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Saving money for retirement is a very important act. By putting money aside, you are building up financial security for when you are no longer able to work. The sooner you begin to pay into a pension, the more money you will receive when you do reach retirement. There are many ways to do this and in this guide we aim to explain different types of pensions.
- What is a pension?
- What types of pensions are there?
- The basic state pension
- Second state pension (S2P)
- What does 'contracting out' mean
- Stakeholder Pensions
- Personal Pensions
- Occupational salary-related schemes
- Occupational definined contribution schemes
- Self-Invested Personal Pensions (SIPPS)
- What are annuities?
WHAT IS A PENSION?
A pension is a type of long-term investment which is in some cases exempt from tax. The money which is placed into your pension cannot be accessed until you reach the age of 55 (from April 2010; prior to that the age is 50). There are various rules and in some cases you can release or liberate your pension – this will be explained in the guide.
WHAT TYPES OF PENSIONS ARE THERE?
Generally, pensions divide into two main categories:
- State pensions
You may be eligible for a type of state pension, but it does depend on your circumstance. There are two main types of state pensions: the Basic State Pension and the Second State Pension (S2P). The Second State Pension was formerly known as SERPS.
- Non-State pensions
Non-state pensions are offered by companies (employers) and there are three main types: the Stakeholder pension, the Personal pension, the Occupational Salary-related Scheme and the Occupational Defined Contribution Scheme.
THE BASIC STATE PENSION
People who work in the UK generally pay National Insurance contributions which are deducted from their regular salary/wage slip. By doing so, a person is building up to be eligible for a basic State Pension when they reach pensionable age – this is currently 65 for men and 60 for women (note: the age for women will rise to 65 between 2010 and 2020. In 2024, the age for both men and women will increase to 68).
SECOND STATE PENSION (S2P)
UK employees can also build up a Second State Pension (S2P – formerly known as SERPS). The amount you get will depend on how much you earn your National Insurance Contributions (NIC) records from your entire working life. If you cannot work because of a disability or long-term illness, you may still be entitled to some S2P, but self-employed people cannot build up a pension via this method.
WHAT DOES 'CONTRACTING OUT' MEAN?
All employees who earn above a certain amount on which they make NICs are included in the Second State Pension unless they decide to reject this option – this is called contracting out. Once you do this, you will remain contracted out unless you decide that you want to contract back in. You can do this whenever you wish. If you contract out of the Second State Pension, you thereby give up your entitlement and build up a replacement within a personal pension fund. HM Revenue & Customs while also pay a rebate of your NICs into your personal pension.
Some employers offer Stakeholder pensions, or you can start one of your own accord. They are classed as money purchase pensions. Employers who offer stakeholder pensions may have the contributions paid via your salary/wages and they may choose the pension provider on your behalf.
There are some set minimum standards set down by the Government on this pension type, and they are:
- low minimum contributions
- flexible contributions
- transfers free of penalty
- limited charges
- an investment fund chosen for you if you don't want to pick one yourself
How do Stakeholder Pensions work?
Stakeholder pensions take your contributions, your tax relief and your investment returns and use them to build up a fund. This fund is then used to invest in shares and other investments in order to grow the capital over time until you reach retirement. Generally you can choose from a range of funds. Once you reach retirement, you may withdraw a lump sum from the fund (which is tax free), and use the rest to set up a lifetime annuity.
How much Pension Income will I get?
The amount of income you get from a stakeholder pension depends on a variety of factors. These include how much you pay into the fund, whether your employer also makes contributions, how well your investments perform over the years, how much was removed by way of charges (by the pension provider) and how much of a lump sum you remove.
Remember that by investing money in shares via a fund does put your money at risk of loss – especially if any of your chosen investments lose value. Make sure you are clear on the risks to your capital before you take a stakeholder pension.
A personal pension is ideal for people who are self-employed or for those whose employer doesn't arrange pension schemes. Like stakeholder pensions, personal pensions are a type of money purchase pension.
With a personal pension, you choose your pension provider and arrange regular contributions to. They will then claim tax relief (at a basic rate) and add this to the fund. Your provider will also offer a range of investments which you can choose from – make sure you understand them and how they work before placing your money on any of them. Note: higher taxpayers are required to claim additional rebate via their tax return.
Like stakeholder pensions, you can then take a lump sum (free of tax) from the fund once you reach retirement and can use the rest for an income (a lifetime annuity is most commonly used). In addition, the same factors apply to the amount of pension income you will receive – the amount you pay, the performance of your investments and the fees charged by your provider.
OCCUPATIONAL SALARY-RELATED SCHEMES
These are also known as Final-Salary schemes or Defined-Benefit schemes, and are offered by some employers. The scheme is run by trustees – they are appointed to look after your (and other scheme members') interests. Your employer will also contribute to the scheme and it is their responsibility to make sure that there is enough money when you reach retirement to pay you your pension.
There are some benefits and disadvantages to occupational salary-related schemes, including:
- The benefits are related to your working salary – so when you receive a pay rise, so does your pension benefit
- Your annual pension income generally rises each year in accordance with a set percentage or with the RPI (Retail Prices Index).
- Your pension is not dependent on a well-performing investment (such as the stock market).
There is risk that your employer is unable to pay the pensions come retirement, due to the business folding (becoming insolvent).
However, to combat this risk, the UK Government introduced a Pension Protection Fund in 2005 which is designed to protect against such an event from happening. In the event that an employer becomes insolvent, former and current employees are paid some compensation from the protection fund. Unfortunately, this may not be the full amount.
What if I Leave the Job?
You can preserve or defer your pension if you change jobs – you therefore stop paying into the pension and leave it at that until you reach retirement. On the other hand, you could transfer it to your new employer. However, there are one or two risks involved in transferring your occupational salary-related pension scheme – so make sure you seek independent financial advice before considering this option.
OCCUPATIONAL DEFINED CONTRIBUTION SCHEMES
This type of pension scheme is offered by some employers and is run by trustees who look after the interests of scheme members. Generally, employers contribute to the scheme and deduct your contributions before tax from your salary. This pension type is a money purchase pension.
Similarly to a stakeholder pension, an occupational defined contribution scheme uses the fund to invest in a range of investment types including stocks and shares. This is designed to lead to growth on the money over the years until you reach retirement. In general, you are able to choose from a range of funds to invest in.
When you reach retirement, you can take a lump sum from your fund (tax free) - Your lump sum must be removed before your 75th birthday – and the rest is used to give you an income. The amount you receive will depend on the performance of your investments, how much you pay into the fund, whether your employer also contributes, how much you take as a lump sum and so on. Remember to consider all of the risks involved in placing money in an investment or investments (such as shares). The value of the investments can go up – but also down.
SELF-INVESTED PERSONAL PENSIONS (SIPPS)
This is a type of pension fund which allows the holder to manage their own fund. It is a wrapper and holds investments for you until you reach retirement.
Generally, SIPPs are seen as being more beneficial for people who have investment experience and who have large funds. The charges and fees associated with SIPPs are typically higher than on a regular personal pension or stakeholder pension.
You can invest in a range of assets with a SIPP, including:
- Unit trusts
- Investment trusts
- Government bonds (gilts)
- Deposit accounts
- National Savings
- Commercial property
We have outlined SIPPs in detail in our Information Library under their own heading.
WHAT ARE ANNUITIES?
With money pension schemes (such as stakeholder and personal pensions) you can arrange for a lifetime annuity when you take your pension – to provide yourself an income during your retired years.
An annuity is offered by an insurance company in exchange for a lump sum – you can usually arrange for this through your pension provider. The annuity will then provide your regular income for a set period of time.
There are many different types of annuities, including:
- Lifetime Annuities
- Single or Joint-Life Lifetime Annuities
- Impaired Life and Enhanced Annuities (includes Smokers)
Your money purchase pension can be converted into a lifetime annuity – this will provide you with income for the rest of your life. This type of annuity is generally sold by a lifetime insurance company and you can tailor it to your needs – such as making it enhanced or impaired which can give a higher income if you are a smoker or have an illness/medical condition.
How Much do I Get?
The amount of income you receive from a lifetime annuity depends on a variety of factors, including how much is in your pension fund after you have removed a tax-free lump sum. Other factors include:
- Your health
- Your lifestyle
- Your age (the older you are, the higher your income will be)
- Whether you are male or female (men receive more because their life expectancy is lower)+
Single and Joint-Life Lifetime Annuities
You can choose to have a lifetime annuity just for yourself, or for yourself and a partner or dependant. The second option means that your partner/dependent will continue to receive income after you die.
A Single Life annuity is ideal for people who are single or have no other dependant relying on you for financial support. Alternatively may be married/have a partner, but your spouse has their own pension plan. A single life annuity will cease when you die.
A Joint-Life annuity continues to pay your partner/dependant even after you die, for their rest of their life. In some cases, there is a limit on the period of payments (for instance, if you have children on your joint-life annuity – it may cease when they reach a set age). A joint-life annuity generally is more expensive, because it is expected to continue for longer.
Make sure you find out exactly what is involved/offered from your annuity provider, as some have varying degrees of cover. For instance, some joint-life annuities don't cover your partner if you are not married or in a civil partnership. Others may not cover spouses/partners who are aged more than ten years younger than you.
Impaired Life and Enhanced Annuities
The income on impaired life and enhanced annuities are higher than on other types. This is because your lifespan is classed as being reduced thanks to health problems. An Impaired life annuity is available for some of the following health problems/medical conditions:
- Chronic disease (such as Asthma)
- High blood pressure
- Multiple sclerosis
- Heart attack
If you are overweight (obese) or a smoker, you could be eligible for an Enhanced annuity. In some cases, this annuity type is even offered to people who live in certain areas or have had certain occupations - have a look around to see what is on offer.
Can I Protect my Annuity?
You can protect your annuity if you want extra security after you die. You can set up a Guarantee period – this means your annuity will pay out for a pre-set amount of years whether you die or not. This is not a recommended option for a joint-life annuity because the income will stop at the end of the guarantee period rather than when your partner/spouse dies.
Alternatively, you can set up an annuity protection lump sum death benefit. This is designed to protect your annuity if you die before the age of 75. Your estate or beneficiaries will be paid a lump sum equivalent to the amount you used to buy an annuity when you die – there will be a tax charge and there could be an inheritance tax charge.
Generally, taking extra protection on your annuity will costs more than a regular annuity.
Are Annuities subject to Tax?
Annuities related to pension schemes are generally taxed as earned income. Note that there may be additional tax charges on annuity protection (see above). Please make sure you discuss this with your annuity provider.
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