Pensions Explained
Simple Guide to Pensions and Retirement Planning
We all have a decision to make as to how we would like to spend our latter years when the shackles of employment are no longer an issue, and we have leisure time on our hands.
What is a Pension?
A pension is an income that is received in retirement and helps to replace some of the earnings that are lost at the end of our working life.
How is the Pension Paid?
Normally monthly in arrears but is taxable.top
What Happens When We Retire?
1. We can rely on the state for a benefit that will be paid dependant on the National Insurance contributions made during our working lives.
2. Employees, (not self employed), are entitled to an additional earnings related state pension (SERPS), which began in 1978 and is dependent on national insurance contributions. For those a little long in the tooth there is also the state graduated pension entitlement for earnings between 1961-1975.
3. We may be lucky enough to have an occupational pension, set up by our employer who usually contributes into the plan for us. If the scheme is final salary then a guaranteed pension will be received at retirement related to the pensionable salary prior to retirement, which may be subject to the earnings cap for post 1989 members, and the number of years service with that employer. If the scheme is money purchase the pension received will be determined by the contributions made during that employment, the value of the fund built up over the years to retirement and finally to the cost of buying an annuity on the date you retire. The income received from either scheme is subject to the Inland Revenue maximum benefit limits for occupational schemes of 2/3 of final salary. See also group personal pension (GPP) below.top
4. We may have set up our own personal pension plan with a provider of our choice. The income that we receive from this, very much like the money purchase scheme above, will depend on the contributions. At our chosen retirement date, which can be any time between the ages 50-75, the fund is exchanged for an annuity which will provide a guaranteed income for life. It should be noted that annuity rates fluctuate dependent on interest rates, (long dated gilt yields), at the time of purchase and age, health and sex of the purchaser (annuitant). With this money purchase arrangement there is no limit to what can be received as a pension but there are limits to contributions that can be made and these are related to gross income, age in the fiscal year of payment and for post 1989 members subject to the earnings cap.
5. There may also be some retained benefits left behind within a previous employment pension scheme that will provide additional income. This will normally arise where at least two years service was completed at a time of leaving the company.top
What Type of Pension?
1. Level benefit guaranteed for 5 years to dependants.
2. Level benefit guaranteed for 10 years to dependants.
3. Joint life with spouse receiving % on your death
for life.
4. Indexed pension.
5. Fixed rate increasing pension.
6. Phased retirement.
7. Drawdown where an income is taken from fund (sort
of loan) in hope that annuity rates may improve at a later date.top
Explanation of above pensions
1. This is a level income paid for life to the member
but if he/she dies in the first five years the full pension will
continue to be paid to the end of the guaranteed period then cease.
2. As No. 1 above, but the guaranteed period is 10 years.
3. This is an income paid to the member until his/her
death when a % (e.g. 50%) may be continued to the spouse for life.
4. An indexed pension will give protection against the
effects of price inflation as it will increase each year in line with
the retail price index (RPI).
5. This is a pension which increases annually by a
fixed rate (e.g. 3%, 5%).
6. This is where a personal pension benefit is taken
in stages perhaps to facilitate members' desire to work part time and
supplement income from part of pension plan (e.g. working 4 days
instead of five then perhaps a year of two later work 3 days and draw
some more of the pension income).top
7. Income withdrawal is a sort of loan against the
fund, which may be taken because the member hopes annuity rates may
improve at a later date or maybe because he/she is young at the time
of drawdown, which must incidentally be a minimum 35% of maximum, and
because annuity rates improve the older you are. The member may need
a cash sum but may not need income at that particular time. It also
allows the member to retain control over their investments for
several years longer and leaves the investment with potential to grow
until the income is needed. This could mean that there is a larger
fund from which to buy an annuity in the future and which should
therefore produce a larger regular income. There are various other
reasons for taking drawdown and if this is of particular interest it
is suggested that the matter be discussed with a financial adviser.
N.B. The annuity under income withdrawal must be purchased by age 75
Advantages of Pensions
· Provides a guaranteed income for life.top
· Income can be indexed to keep up with price inflation.
· Qualifies for tax relief on contributions. What
this means is that a basic rate taxpayer receives an investment of
£100 gross for a net contribution of £77 as the inland
revenue make up the difference. A higher rate taxpayer receives the
same investment for a contribution of £60 but has to claim the
higher rate relief 17% in his/her tax return.
· Fund grows free of capital gains tax.
· Income derived by fund through dividends and
interest are tax free with exception of dividends from UK shares.
· At retirement a tax free lump sum can be taken
(25% for personal pensions, maximum 150% final salary for company
schemes prior to 1989 or greater of 2-¼ times retirement pension
and 3/80 ths of capped final earnings for maximum 40 years service
post 1989).
· If written in suitable trust falls outside of
estate for Inheritance Tax.top
Disadvantages of Pensions
· Money is tied up until retirement date (minimum
age 50).
· At present only available to those with
eligible earnings in UK.
· Pension income will die with you unless other
choices are made at retirement.
· If pension set up since 1989, earnings cap applies.
· Restrictions on level of contribution, (age,
whether company scheme, earnings cap).
· Company schemes have limits on levels of
benefits that can be paid, i.e. 2/3rds of final salary. (Earnings cap
may apply for post 1989 members).
· Funds from personal arrangements can pay
maximum 25% tax free cash.
· Income is dependent on annuity rates at time
pension is required so could be at bad time when interest rates are
considered poor.top
No two people are alike and we all have different goals in life and standards of living that we wish to achieve.
The first step to take towards these goals is to work out what is needed and desired for your retirement.
Help is at hand for those who want professional help and advice, it can be obtained through independent financial advisers (IFA's), or from product providers such as the insurance companies and through banks, through financial advisers or financial planning managers.
As pension planning is a major lifetime decision it is advisable to seek professional advice.
It is always a good idea to obtain a pension forecast from the DSS as to what your state benefits are likely to be and this is available by completing form BR19, which you can get from your local social security office, and send it off in the envelope that is provided.
The Government believes that the state pension is the foundation on which to build the retirement income that you need. The state pension alone is unlikely to provide other than for basic needs so additional planning is often essential.top
Incentives Available
Tax relief is given by the Inland Revenue to encourage more people to save for their retirement and not to rely entirely on the state to provide. As already stated the state pension is unlikely to produce more than one's very basic needs.
Employer's Pension Scheme
This is what most employees making plans for retirement will automatically be put into. They are also described as Company Schemes. Either an employee will be paid a fixed percentage of their final salary during retirement (final salary or defined benefit schemes) or income will be paid from the investment performance of fixed sums paid by the company to the employee's pension scheme (defined contribution schemes). In the former, the risk of performance of the pension money is borne by the employer, whereas in the latter, the risk of performance is borne by the employee.top
Because of the low returns in the current low inflation economic environment, more employers are moving to defined contribution schemes. It has been calculated that a 10% contribution over the working life of an employee retiring in the 1980s resulted in a 2/3rd final salary pension. Current projections suggest that the same payment rate for present day employees will only result in a 25% final salary pension.
Employees concerned about how much their scheme will pay them can make additional payments to their company scheme via Additional Voluntary Contributions.
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