Welcome to the Smart Team’s four-part guide to pensions.
Over the next two weeks, we’ll be looking at:
- how pensions work
- the differences between private/personal pensions and workplace (auto enrolment) pensions (plus salary sacrifice schemes)
- ways to draw down pension income including the Money Purchase Annual Allowance, and
- ensuring that enough cash stays in your pension so that the money doesn’t run out.
First of all, and at the risk of stating the blindingly obvious, “what is a pension?”
A pension is a long-term savings and tax-efficient vehicle that you invest in over a number of decades with the goal of providing you with enough earnings when you retire. There are different types of pension and several ways of realising your savings later on.
There are two major types of pension in the UK – a personal pension and a workplace pension. A personal pension is one that you select yourself and into which you pay your savings. A workplace pension is selected by an employer and both you, your employer (which could well be your own company), and the Government makes payments into it.
In this article, how pensions work…
Advantages of a private/personal pension
For many people, understandably, there is a reluctance to invest in pensions because there is the safety net of the state pension and any contributions towards a pension will reduce your take home pay. Your money is locked away until you’re 55 so pensions appear to lack the flexibility needed to cope with a person’s sometimes changing financial circumstances.
However the government is encouraging people to take personal responsibility for their retirement savings, because the State pension is struggling to keep up with the demands from a population that is living longer. State retirement age has been pushed back to 67 and is likely to go to 70 within a generation.
There are several important benefits to paying into a pension –
- Tax relief – for example, to invest £100 in a pension, a basic rate tax payer needs to pay in £80 and the Government tops this up by £20. For higher-rate tax payers, you pay in £60 and the Government tops it up by £40. For additional rate, you pay in £55 and receive an additional £45 from the Government. (Higher-rate and additional-rate payers must reclaim tax unless the company puts the money straight in from your pre-tax pay), and
- Employer contributions – with workplace pensions, your employer will top your contribution up by 3% (from tax year 2020/21) of your salary between £5,876 and £45,000.
- At retirement up to 25% of the pension can be taken free of tax. This is known as the “Pension Commencement Lump Sum”. Any sums over this limit will be taxed as earned income.
- Your pension fund can be passed to your spouse, children or grandchildren free of Inheritance Tax, making the scheme a means of helping your family by leaving them a legacy to help them towards their own retirement.
- Control your income tax – by making personal pension contributions you can recover lost tax and even reduce the overall rate of tax you pay. 40% taxpayers have the potential to recover their higher rate tax, recover the High Income Child Benefit charge, and even recover the lost Personal Allowance for those earning between £100,000 and £123,000.
In essence, you get some of your tax back on the money you put into your pension and the gains you make from its increases are mainly free of tax as well.
How much can I put in my pension?
You are limited on how much you (or the company you work for which runs the scheme to which you belong) can invest in your pension every year.
You can invest up to the amount that you earn (“earnings limit”). Any amount you invest above what you earn does not qualify for tax relief. So, if you earned £30,000 in a year but invested your entire £50,000 in savings, only the initial £30,000 would get tax relief.
An “annual limit” of £40,000 may be paid into your pension with tax relief for those earning £40,000 or more. You can also add an unused allowance from the preceding three tax years to that figure to maximise your advantage.
Smart Team Example – if you invested £20,000 in your pension each year for the last three years, you would have £60,000 in addition to your annual limit of £40,000 in this tax year.
If you earn more than £150,000 in a year (including salary, your pension contributions, and your employer’s pension contributions), your annual limit will reduce by £1 for every £2 you earn over £150,000. So, if you earned £170,000 over the year, your annual limit will shrink from £40,000 to £30,000.
Finally, there is a lifetime limit of, in the current tax year, £1,000,000. If your pension savings (including any interest or capital gains) are above this amount, you don’t get relief on any further contributions.
If you run your own company and have subscribed yourself into your own workplace pension (where your company also makes contributions), any contributions from your company count towards your allowance.
Smart Team tip – any money your company pays into your own pension account reduces profitability and therefore any corporation tax liability.
Final salary pensions
Although many of them are now closed, final salary pension schemes used to be the most common type of pension that people invested in through the companies they worked for.
Essentially, when you come to retire, you are paid a proportion of your “final salary”. Each year, your pensionable earnings are calculated to reflect any change in your pay. When you decide to retire, your final pensionable earnings are worked out once and for all.
During the time you’ve been saving into the pension, you’re building up an accrual rate every year – sometimes it can be one fiftieth or one sixtieth. The accrual rate is defined in the rules of the pension scheme.
As an example, if someone has been on a final salary pension for 30 years, each year they’ve saved counts as one fiftieth, and this person’s final pensionable earnings are £40,000, this is the calculation:
Length of service (30 years) X pensionable earnings (£40,000) = Pension of £24,000 per annum
Accrual fraction (50)
This means that, when this person retires, they will receive £24,000 income per year. In the third article in this series, we’ll look at different ways of accessing the cash.
Money purchase pension
This is now the most popular type of pension. With a money purchase pension, you can swap your cash at the end of the pension for an “annuity”, or take withdrawals directly from the pension fund, known as “pension drawdown”. An annuity is a type of insurance that will pay you a fixed sum (subject in many cases to inflation) for the rest of your life, but the guaranteed income will depend on age when you started the arrangement and cannot be changed. Pension drawdown is a more flexible way of taking withdrawals that can be changed but is not guaranteed to last for the rest of your life.
There are six main types of money purchase pension variations:
- Self-invested personal pensions (SIPP) – do-it-yourself pensions scheme. You decide where you invest. Income from assets within the scheme is not taxed and there is no capital gains tax payable on divestment from a particular asset.
- Trust-based workplace pension schemes – a workplace pension scheme run by a group of trustees that you appoint, not by a large pension provider.
- Contract-based workplace pension schemes – these schemes are managed by a third party (like an insurance provider) on the basis of a contract agreed between the member of the scheme and that provider.
- Trust-based pensions – money is kept away from your company by a board of trustees. These schemes allow benefits to be passed onto your partner or anyone dependent on you
- Group personal pensions – you will normally have the choice of the type of investment you want to make with a group personal pension but an employer chooses the third-party insurance provider.
- Stakeholder pensions – similar to the workplace pensions mentioned above. Their main features are low minimum contributions with capped charges and flexible payments.
What are the types of things my pension can invest in?
Pension companies invest in many different types of asset. It’s your decision to choose a pension whose investment strategy and risk profile matches your own.
Most people investing in a pension choose providers offering a diverse portfolio of assets to try to spread the risk. It’s always dangerous to put all your eggs in one basket. What may be the darling of investments one year might be toxic next year (think dot-com shares at the turn of the century, complex derivatives around the time of the Financial Crisis or US housing stock at the start of the credit crunch).
If you run a SIPP scheme, you are allowed to invest in and receive the tax benefits on –
- stocks, shares, futures, and options (only on a recognised exchange)
- authorised UK unit trusts
- open-ended investment companies
- UCITS funds
- unauthorised unit trusts as long as they don’t invest in residential property
- unlisted shares
- FCA-regulated investment trusts
- unitised insurance funds from EU insurers and IPAs
- deposits and deposit interests
- commercial property (including hotel rooms)
- non-residential ground rents
- traded endowments policies
- derivatives products
- legislatively-approved, investment-grade gold bullion
SIPP schemes are designed for experienced investors comfortable with the risks associated in taking their own decisions.
We look in more depth at the different types of pension offered and the salary sacrifice scheme.
If you have any questions on pensions, please call Smart Team on 01202 577500 or email [email protected]