There are a huge number of different types of pensions available in the market, this is just a brief summary of some of the terms that you may encounter when looking at pensions.
- Final Salary/Occupational Pension
- Defined Contribution Schemes
- Personal Pension
- Tax Free Cash
- Annual/Lifetime Allowances
- Open Market Options
- Income Drawdown
Final Salary/Occupational Pension
Often known as Defined Benefit Schemes, these sorts of pensions are now generally less common than they once were. The main occupational pension schemes still available are within the public sector, although some Firms still offer occupational pensions on a defined benefit basis. “Defined Benefit” generally means that you do not know what you will pay in over the term of your working lifespan, but you do know what you will get at the end as a percentage of salary when you retire from the Scheme. Generally, these sorts of schemes are index linked in payment and they offer a generous tax free sum at retirement, together with accompanying lump sums if the pension member dies in service prior to retirement. Dependents benefits are also generally available.
Defined Contribution Schemes
“Defined Contribution Schemes” basically covers every other sort of pension.
“Defined Contribution” means that you know what you will pay in, the contribution is generally set by you, or your employer. Most employers now still offer an occupational pension scheme, into which they will pay, and the member generally pays as well, but the basis of the scheme is now more commonly a defined contribution scheme, meaning that you build up a fund and when you retire, you take a tax free lump sum from the fund, with the balance being made available to pay you an income in retirement. Defined contribution schemes give no guarantee of levels of pension at the point of retirement, they are generally invested in collective funds within the pension.
A personal pension is a defined contribution scheme which is owned by the member. Generally, the individual invests in a pension on a regular or lump sum basis and builds up a fund over the course of their working lifetime through their own contributions. The performance of a personal pension is dictated by the performance of the funds in which it invests, these are generally collectives. The risk and volatility of the pension is again, dictated by the funds in which the pension is investing.
As with most defined contribution schemes, the important factor is to fund your pension as much as you can, especially in the early years. Because in the long term, the level of your retirement benefits will be dictated by the amount of money you have paid in over the period of your working lifespan, and the performance of the underlying funds.
Generally for the larger fund, a SIPP may be attractive. SIPP stands for “Self Invested Personal Pension” and it is a defined contribution scheme, but the member takes more control over what they invest in. For example, a member may wish to have their pension fund invested in a commercial property (perhaps for use in conjunction with their business), or indeed, the member might wish to take more control and invest in individual shares. A SIPP is a defined contribution scheme, it invests generally in investments that are subject to fluctuation and do not offer guarantees, and like all defined contribution pensions, it does not offer a guarantee of any level of income at retirement, ultimate levels of retirement benefits are always based upon investment performance.
Tax Free Cash
Under current UK Inland Revenue rules, you are eligible to take a proportion of your retirement fund as tax free cash at retirement. This is generally 25% of the fund value and the remaining 75% is then used to generate an income for you in retirement.
Recent Governments have introduced restrictions on how much you can pay into a pension each year, and also, how much you can accumulate within a pension during your lifetime. Both of these limits are subject to constant change by successive political administrations, but the net effect of the annual allowance and the lifetime allowance is that you need to monitor your pension funds closely, and also ensure that you fund your pension sufficiently in the early years of your working career, before you start to run out of time because your annual allowance for total contributions becomes restrictive.
Equally, it is very important to monitor the level of your pension fund and measure it against the lifetime allowance, which again is constantly changing.
Pensions remain a very attractive and tax efficient investment providing you stay within your allowances.
Open Market Options
It is imperative that you seek advice prior to buying an annuity, rather than accepting your pension provider offers.
Income drawdown is now a very common way of taking income from your residual pension fund in retirement. Basically, most people take the tax free cash (25%) and then with the remaining 75%, they then need to generate an income. For many people, the best way to do this is to leave the remaining 75% invested, hopefully to grow, and a level of income is drawn each year from the fund based upon current prescribed rates which are issued by the Government’s Actuary Department. The levels of income are subject to review periodically, but the fund remains within the pension, unlike buying an annuity.
Currently, contributions into a pension are eligible for tax relief at your highest level of income tax. Obviously, like all things, this is subject to change.
Income drawdown is available on a capped and flexible basis, eligibility for each type of drawdown depends on the individual investor.
An annuity is basically where you hand over the balance of your pension fund to an annuity provider with the guarantee that they will give you a set level of income for the rest of your life. This income is generally guaranteed. The type of income chosen is up to you, you can have an annuity that pays just to you until you die, an annuity that is index linked, an annuity that pays to you and then to your Spouse, the choice is up to you. But, with an annuity, once purchased, the fund value has gone and has been exchanged for an income.
All of the investments mentioned above involve a degree of risk. The value of all investments can fall as well as rise, and often the value of an investment is not guaranteed. All of the above narrative is based upon our current understanding of UK Inland Revenue practice, which is always subject to change in the future, sometimes these changes can be retrospective.
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