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The state pension provides a basic income for retirement, although not everyone is entitled to receive it and even those who do qualify may not receive the full amount. Even for those who do, it may not be enough to live on. It’s therefore important for people to make their own pension provisions, which the government itself is trying to encourage. Even if you don’t know much about pensions, you’ve probably heard talk of the ‘pensions crisis’ now being faced by people in the UK. A combination of various factors has resulted in a need for extra saving for retirement. Medical advances have improved the general state of health of the population in recent decades, allowing more and more people to enjoy long and active retirements. Along with the issue of slower stock market growth over recent years, this means that many people may not have as much money as they had anticipated to see them through their later years. As a result there’s been a huge government and media focus on planning for retirement, trying to raise awareness of the importance of setting aside as much money as possible during working years in order to live comfortably and securely in retirement. However, the subject of pensions can be mind-boggling and it can be difficult to know where to start. That’s why we’ve created this guide – it’s a basic introduction to private pensions and the options available. It’s intended as information and does not constitute financial advice. You should always speak to a financial advisor for help and advice before making any major financial arrangements. You might be asking yourself ‘why bother with a pension – there are lots of other ways to save?’ Indeed there are – from savings accounts to stock market investments – but the one key difference with pension schemes is that contributions made into them benefit from tax relief, and the retirement income from them is not subject to tax. This is what makes pension schemes a popular way of planning finances for later in life. When it comes to private pensions, there are two types – ‘defined contribution’ and ‘defined benefit’. You’ll only be able to get the latter (also known as ‘final salary’) through occupational (work) pension plans, depending on what your employer offers. However, anyone can set up their own defined contribution (also known as ‘money purchase’ pension plan. As the name suggests, ‘defined benefit’ or ‘final salary’ plans guarantee a certain income, which is calculated according to how much you earned in your last year of work with the company as well as how long you have worked there. The maximum income generally available is two thirds of the salary you earned in your final year. Such schemes are considered by many to provide the best income of any type of personal pension. However, they can be costly for employers to manage, especially as stock market returns have been dwindling over recent years. (Members’ contributions are invested in various stock market funds.) If the pension plan fund doesn’t have enough money in it to pay out its pensions, it’s up to the employer to make up the shortfall to ensure that the members still get their guaranteed income. Along with the tax on dividends introduced in the late 1990s, which must be paid by the employer, final salary schemes have become less and less attractive options for many companies. In defined benefit plans, the contributions that individuals make are invested in the stock market, and, at retirement age, the amount of money that has built up is used by the individual to buy an annuity, or a specified regular income. However, there’s no telling how much of an income the member will obtain as the pension fund into which the contributions are made is subject to the vagaries of the stock market, which may perform better or worse than predicted. It also depends on what the annuity rates are when the annuity is purchased. With most personal pension plans, there’s an element of choice as to how you invest your contributions. Different funds provide different levels of risk. The riskier the investment, the higher the potential return – although equally this can also mean the higher the potential loss. You’ll need to think about your attitude towards risk before you decide where to invest. Do you want to play it safe and go for less risky funds with less growth potential, or are you prepared to gamble with riskier investments in the hope of making a bigger profit? There are also various different options for purchasing annuities: • Purchase the annuity offered by your pension plan. • If you think you can get a better deal elsewhere, use your funds to purchase an annuity from any other financial services provider. • Convert up to a quarter of the fund into cash if you want a tax-free lump sum, and use the rest to buy your annuity. • If you’re concerned at the performance of your pension fund at the time your pension plan matures, you can delay buying your full annuity by instead purchasing an initial short-term annuity (five years maximum). By keeping your pension invested for longer before you buy your long-term annuity, its value could increase if the stock market picks up – although it could just as easily decrease if there is no improvement or if the stock market slows down further. • You could also hold off buying an annuity by drawing an income straight from your pension fund while it remains invested, although again, returns could decrease as well as increase. The financial term for this arrangement is ‘unsecured pension with income withdrawal’. • If you don’t want to buy an annuity at all, you can receive an ‘alternative secured pension’ from your 75th birthday. It used to be compulsory to buy an annuity by the time you reach 75, but the government changed the regulations to allow people over 75 to take an income straight from their pension fund. There is a limit to how much you can take though – up to 70% of an annuity. To sum up the key difference between defined benefit and defined contribution schemes, the former (‘final salary’) places the risk onto the employer, as they must ensure that a certain level of income is met, whereas the latter (‘money purchase’) places the risk onto the individual – if there isn’t enough money to provide a reasonable retirement income, the individual will need to have other financial contingencies in place (i.e. separate savings or investments) to compensate for the shortfall. You may also have heard of stakeholder pension plans. These were introduced by the government in 2001 as a quick, easy, cheap and convenient way to allow people whose employers don’t offer group personal pension plans to set up their own pension plan. They work in more or less the same way as defined benefit/money purchase schemes by raising funds through stock market investment in order to buy an annuity at retirement age. There are limits on how much the pension provider can charge for annual administration (1% of the fund value) and there are no penalties for leaving the plan, transferring funds or stopping payments towards it. The drawback is that the amount that can be invested is limited. This may not be a problem for low to middle earners, but those on high salaries may find them restrictive. This article is copyright protected and is not for republishing |
