension you will have to make contributions to the ‘pot’. As we have previously mentioned, with state pensions the contributions are from your National Insurance payments which are made throughout your working life, and if you have a workplace pension, contributions from you and your employer. Similarly, contributions to all other pensions mentioned above are funded from you and/or your employer
Benefits of Pensions
Pensions are a tool used for people to provide an income for when they retire. Many people do not save enough for their retirement to maintain their lifestyle for when they retire, and in turn this is becoming more expensive for the government to provide income for retired individuals who fall into this category. Due to this, the government has introduced tax benefits for people who save into a pension, especially for defined contribution pension schemes where instead of paying tax to the government, you can contribute to a pension tax free to receive that money in the future. In addition to this, it is now required for employers to enrol their employees into a workplace pension scheme which will increase the available pot for your pension.
How Pensions work behind the scenes
Once you have contributed to a defined contribution pension, the money doesn’t just sit in a savings account to be ready for when you retire. There is an element to investment which the funds are used for. This will give the potential for the pot to grow in size to provide you with a greater income than if the pension pot was just sitting in a savings account. Once you have started a pension you need to decide where the money is invested and there are lots of providers out there that offer multiple funds with different risk levels to make the decision easier for the average consumer. You will also need to be aware of any fees and charges that providers may charge. These will differ from provider to provider. As with any investment, where there is potential for growth, there is also potential for loss. Depending at what point in your life you are at, should dictate how much risk you want to take with your pension. For example, usually if your closer to retirement you may want to have little to no risk so you have a guaranteed fund for when you retire compared if you have just started a career, you may be interested in slightly higher risked investments to allow more growth. In other cases this may depend on your attitude to risk combined with your capacity for loss. It is very important for you to regularly check in on your pension’s performance.
Unlike defined contribution pension, with a state or defined benefit pension your pension pot is ‘guaranteed’ in terms that you will receive an income for when you retire. As the income is ‘guaranteed’ there is no need for an investment decision to be made. However, it still may interest you to open a defined contribution pension in addition to state or defined benefit pensions.
Tax Reliefs and Allowances (information correct as of June 2020)
As previously mentioned, the UK government allows many tax reliefs for individuals to contribute to a pension. Please note that these will depend on the individual's marginal rate of tax and is based on net relevant earnings up to a maximum of £40,000.
See below some information regarding reliefs and allowances; Please note that this is note an extensive or exhaustive list and your personal situation may differ. Please contact us for more information.
Pensions contributions per annum have a 100% relief on contributions up to £40,000
Tax Relief on Pension withdrawal is currently 25% tax free of the value of the pension’s ‘pot’. The whole pot can be withdrawn but applicable taxes will be payable.
Lifetime allowance is currently £1,073,100
This page is for information purposes only and should not be used to make any decisions on your pension provisions.
A PENSION IS A LONG TERM INVESTMENT AND THE FUND VALUE MAY FLUCTUATE AND CAN GO DOWN. YOUR EVENTUAL INCOME MAY DEPEND UPON THE SIZE OF THE FUND AND RETIREMENT, FUTURE INTEREST RATES A TAX LEGISLATION.