Pensions – What You Need To Know
Our partners, financial planning experts Nudge, give the low-down on what you need to know about pensions
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Three important things you probably didn’t know about pensions
1. You’re not alone
A pension is very much like any other type of saving except that it’s specifically for retirement and crucially, you get some extra help too.
When you put money into a pension through your workplace, your employer pays into it too. How much will depend on the type of pension scheme you’re part of, but it’s something you should find out if you don’t know already, so you can understand exactly what’s going towards your retirement.
Pension contributions also benefit from tax relief. This means what you put in also gets topped up by the Government. So if you were to put £100 into your pension, it would actually only cost you £80, £60 or £55 depending on the rate of income tax you pay because the rest is in the form of tax relief.
2. Your pension savings will grow
Not only do you get help saving for retirement, but the money you put away will also grow beyond these contributions. Your pension is usually invested on your behalf, although there are types of pension where you have more control over where it goes. Any returns are added to your saving pot, though there is also usually a cost for managing where your pension is invested too. The longer period of time you save for, the more opportunity there is for that money to grow.
3. Your State Pension is unlikely to be enough to retire on alone
Many people don’t think much about saving into a pension, particularly when they’re younger, and may think that the State Pension will be enough. But this is unlikely. If you were to retire today and had no other savings (pension or otherwise) you would be entitled to only £175.20 per week at the most. That’s £8,767.20 per year. For many, this would not be enough on its own to live on.
The State Pension is also only available when you turn 65 currently (this is set to rise in future) while for non-State Pensions, you can access the money from the age of 55.
Understanding the type of pension you have
There are three main types of pension:
• the State Pension
• defined benefit pension
• defined contribution pension
You may have more than one type of pension.
State Pension
Most people get some State Pension. It’s paid by the Government and is a secure income for life which should increase by at least the rate of inflation each year.
You build up your entitlement to State Pension by making National Insurance contributions during your working life. In some cases, you can do this even when you’re not working, such as when you’re bringing up children or claiming certain benefits.
To be eligible for the full State Pension you will need 35 years NI record. You’ll usually need at least 10 qualifying years on your national insurance record to qualify.
From April 2016 a new flat-rate State Pension was introduced. For the current tax year (2020-21) the full amount of new State Pension is £9,110.40 per year.
However, you might be entitled to more than this if you have built up entitlement to ‘additional state pension’ under the old pre-April 2016 system – or less than this if you were ‘contracted out’ of the additional state pension.
Defined benefit pension
You’re most likely to have a defined benefit (DB) pension if you work in the public sector or for a large company.
This is a salary-related pension which pays out a secure income for life and increases each year. The pension you get is based on how long you’ve been a part of the scheme and how much you earn.
You might have a final salary type scheme where your pension is based on your pay when you retire or leave the scheme. Alternatively, you may have a career-average pension where your pension is based on the average of your pay while you were a member of the scheme.
Defined contribution pension
With this type of scheme, you build up a pot to pay you an income when you reduce your working hours or stop working completely. This is based on contributions from you and/or your employer over your working life and investment returns. Defined contribution (DC) pensions include workplace, personal and stakeholder pension schemes.
The size of your pot depends on how much you and your employer contribute, the charges and how well your investments perform.
You can start taking your pension from the age of 55. With this type of pension scheme, you can usually withdraw at least 25% of your pot tax-free.
What can you do with each pension?
State Pension choices
You won’t get your State Pension automatically – you have to claim it. You should get a letter no later than two months before you reach State Pension age, telling you what to do.
You can also defer taking it. If you want to wait to claim your pension, you don’t need to do anything. Your pension will automatically be deferred until you claim it and will increase by 1% for every nine weeks you defer. This works out at just under 5.8% for every full year.
The extra amount is paid with your regular State Pension payment when you finally take it.
Defined benefit pension choices
Most defined benefit pension schemes have a normal retirement age of 65. If your scheme allows, you may be able to take your pension earlier but this will reduce the pension you get quite considerably.
Again depending on your scheme, you may be able to defer taking your pension and this might mean you receive a higher income when you do take it.
When you take your pension you’ll usually have to decide whether to take some of it as tax-free cash. You can take roughly up to a quarter of the value of your pension benefits like this. Reducing the amount of tax-free cash you take will increase the amount of income you receive.
It is possible to transfer your defined benefit pension to a defined contribution pension which would then allow you to access your pension more flexibly. However, consider this option very carefully as you might be giving up very valuable benefits. Before going ahead with a transfer from this type of scheme speak to a regulated financial adviser.
Defined contribution pension choices
Once you reach 55 (or younger if you’re in poor health) you have complete freedom over what to do with your pension pot. However, the longer you leave your pot to continue building up, the more money you will have to live on in retirement. If you are still unsure of the best option for you, consider taking regulated financial advice.
Taking your pension – your options
You have four different options for taking a defined contribution pension when you retire, as well as a fifth option that's a combination of those. You can usually take up to 25% of your pension without paying tax.
1. Leaving it untouched
The earliest you can start taking money from your pension is usually 55 but you don’t have to – you can leave your money invested in the pension and continue contributing to it.
As long as your money stays invested in your pension, you won’t pay any tax. Any money you leave in your pension will pass on tax-free if you die before the age of 75.
2. Getting a guaranteed income
You might want to use your pension to buy an annuity which is a type of insurance policy that gives you a guaranteed income.
This is usually for the rest of your life, regardless of when you die, but can be fixed for a specific number of years if you would rather. Other choices include whether or not it provides for just yourself or your partner as well and whether the amount increases, decreases or remains level.
If you are in poor health, meaning you may not live as long, you are potentially able to take an enhanced annuity which will provide you with more money.
If you decide to buy an annuity you can still take 25% of your pension pot tax-free as cash. You would then likely pay income tax on the pay you get from your annuity.
3. Getting a flexible income
There are two ways you can get a flexible income from your pension:
• Take 25% tax-free lump sum in one go and then dip into the pension when you need it leaving the rest of the pension invested - this is called ‘flexi-access drawdown’
• Take smaller cash sums as you need them, getting 25% of each cash sum tax-free
With both of these options:
• They are specific retirement products that are bought from a pension provider
• You can take as much money as often as you want but there will possibly be a charge every time
• You could also still contribute to the pension up to a limit of £4,000 a year
4. Taking your whole pot as cash
If you take your whole pension in one go, 25% is tax-free and the remaining 75% is taxable.
If you’re considering this, you should think about how you can use the money to give you an income in retirement and seek professional advice.
Choosing a combination
Mixing your options can be complicated so it can be helpful to seek advice
Tax implications
You are likely to have to pay tax when you take money from your pension pot. Further tax charges will also apply if the value of all of your pension savings is above the lifetime allowance limit, currently £1,073,100.
Taking money from your pension may also affect the tax relief you can achieve on future pension contributions.
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Advice provided by our partners at Nudge. For more information visit https://www.nudge-global.com/
