A very quick and simple guide to pensions
What is the first thing that comes to mind when you hear the word pension? It may well be one of the following:
- It’s too far in advance for me to think about now.
- I don’t really understand pensions at all.
- It’s too scary to think about.
- I can’t afford a pension so will just hope for the best.
In this article we aim to demystify the whole area and provide a simple guide to pensions. We will look briefly at:
- What is a pension.
- Different types of pension.
- The advantages of pensions.
- When you can get your pension.
What is a pension?
A pension is a pot of money that you can accumulate during your working years to provide an income for retirement.
The three main types of pension are:
- State pension
- Occupational or workplace pension
- Private pension
Let’s take a quick look at each of these.
Different types of pension
There is no legal retirement age in the UK. Prior to 2011, you had to retire by age 65 at the latest. But now it is completely up to you.
However, there is a set age, fixed by the government, at which you receive your state pension. This is currently 66 for both men and women, and will rise to 67 between 2026 and 2028. It is scheduled to rise further to 68 between 2037 and 2039.
The full amount of state pension is currently £179.60 per week, before tax. But the actual amount you will be entitled to depends on your National Insurance record. You can check your specific situation by entering your details on the Gov UK State Pension forecast tool.
As well as your state pension, you might be entitled to a pension either from your current or previous employer or from a private pension scheme if you have ever paid into one.
Occupational / workplace pension
If your employer operates a pension scheme they are legally required to automatically enrol you in this if you earn more than £10,000 per year and are aged between 22 and state pension age.
Your employer will contribute money into the pension scheme, usually at least 3% of your salary. You can also make extra payments – either by Additional Voluntary Contributions or salary sacrifice – into many occupational pension schemes if you want to do so.
The pension scheme will be either a final salary or money purchase scheme:
Also called defined benefit, your pension will be based on your earnings and how long you are a member of the scheme.
Also called defined contribution, your pension will be based on the amount paid into the scheme, how this money is invested, and how well the investment performs.
Private or personal pension
You can choose to set up a private or personal pension whether or not you are in an employer’s pension scheme. This type of pension is a way of saving more for your retirement. You can make payments either on a regular basis or by a lump sum, and your payments will usually be eligible for tax relief.
There are two main types of private pension:
Your pension is managed by a finance company who will take complete responsibility for investing your pension money, telling you how much it is worth, and arranging for payment when the time comes.
A SIPP – Self-Invested Personal Pension – is a private pension that is managed by a finance company but you make all the investment decisions yourself. Whether this is stocks and shares, investment trusts, unit trusts, government bonds or any other kind of investments or funds is completely up to you; the finance company will not give you advice.
If you decide to invest in a personal pension it is worth taking independent financial advice to ensure that you are getting the type of pension that is right for your needs, and that will give you the best return for your money.
The advantages of pensions
There are three main advantages of having a workplace or private pension:
You can get your pension earlier than state pension age
Many occupational pensions can be accessed before state pension age, if you take early retirement from your job.
Most private pensions can currently be accessed at age 55, though this is expected to rise to 57 by 2028. You should be able to withdraw up to 25% of the value of the pension fund as a tax-free cash lump sum. The remainder of the fund can either be left in the fund to provide income. It can be accessed either on a regular basis (usually via a “drawdown” arrangement) or by occasional withdrawals. An alternative is to use the remaining fund to buy an annuity, which would provide you a guaranteed income for life.
Either way, there will be tax to pay on any money you withdraw from your pension once you have used up your 25% tax free allowance.
Your pension income will be higher
Obviously the more money you put into your pension pot, the more money will be available when the time comes to use it. So even though it may be a sacrifice to pay extra pension contributions to either a workplace or private pension, it is a good investment for the future.
You will pay less tax
You will not be taxed on any pension contributions you make.
If you have an occupational pension, your employer will normally sort this out for you. They may operate a net pay system, under which they deduct your pension contributions from your salary before you pay tax on them. Or they may operate pension tax relief at source, taking 80% of your pension contribution from your salary and requesting the remaining 20% from HMRC.
Some private pensions will also handle the tax relief at source, others may need you to complete a tax return and claim back tax on your pension contributions. If in doubt, check with your pension provider.
When you can get your pension
We have already seen that you cannot get your state pension until you reach state pension age, currently 66 – but that you may be able to access an occupational and/or private pension before then.
This means that if you decide to retire before state pension age, you can use your other pensions as sources of income. You may also want to continue doing some kind of work to fill any gaps. You are allowed to work and earn money even if you are drawing a pension.
This also applies to your state pension if you are eligible. So, even when you are state pension age (currently 66) you could draw your pension and still work.
If working provides you enough money to live on, you may decide to defer your state pension. If you do this you could either increase the value of your state pension by around 10.4% for each year you do not claim it; or you could have a lump sum later on for the deferred amount plus interest.
If you are continuing to work whilst also drawing one or more pensions, just bear in mind that you will continue to pay tax on the value of your combined income. So if you are in the position of deciding whether or not to draw a pension whilst still working, you need to look at your required level of income and work out the best combination that will provide that without you having to pay more tax.
At the moment any income over £12570 a year is subject to tax of 20%, rising to 40% tax for income over £50270 a year. You can find out more about personal allowance and income tax rates on the Gov UK website.
We hope that this article has demystified the world of pensions, and given you some inspiration about how to plan for a better future.
If you are currently in the process of sorting out your finances and need a small loan to cover any gaps, remember that Loans 2 Go offer unsecured personal loans which may be able to help.
Check back here soon for more financial and lifestyle tips from Loans 2 Go.