By Mr. MoneyJar
A pension is a long term savings fund, paid into over the course of a person’s working life, as a way to save up for retirement. Once you reach retirement you can access it either by spending it bit by bit, or by using it to buy an insurance product called an annuity, which will pay you a set income for the rest of your life.
Aside from the accessibility criteria, your pension is fundamentally very similar to any other sort of savings account. It is a real, active account that you can - and should - check regularly.
You can nominate a beneficiary to receive the money you’ve saved if you pass away before you retire (mine’s my partner), and like a bank account it’s possible to have one or many pension pots at the same time. Your pension may also be subject to management fees.
Where pensions do differ from regular savings accounts is that they are subject to annual and lifetime limits.The current annual limit is £40,000 per tax year for most earners, and the lifetime limit is £1.073m.
Pensions are also eligible for various forms of tax relief and bonus contributions, and the ‘retirement age’ can vary by pension type. The three types of pension are the State Pension, Workplace Pensions and Individual Pensions. We’ll cover each in detail within this article!
The State Pension
The State Pension was introduced in 1948 just after the Second World War, to ensure that workers had a social safety net once they reached the end of their working lives.
It’s funded by our National Insurance contributions - a form of income tax - and is paid to eligible retirees once they reach the State Pension age. To receive the State Pension you need to be a man born after 6 April 1951, or a woman born after 6 April 1953 and must have at least 30 qualifying years of National Insurance contributions.
The State Pension age is currently 65 years and is set to increase to 67 by October 2028. There are plans to increase it even further mainly driven increases in life expectancy over the decades. You can find out what your State Pension Age will be using the GOV.UK State Pension Age Calculator.
There are two types of workplace pension:
● ‘Defined benefit’ pensions, which pay out a specific amount of money as income depending on how long you’ve worked for your employer; and,
● ‘Defined contribution’ pensions, in which you (the employee) builds up a pension pot through regular salary contributions over the course of your working life
Defined contribution pension schemes are far more common nowadays and so will be the focus of this section.
With a defined contribution pension, a percentage of your salary is deducted from your gross salary every month and is invested in assets like stocks and bonds via a workplace pension scheme. Because the money is invested, the earlier you start contributing, the longer your money has to compound and grow. The final value of your retirement pot will depend on how those investments have performed.
If you are 22 years or older and earn over £10,000 a year, then there’s a high chance you’re paying into a Workplace Pension. 76% of UK employees currently do so. There’s a lot of buzz around investing nowadays, but long story short if you pay into a workplace pension, you’re already an investor - hurrah!
It is mandatory for employers to set up pensions on behalf of employees meeting the above criteria - called ‘auto enrolment’ - and for both parties to make a total minimum contribution equivalent to 8% of the employees’ gross salary. Further, under current rules at least 3% of this contribution has to come from your employer.
The remaining 5% contribution is made by you, the employee - a 4% contribution - and the government, who contribute a further 1% in the form of tax relief. Simply put, these employer and government contributions equate to free money. You can opt out of a Workplace Pension, but by doing so you’re missing out on free cash!
The percentages above are just the mandatory minimums, and also assume you’re a basic rate (20%) taxpayer. If you’re a higher (40%) or additional rate (45%) taxpayer, you could be entitled to even more tax relief.
Better still, some employers will ‘match’ employee contributions over and above the 3% minimum up to a certain point. Speak to your HR department or re-read your employment contract to find out if they do this.
For a list of the top paying workplace pension schemes, check out this database over at the Pensions and Lifetime Savings Association website. It tracks the most generous employer schemes, all of which have been awarded the Pension Quality Mark.
There are three types of Individual Pension - Personal Pensions, Stakeholder Pensions and Self Invested Personal Pensions (SIPPs).
You can pay into an Individual Pension at the same time as a Workplace pension, but Individual Pensions are also great options for people who are self-employed but also want a tax efficient way to save for retirement. Remember that 76% figure for the number of UK employees paying into a pension? Well that falls to just 31% for self employed workers. Scary.
● Personal Pensions enable you to make contributions to a pension pot set up with a pension provider, who’ll normally invest the money and manage it for you. The provider may also provide various investment plans depending on the amount of risk you want to take, or if you want your money in ethical or sustainable investments
● Stakeholder Pensions are like personal pensions except they have strict government rules on how they’re managed. These conditions are designed to make them more accessible and to limit the amount of charges that you have to pay. They are otherwise similar to Personal Pensions
● SIPPs are like Personal Pensions in that you set them up with a pension provider, but you have to fully manage the investments yourself. As such, SIPPs are most suited to experienced investors
How do I use my pension?
One thing we’ve not mentioned is that the age of access for a Workplace/ Individual Pension is slightly earlier than the State Pension age. Under current rules it’s 55 years, and this is known as the Pension Freedoms age. However as you’ve probably guessed, this age scheduled to increase to 57 by 2028, again because people are living so long.
All in all, your retirement will most likely be funded by your Workplace and/or Individual Pension from age 55 depending on how early you choose to take it, and then supplemented by your State Pension once it kicks in.
Once you reach Pension Freedoms age, you’ve a few choices. You can use your pension savings to:
● Buy an annuity - an annuity is a type of insurance policy that provides you a set income for the rest of your life
● Drawdown on your pension - this is where you re-invest your pension to provide a regular taxable income. The income you receive will depend on how those investments perform
● Withdraw it as a lump sum - you can withdraw up to 25% of your pension pot as a tax free lump sum and use it however you like, however, any subsequent withdrawals will be subject to income tax
You can also choose to do a combination of the above.
Some final thoughts
● Pensions can seem like a really distant, far off thing, but fundamentally, they’re very similar to any other savings account. The main differences are the age at which you can access the money, the contribution limits, and your entitlements to tax relief and bonus contributions
● The money in your pension is being invested. The earlier you start, the better chance your money has to compound and grow. If you pay into a Workplace or an Individual Pension, you’re an investor
● Take an active interest in your pension, check it regularly and have an understanding of what it’s being invested in. If you’ve worked at a few jobs, then chances are you have multiple pots. Make sure you keep on top of them!
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