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Beginners’ guide to pensions and retirement

Contents

When it comes to pensions, you have plenty of options…

They say 70 is the new 50 as many people live and remain fit and active for years longer than their grandparents. This means the need for a decent pension has never been greater.

Your retirement should be something to look forward to – a chance to take up new hobbies, spend more time with family or friends or travel the world – not worry about how to make ends meet.

Whatever you want to do, understanding how to build up enough retirement savings and how pensions work should help you achieve your goals.

In this guide we explain the different pension savings options you can have and how to make the most of your money when you come to retire.

How pensions work

Pensions can sometimes seem a confusing subject, full of financial jargon and complicated rules. So let’s start with the basics.

A pension is a tax efficient way of saving for your retirement. When you retire or reach a certain age, the pot of money you’ve saved is used to provide a taxable income until you die.

The current advantage of pension savings over the various other ways of saving is that you get tax relief on the money you put in – but more of that later in this guide. The exact tax benefits of a pension will depend on your personal circumstances and tax rules, both of which can change.

The level of income you receive from your pension plan will depend upon a number of factors including the value of the plan when you decide to take your pension, which isn’t guaranteed and can go down as well as up. The value of your plan could fall below the amount(s) paid in.

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What types of pension are there?

From the State: The basic State Pension

How much you get depends on the number of qualifying years gained through National Insurance contributions you’ve paid or been credited with throughout your working life. The number of qualifying years you require will depend upon your age and whether you are a man or woman. Men born after 5 April 1945 and women born after 5 April 1950 need 30 qualifying years to be entitled to the full basic State Pension.

For tax year 2014/2015 it pays £113.10 a week for a fully qualifying single person. If you have fewer than 30 years, your State Pension will be less than this but you might be able to top up by paying voluntary National Insurance contributions.

See www.gov.uk/state-pension for more information on what you’ll get, eligibility and how to claim.

Additional State Pension

As well as the basic State Pension, you may also be entitled to an Additional State Pension. This is linked to your earnings while you were employed and will vary depending on your personal circumstances.

You can obtain a State Pension Statement (previously called a pension forecast) of what you might get from the State, which includes both your basic State Pension and any additional State Pension entitlements.

To get a statement, either:

  • Apply online at www.gov.uk/state-pension-statement or contact the Future Pension Centre helpline on 0845 3000 168
  • or write to the following address –
    Future Pension Centre,
    Department for Work and Pensions,
    Tyneview Park,
    Newcastle Upon Tyne,
    NE98 1BA United Kingdom

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Pension schemes provided by your Employer:

Many employers provide an occupational pension scheme for their staff. An occupational pension simply means it’s linked to your occupation and work, rather than an individual stand-alone plan you choose for yourself. Occupational Schemes can be either Final Salary Schemes or Money Purchase Schemes.

Work linked pensions can be a good option as most employers will also make a contribution to your pension fund.

By 2017, all employers will be required to enrol eligible employees into a pension scheme which satisfies auto-enrolment legislation. Both the employee and employer will be obliged to pay a minimum level of contributions.

Types of Occupational Scheme:

Final Salary schemes (also called ‘defined benefit schemes’): These link your retirement income to your wages and your employment history. They can pay a retirement income equivalent of up to two thirds of your final salary. If your company offers one of these and you’re eligible to join – many are now closed – it may well be in your best interest to do so.

Group Money Purchase schemes (also called ‘defined contribution schemes’): With this type of pension, the size of your retirement income is linked to a number of factors, including how much money has been paid into your pension pot, and the investment growth achieved. Companies may either run the scheme as an occupational scheme or alternatively provide a group personal pension or group stakeholder plan – often depending on the size of the firm.

Stakeholder Pensions

If your employer has five or more employees, and does not offer access to one of the previously mentioned types of scheme, you must as a minimum be offered access to a Stakeholder Pension.

Stakeholder Pensions are a type of Group Money Purchase Scheme that must meet a number of Government requirements.

These are:

  • A low minimum investment – as little as £20
  • Charges capped at 1.5% of the fund each year for the first 10 years, 1% a year thereafter, and
  • The flexibility to stop, start and change contributions without penalty.

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If you’re self-employed

Individual Pensions

You can also save for your retirement in an individual pension. This is basically your own pension pot that will continue regardless of where you are working. You can even pay into an individual pension if you’re not working, up to certain limits.

Individual pensions can be split into three types:

  1. Stakeholder Pensions
  2. Personal Pension Schemes
  3. Self Invested Personal Pensions (SIPPs)

Stakeholder Pensions must meet a number of Government requirements.

These are:

  • A low minimum investment – as little as £20
  • Charges capped at 1.5% of the fund each year for the first 10 years, 1% a year thereafter, and
  • The flexibility to stop, start and change contributions without penalty.

Because they have to be low cost, you may find that the number of funds you can invest in is more limited than a non-Stakeholder personal pension plan.

Personal Pension Schemes

These schemes are likely to have a higher minimum contribution – often at least £100 per month – and higher annual charges than Stakeholder schemes.

However, they normally offer greater investment choice and flexibility.

SIPPs

Although with most personal pension schemes, you can let your pension provider make the day to day investment decisions, a Self Invested Personal Pension (SIPP) can allow you to take a much more active role in the investment of your pension pot.

You may be able to choose from a range of fund managers – not just the ones from your pension provider – and you could invest directly in commercial property. But you should seriously consider getting financial advice before you sign up.

Please bear in mind

Where the value of your pension pot relies on investment growth, you need to remember that the value isn’t guaranteed and can fall as well as rise depending on investment performance (and currency exchange rates where a fund invests overseas).

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Questions to ask

The pension you choose will depend on your individual circumstances. To get you started here are some questions to ask:

Will the State Pension give me enough income to maintain my current lifestyle?
If you think you would need more than the pension available from the State, you should probably start to think about saving for retirement sooner rather than later.
Does my employer have a pension scheme and would they contribute towards my pension?
If your employer has a pension scheme, you should certainly consider joining, particularly if your employer will contribute. Remember that by 2017, all employers will have to provide their employees with access to a pension scheme and contribute to it.
What are my existing pension arrangements?
You may be a member of your current or former employer’s occupational pension scheme or group personal pension, for example. Alternatively you could already have a personal or Stakeholder pension.
Do all individual pensions receive tax relief?
Usually any payments that you make into a personal or Stakeholder pension plan can qualify for full tax relief. So, effectively, the taxman ‘tops up’ your pension. The value of the tax benefits depends on your individual circumstances. Your circumstances and tax rules may change in future.

How does it work if I am a basic rate taxpayer?

If, for example, you make a payment of £80 a month to your individual pension plan, HM Revenue and Customs will top it up with an additional payment of £20 (basic rate tax relief). So you now have £100 a month going into your pension plan.

What you pay: £80
Add tax relief: £20
Total going in to your pension: £100

How does it work if I am a higher rate taxpayer?

If, for example, you pay the same £80 you’ll get the same automatic £20 top-up. You can then claim the difference between basic and higher rate tax relief in your self-assessment tax return. This is currently £20, so your £100 gross payment effectively costs you only £60 under current tax rules.

What you pay: £80
Add automatic tax relief: £20
Additional tax relief you reclaim: £20
Net cost to you: £60
Total going in to your pension: £100

The information on this page is based on current tax rules, which may change in the future.

Additional rate taxpayers (those with taxable income over £150,000 pa) may also claim additional rate tax relief via their tax return.

Is there any upper limit to how much I can pay in?

No, but you should be aware of the following:

  • Tax relief is only available on contributions that don’t exceed your relevant UK earnings, or £3,600 if higher, in each tax year. Relevant UK earnings are income from employment or self-employment, subject to UK tax. Your pension provider may not be able to accept contributions which do not qualify for tax relief.
  • If the total contributions to all your pension plans in any tax year, including any by your employer, are more than the Government’s Annual Allowance, you’ll normally be liable to pay a tax charge based on your highest rate of income tax. The Annual Allowance is set at £40,000 for the 2014/2015 tax year.

If the total value of your pension benefits is more than the Government’s Lifetime Allowance, a tax charge will normally be deducted from the excess amount, before it is paid out. The Lifetime Allowance for the 2014/2015 tax year is set at £1.25 million.

The information on this page is based on current tax rules, which may change in the future.

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When you retire

The moment has come for you to retire. You can normally decide to take a retirement income from your pension from age 55, in many circumstances even if you’re still working.

At your selected pension date, you’ll have a number of options to choose from. You don’t have to make these decisions until you’re approaching retirement, when you may want to discuss your options with a financial adviser.

If you are a member of a final salary scheme, the retirement income you’ll receive will be determined by the rules of the scheme. It will be based on your earnings and the length of time you’ve worked at the firm. You’ll need to contact the scheme administrators for details of your retirement income, and your options.

If you are a member of a money purchase scheme, you will have a number of different choices depending on the size of pension pot you have built up, the type of pension you have and how old you are.

You don’t have to buy your retirement income (typically an annuity) from your pension provider. You or your adviser may be able to find another pension provider who can offer you a higher level of retirement income.

The value of the plan when you decide to take your benefits isn't guaranteed and can go down as well as up, and could fall below the amount(s) paid in.

Your retirement choices are likely to include:

  • Use your pension pot to provide a taxable income for life,
  • or take up to 25% of your pot as a tax-free lump sum, and use the rest to provide a taxable income,
  • or use your pension pot to provide income (and tax-free lump sum) in stages. This is commonly referred to as ‘phased retirement’.

The tax treatment depends upon your individual circumstances and may be subject to change in the future. Tax rules can change.

You’ll normally have options as to how you use your pension pot to provide income.

These include:

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Annuities:

An annuity is a plan which provides regular income payments or ‘instalments’ for life, in exchange for a lump sum (your pension pot). Once you have decided to buy an annuity, you must choose which type suits your needs. Once you've chosen an annuity, you won't be able to change or cancel it.

  • Level annuity. Your payments are fixed at the outset and continue at this level until you die.
  • Escalating annuity. Your payments can change each year. For example, you may choose an annuity which increases at a fixed rate each year of, say, 3% or 5%. Or you may choose an annuity which changes in line with the Retail Prices Index (RPI). Your annuity payments will initially be less than that available from a level term annuity.
  • Unitised annuity. If you buy a unitised annuity, you link your income to the performance of an investment fund or funds. This means your pension income could go down or up. There are typically no guarantees.
  • Enhanced annuity. (Sometimes called impaired life annuities.) People with medical conditions which could reduce their life expectancy such as high blood pressure, cancer or diabetes could get a higher income from their annuity. They’re paid more because the annuity company believes their life expectancy is less.

Before you buy here are a few questions to ask yourself:

  • Do I want to provide an income for my spouse, partner or any dependent children when I die? You can choose to buy an annuity which will continue to be paid to your spouse, partner or dependant(s) following your death. The annuity amounts payable to you will initially be less if you choose this option.

  • Do I want the payments to be guaranteed? This means they’ll continue to be paid for the guaranteed period (typically five years, but can be as much as ten) regardless of whether you die within that period. Your annuity payments will initially be less if you choose this option.

  • Do I want the income to remain level or increase or change as time goes on?

  • Do I want to be ‘locked into’ a plan for life? Other options may provide you with more flexibility.

Please bear in mind

You should always take financial advice before making any decisions about how to take your retirement income. Your adviser may charge a fee for this advice.

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Income Drawdown

An alternative to buying an annuity, income drawdown, as the name perhaps suggests, lets you ‘draw down’ (or take income) from your pension pot on a regular basis.

Your pension pot will remain invested. Each year, you can choose to take a taxable income from your pension pot, subject to limits imposed by the Government.

When can I buy an annuity with my pension pot in my Income Drawdown plan?

You can use all or part of your pension pot at any time to buy an annuity (though some providers may have age restrictions).

You must choose to take any tax-free cash lump sum at outset, when you first ‘move into’ drawdown.

On your death, the remaining pension pot can be used to provide a taxable income for your dependants. Or the pot can be paid to your beneficiaries as a lump sum, less a 55% tax charge.

If any income and the charges deducted from an income drawdown plan are more than any investment growth, the value of the plan will go down. This could reduce the amount of income that you can take in the future and the income from any annuity bought later.

Before you buy here are a few questions to ask yourself:

  • Do I have other income, for example from savings, to supplement my pension income?

  • Am I willing to take the risk that my overall income could be less through income drawdown than by taking it in one go through an annuity and cash lump sum?

  • Do I want to manage my pension fund and the income I receive?

  • Do I want to be able to leave a lump sum death benefit to my family if I die?

  • Is my pension pot big enough to allow me to take income drawdown? The minimum fund size is typically £100,000 after you’ve taken any tax-free lump sum.

You should always take financial advice before making any decisions about how to take your retirement income. Your adviser may charge a fee for this advice.

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Phased retirement

If you intend to ease yourself into retirement gradually, then you might want to consider phasing your retirement. On a regular basis, usually annually, you can use part of your pension pot to provide a taxable income, or take a tax-free cash lump sum and reduced income.

Your income can be provided either by buying an annuity, or by income drawdown.

The part of your pension pot not used to provide an income (and tax-free cash) remains invested with your pension provider. If you die before you’ve taken all your pension pot, the remainder can be used to provide a lump sum death benefit to your beneficiaries. Alternatively, it can be used to provide a taxable income for your dependants.

Before you buy here are a few questions to ask yourself:

  • Am I intending to give up work all at once or gradually cut down my working hours?

  • Do I have other income, for example from savings, to supplement my pension income?

  • Am I willing to take the risk that my overall income could be less through phased retirement than by taking it in one go via an annuity and cash lump sum?

  • Do I want to manage my pension fund and the income I receive?

  • Do I want to be able to leave a lump sum death benefit to my family should I die before the phasing is complete?

  • Is my pension pot big enough to allow me to phase my retirement? The minimum fund size is typically £100,000.

You should always take financial advice before making any decisions about how to take your retirement income. Your adviser may charge a fee for this advice.

Another option you could look at is to take out an equity release scheme which could possibly top up the amount you receive.

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What’s your situation?

I’m nearing retirement age, what should I be doing?

You need to find out how much money you have saved, and what income you can expect in retirement. Your pension provider(s) will be able to help.

Helpful notes

You also need to know how much you can expect from the State. You can request a State Pension statement up to 30 days before you reach State Pension age. You can apply online at www.gov.uk/state-pension-statement or contact the Future Pension Centre helpline on 0845 3000 168 or write to the following address –

Future Pension Centre,
Department for Work and Pensions,
Tyneview Park,
Newcastle Upon Tyne,
NE98 1BA United Kingdom

If you’re over State Pension age or less than 30 days away from it, you can’t get a State Pension statement. You’ll need to contact the Pension Service to get an estimate.

Telephone: 08456 060 265
Textphone: 0800 731 7339 Monday to Friday, 8am to 6pm.

You should always get financial advice before you come to any decision about your retirement. Your adviser may charge a fee for this advice. Remember, the choices you make could be for life.

If you find you don’t have enough income to fund your retirement plans you could look at the other options available to you, for example equity release schemes. In general terms, such schemes can let you unlock part or all of the value in your home. Your financial adviser can provide you with information on how these work, and advise you on whether or not they are suitable for you.

I’m already retired, what can I do to increase my retirement income?

If you have savings, consider whether they are producing enough income. Could they produce more? You may want to look at fixed rate bonds, or other savings accounts that pay a higher income.

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I haven’t started planning for my retirement, so where’s a good place to start?

It’s never too late to start planning for your retirement, as something is generally better than nothing. Take financial advice before you sign up to a new pension.

  • In your 20s: The earlier you can start the better, as your money will have the maximum chance to grow. Consider paying into any occupational pension on offer, as your employer may pay in contributions on your behalf. If no work related scheme is available you could look at an individual pension. Consider investing the maximum you can afford – though it’s worth noting you can’t normally touch the money until you are at least aged 55.

    Make sure you also have adequate and accessible emergency savings.

  • In your 30s: As you’re nearer retirement age, you’re likely to have to put more into a pension than someone starting in their 20s to achieve the same income. But you still have plenty of time to build up a decent pension. Consider paying into any occupational pension on offer, as your employer may pay in contributions on your behalf. If no work related scheme is available you could look at an individual pension. Consider investing the maximum you can afford – though it’s worth noting you can’t normally touch the money until you are at least aged 55.

    Make sure you also have adequate and accessible emergency savings.

  • In your 40s: If you haven’t started retirement planning yet, you’ll need to give some serious thought as to how much you should save. A financial adviser can help. Consider paying into any occupational pension on offer, as your employer may pay in contributions on your behalf. If no work related scheme is available you could look at an individual pension. You may also want to consider alternative savings plans to run alongside. Investing in an Individual Savings Account (ISA) is potentially tax efficient. Unlike a pension, tax relief is not available on your contributions, but any savings growth can be withdrawn free from personal tax.

    Once you’ve invested the maximum allowed in an ISA, consider the other savings and investment options available to you. Again, a financial adviser can help you to choose the most suitable investments for you.

  • In your 50s: Time may be running out to fund a decent retirement through a pension, but you shouldn’t forget how tax efficient a pension can be. Consider paying into any occupational pension on offer, as your employer may pay in contribution(s) on your behalf. If no work related scheme is available you could look at an individual pension. You may also want to consider alternative savings plans to run alongside. Investing in an Individual Savings Account (ISA) is potentially tax efficient. Unlike a pension, tax relief is not available on your contributions, but any savings growth can be withdrawn free from personal tax. Once you’ve invested the maximum allowed in an ISA, consider the other savings and investment options available to you. Again, a financial adviser can help you to choose the most suitable investments for you.

  • In your 60s: If you haven’t put anything aside for your pension by the time you reach your 60s, then your options are probably limited. If you intend to delay your retirement to your late 60s, then you may still consider a pension to be an option.

    However other types of savings plans may provide a more flexible alternative. Investing in an Individual Savings Account (ISA) is potentially tax efficient. Unlike a pension, tax relief is not available on your contributions, but any savings growth can be withdrawn free from personal tax.

    Other savings and investments can provide growth potential, or income potential. You should speak to a financial adviser to help you determine what are the most appropriate options for your circumstances.

Please bear in mind

The information on this page is based on current tax rules. The value of the tax benefits depends on your individual circumstances. Your circumstances and tax rules may change in future.

You should always take financial advice before making any decisions about how to invest for your pension. Your adviser may charge a fee for this advice.

Read our guide about Choosing a Financial Adviser or find an Independent Financial Adviser near you.