We all know that putting money aside now to pay for your retirement is a smart decision. But what type of pension will work best for you, and how do you go about getting one?
What is a pension?
A pension is a savings plan aimed at building up a pot of money for your retirement. The money is paid in either by you, your employers or a combination of both. Money paid into a pension is topped up by the government as an incentive to encourage you to save.
The money in your pension plan is held by a company, usually an insurance company, which provides you with a range of options over where it is invested (eg, shares, bonds, property or cash).
The aim is for your money to grow as much as possible so that you can buy a pension (or annual income) during your retirement. The earlier you start paying into a pension, the easier it will be to build up a large pot of money and therefore a larger income in retirement. Money can be paid into a pension through a regular amount each month or in one-off lump sums.
Pension types: the state pension
The most well-known pension scheme is that provided by the government: the state pension. However, the cost of providing this benefit is rising as people are living longer in retirement, and the problem is going to get worse.
A study by charity Age UK predicts that the number of people aged 65 years and older will rise 65% in the next 25 years to over 16.4 million in 2033.
The state pension is provided by the government when you reach the state retirement age. The full state pension is paid to people who meet the National Insurance requirements, and is currently £97.65 per week for a single person and £195.30 per week for married couples.
State pension top-ups
However, people can top up their pensions through government add-ons, such as the state second pension (S2P) and the state earnings-related pension scheme (Serps), which have made the state pension very complex.
The government is currently introducing legislation to bring in a £140-per-week flat-rate state pension, sometimes referred to as the universal pension, which is hoped to remove some of the complexity.
Men can take their state pension at age 65, but women have been allowed to take the state pension from 60. However, the government has started a process of equalisation, and from 2018 women will only be able to take the state pension at 65. The state pension age is then set to rise to 66 for both men and women by April 2020.
With the country’s finances stretched to capacity, it's not sensible to rely on the government to fund your retirement. Individuals need to take responsibility for paying for their future. There are two types of private pensions that you can set up by yourself or that your employer may offer:
Defined benefit pension schemes
These pension schemes are run by employers, although they are few and far between nowadays because of the increased cost of running them. This plan pays out a pension which is equal to the number of years worked for a company multiplied by a portion of the employee’s salary at retirement.
Defined benefit schemes are also known as final-salary schemes, as they take into account the employee’s ‘final salary’ before retirement in the calculation of the pension income. These schemes are typically very generous and are distinguished by a set outcome.
Defined contribution pension schemes
This type of pension is the plan most commonly run by employers, many of which have swapped old defined benefit schemes for defined contribution schemes to save money.
Defined contribution pensions, which are also known as money purchase schemes, are paid into by the employer and employee.
Although the amount contributed by the employer, and sometimes the employee, is a set amount of the salary paid, unlike with defined benefit schemes the final income paid in retirement is not guaranteed.
Different types of pension accounts
Personal pension plan (PPP): PPPs are a common type of pension, which are set up by individuals whose employers do not offer a scheme or who want to save more money for retirement outside the workplace scheme.
These schemes are run by financial organisations, such as life companies, banks and insurance companies. Money can be invested in regular instalments, for example through a monthly direct debit, or in lump sums.
The company that you give your money to has the task of investing your money based on your risk profile, and will aim to increase your pension pot to give you more income in retirement.
Group personal pension (GPP): A GPP is a collection of personal pension, plans usually set up through an employer. The employer deals with one life company, bank or insurance company to organise the scheme, and each employee is given a personal pension plan within it.
The financial company that sets up the plan will invest the money depending on the specifications of each employee and how much risk they are willing to take. The aim of the investment is to try to increase the pot of money you will have to live on in retirement.
Self-invested personal pension (Sipp): Like personal pension plans, Sipps are set up by individuals but, as the name suggests, the money is invested by the individual instead of the company running the pension. Sipps are for those people confident enough to invest their money in the hope of increasing their pension pot and retirement income.
Read more on our guide to Sipps.
Depending on the provider of the self-invested personal pension, investors can gain access to a much wider range of investments, including access to funds, stocks and shares, investment trusts and commercial property through this DIY pension scheme.
Although savvy investors can increase their pension pot substantially, there is also the risk of losing a lot of money if the investments falter. Some employers offer a group Sipp. These pensions work in the same way as an individual Sipp, with the individual taking responsibility for the investment of their money. The only difference is the employer sets up the scheme and both the employer and employee pays into it, usually a set percentage of salary.
Stakeholder pensions: Stakeholder pensions were introduced as a low-cost alternative to personal pension plans (PPPs) in 1999. These plans work in a similar way to personal pension plans: the individual is responsible for contributing money into the scheme, with a £20 per month minimum, to build up their pension pot and retirement income.
The main difference between stakeholder and personal pension plans is that there is a limit on the annual management charge fund managers can levy – up to 1.5% of the pension fund each year for the first 10 years the product is held and 1% per year after that.
How do I get my money when I retire?
A pension plan will not automatically pay out your money to you annually when you retire; you have to decide how to take the money to best generate an annual income.
Annuity: The most common way to take your pension is by buying an annuity. An annuity is essentially an insurance policy, provided by a life company, bank or insurance company. The company pays you a regular income in return for a lump sum (your pension pot).
The life company pays out a level of income based on how long it thinks you will live, taking into account such things as your age, health and even where you live. Annuity rates are linked to gilts and interest rates, both of which have fallen in recent years, meaning you get less income for your money.
Whereas a life insurance pays out if you die too early, an annuity is effectively insurance against living too long, and will pay out until the day you die. Unfortunately, that also means that if you take out an annuity and die a day later the insurer keeps your lump sum.
Income drawdown plans: These plans, also known as unsecured pensions, allow investors much more flexibility and control over how they take their pension. Unlike an annuity that pays out a set income each year, investors are able to reduce and increase the amount they like depending on their circumstances in that year, while leaving the remaining pension pot invested.
Allowing the pension pot to remain invested means investors will benefit from growth in their investments, but also puts their retirement income at risk should the investment go down.
However, those wishing to use income drawdown must have a secure lifetime pension income of at least £20,000 per annum if they wish to take advantage of income drawdown. The secured minimum income can be provided through an annuity, a pension received from a workplace scheme, or money received through the state pension.
What are the tax breaks associated with pensions?
There are two big tax breaks to encourage people to save into a pensions, but ultimately the income your pension providers in retirement will be taxed.
Any payments made into a pension attract tax relief, but the type of pension you have affects when you receive the relief. If you pay into an individual pension, the money you put into the pot has already been taxed, so the taxman contributes an amount, depending on what tax bracket you are in, to offset the tax.
For example, a basic-rate taxpayer pays £80 into their pension, the taxman will add a further £20, making the contribution worth £100. Higher-rate taxpayers also automatically receive the 20% tax relief from the taxman, but as they pay 40% income tax are entitled to claim back a further 20%. This extra 20% is not paid back automatically, and must be claimed through a self-assessment form.
If payments are being made into a company pension, the contributions are deducted before tax is taken from your salary, so you automatically receive tax relief at your highest rate of income tax.
There are limits on tax relief for basic- and higher-rate taxpayers. Tax relief is given on the first £50,000 of contributions for the year April 2011-April 2012, the annual allowance, and there is also a lifetime allowance, the amount of tax relief on pension contributions you can claim over your lifetime, of £1.8 million - this will fall to £1.5 million from April 2012.
If you don’t pay any tax on income you are entitled to tax relief on up to £3,600 per year, and no tax relief on contributions after that amount.
Tax-free lump sum
Although you pay no tax when paying into a pension, you will have to pay tax when you take your money out. When you take your benefits at retirement, for example when you buy an annuity, you are entitled to take 25% of your pension pot as a tax-free lump sum.
However, the annual income that you take each year as pension benefit is taxed as income. If you are still working and paying basic rate income tax, you will pay 20% tax on your pension income. Similarly, if you are a higher-rate taxpayer you will pay 40% on you pension income.
Tax breaks for pensioners
Although your pension is taxed, pensioners do benefit from an increased personal allowance, the amount of income that you can take free from tax, at age 65.
Between the ages of 65 and 74 your pension allowance increases. For the tax year 2011/12 it rises from a £7,475 basic allowance to £9.940. For those aged 75 and over the personal allowance increases again to £10,090.
These personal allowance levels are not set in stone, and can be reduced depending on how much income you take in retirement. If you are 65 or over, you can take an income of up to £24,000 before your allowance is reduced.
Over this amount, and up to a limit of £100,000, your personal allowance reduces by £1 for every £2 over the limit you are. For example, if you take an income of £24,500 per year, your personal allowance will be reduced by £250 to £9,690. If you have an income over £100,000 a year your allowance could be reduced to nil irrespective of your age.
How do I set up a pension?
There are two mains way to start saving into a pension: joining a workplace scheme and setting up your own personal pension.
You can set up a personal pension at any time, whether you are employed, self-employed or not working. You can arrange to buy a pension through a life company, insurance company or bank.
A word of warning: if you are going to set up your own pension you should make sure you do not just take the first deal offered by your bank or insurance company. Make sure you shop around to get the best pension product for your needs at the best price.
Use price comparison websites to check the following:
- What is the return on investment over a set number of years (if the money is ultimately invested by a financial institution rather that the individual)?
- How many funds and what different types of assets does the pension cover?
- What is the minimum investment amount?
- How much does the pension charge in annual fees?
Alternatively, you could use an independent financial adviser (IFA), who can look at the whole of the pensions product market to determine which pension would be the most suitable for you.
If you are employed but not part of your employer’s pension scheme you will be automatically enrolled (known as auto-enrolment) into the scheme from this year. Each employee who is aged 22 or over but under the state pension age, and earns more than £7,475 per year will be auto-enrolled into their workplace scheme.
The pension you are auto-enrolled into will benefit from contributions made by the employee, the employer and the government. The employee will pay 4% of their gross salary, before tax is paid; the employer will contribute a further 3%; and the government will provide tax relief of 1%.
For example, if you pay £40 into the scheme each month, your employer will contribute £30 and the government will give you tax relief of 1% – equivalent to another £10.
Although everyone will automatically be put into their workplace pension, they can opt out if they choose, although they will have to opt out again every three years. If a company does not have a workplace scheme, employees will be auto-enrolled into the government’s National Employment Savings Trust (Nest).