Pension basics: The different types of UK pensions explained

Stephen Desmond


8 min read

Getting your head around the world of pensions can be a daunting prospect. So let’s start with the basics. Here we take a look at the different types of pensions available in the UK to help you decide which options feel right for you.


pensiontypes1

 1. Company pensions 

In summary:

  • Company pension schemes offer great tax benefits
  • You can also benefit from employer contributions
  • All companies must have a pension scheme by 2017
  • There are two types: Defined contribution and defined benefit

For most people, their first contact with pensions happens in the workplace. Many employers, especially large organisations, already offer company pension schemes and by April 2017 all companies will be required to do so by law. Under the new legislation, employers must have a pension scheme in place and workers will be automatically enrolled if they are over 22 years of age, earn more than £9,440 and are not already signed up to another plan.

For workers, a company pension scheme can be one of the simplest ways of putting some money away for retirement. Your employer, with the support of the pension provider they’re using, will typically be able to help you set up your company pension scheme quickly and easily when you start working for them.

One of the great benefits of a company pension scheme is that the company will often match your pension contributions. So if you pay in 5% of your salary to your pension pot, they may match this and pay in the same 5%, giving you a total pot of 10% of your salary for each year you pay in.

As with other types of UK pension, you can also get great tax benefits with a company pension scheme. Contributions to a company pension scheme receive tax relief at your marginal rate of income tax, so a basic rate tax payer will receive 20% tax relief, higher rate 40% and top rate 45%.

There are two main types of company pension scheme – defined contribution and defined benefit (also known as ‘final salary’).

Let’s first take a look at a defined contribution pension scheme. Your eventual pension pot here will depend on the amount of money paid in and how the scheme’s investments have performed during that time.

When you reach 55 you can take up to 25% of your total pension pot tax free. With your remaining pension pot, you can then use it to ‘buy’ a guaranteed income – known as an annuity – for the rest of your retirement years. Or, you can leave it invested in the stock market and take an income from it as it (hopefully) grows in value – known as a ‘drawdown’. The annuity gives you a fixed guaranteed income whereas drawdown will vary depending on the performance of your investments and you can draw all the money out of your pension and be left with nothing.

As of April 2015, you now have far greater flexibility in what you can do with your pension pot.

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Defined benefit (or final salary) pension schemes work a little differently. It guarantees you a certain amount of money each year once you retire. The amount you get is usually based on your final salary when you leave the company and the number of years you worked there. Some companies offer a career average scheme, where the benefit is based on your average salary rather than your final salary.  These schemes have historically been very popular in the private sector and with established large businesses, but have become less common in recent years as they have proved costly for employers to maintain. It’s now quite rare to join a company and find they’ll offer you the chance to join a defined benefit pension scheme.

Government figures from 2013 showed that defined benefit pension schemes tended to hold six times more retirement savings than defined contribution schemes[1].

As you move between jobs, you may have a number of options regarding what you do with your company pension. Depending on the type of scheme your company pension is in, you may be able to continue paying in to it once you leave the company, or you may be able to transfer it to another pension pot, or simply leave it as it is, in which case the money will remain invested and be there for you in later life.

2. Personal pensions

In summary

  • Open to everyone
  • Stakeholder schemes provide extra flexibility
  • SIPPs are aimed at those with investment experience
  • Pension reforms will give savers more control of their money from April 2015

An alternative to enrolling in a workplace pension scheme is to start your own personal pension, sometimes also referred to as a private pension. This involves making regular or lump sum contributions to a regulated financial organisation that invests the money on your behalf. Personal pensions are open to anyone and there is no requirement to be employed. If you’re working, then your employer may choose to make contributions to it as well.  You will still get the extra 20% from the government, which could rise to 40% or 45% if you pay higher or top rate income tax.

Personal pension schemes are often used by people who are not working, are self-employed, or their company doesn’t yet offer a pension scheme, or they’re not eligible to join the company scheme, for whatever reason. The amount of money available in your pension pot once you retire will depend on how much you have put in, the performance of the investments and any administration costs.

Again, you can take up to 25% tax free at the age of 55, then choose between buying an annuity for a fixed income in retirement and opting for drawdown, where your money stays invested in the stock market and you get a variable income from those investments depending on how they perform. The pension rule changes that come in to play from April 2015 will give you greater flexibility in what you can do with your pension pot.

There are a couple of types of personal pension, each with its own set of subtle differences. You may have heard of stakeholder pensions. These are essentially a form of personal pension that need to meet certain criteria. For example, annual administration charges can’t exceed 1.5% and they must accept contributions as low as £20. With stakeholder pensions you can also be allowed to miss payments or stop making contributions for a period of time without incurring a penalty. For these reasons, they are often very well suited to people who want some degree of flexibility.

Self-invested personal pensions (SIPPs) are aimed more at people with experience of the financial markets who want considerably more autonomy and flexibility. With these schemes you can take control of managing your own investment portfolio and make your own decisions as to where your money is invested, bearing the responsibility that entails.

It is also possible to enlist the services of an investment manager to make those investment decisions on your behalf. But bear in mind that not all investment managers are the same: the services they will offer, the way they’ll manage your investments and the charges will all differ. So it’s important to do your homework to get the right one for you.

Personal pensions along with workplace pensions are set for some big changes when the UK government’s reforms take effect in April 2015 [2].

According to chancellor of the exchequer George Osborne: “It’s all about saying to people, ‘Look, you have saved through your lives, you have worked hard for these savings, you should have freedom over how you access them, and I want to make sure you’re in possession of all the best information before you make those choices.'”[3]. So watch this space.

Chancellor George Osborne

3. The state pension

  • New state pension to arrive in April 2016
  • Minimum full pension payment of £148.40 per week
  • Full pension will require 35 qualifying years of National Insurance contributions
  • Questions remain over how long state pension can realistically survive

Anyone working in the UK who is over the age of 16 and earns more than £153 a week (or self-employed and makes an annual profit of at least £5,885) is required to make National Insurance contributions. Doing so for 30 years entitles you to a full state pension (increasing to 35 years in April 2017), which currently means a maximum weekly payment of £113.10. If you’ve missed out on paying National Insurance contributions, perhaps as a result of a career break, then it’s possible to make voluntary payments to catch-up.

Receiving payments does not mean you have to stop working. Depending on your financial circumstances you might choose to defer and start claiming at a later date, which could well mean you receive more money once you do start accepting payments[4].

Things are changing though. As part of the government’s huge reform of pensions in the UK, a new state pension will come into being for anyone eligible to start claiming on or after 6th April, 2016. At the time of writing, an announcement is yet to be made on exactly how much people will receive, but the full pension will be no less than £148.40 per week. You will need to have paid National Insurance contributions for at least 10 years to qualify for anything at all. After that, your contributions record will be used to calculate the size of payments.

If life expectancy continues to rise at current rates then it is quite possible the state pension age will also increase. Many media commentators have questioned whether the state pension will even exist in its current form 20 years from now, with some suggesting the state pension could be means tested in the future.

Which pension is right for you?

So that’s a rundown of the different types of UK pension available. The pension that’s best for you will depend on a number of factors: whether you’re self-employed or not, your age and retirement plans, and so on. A mix of different pension products may be best for you. But one thing’s for sure, the earlier you commit to investing for the future, the better position you’re likely to be in later on in life.

Figures released by the Office for National Statistics at the start of September 2014 revealed that from 2010-2012, 45% of men and 49% of women in Great Britain did not have any personal pension savings whatsoever[5]. A 2013 survey conducted by HSBC found Brits to be the worst in the world at building pension pots[6] and the average person was found to spend 19 years in retirement, but only had enough savings to last for seven of those.

Surveys have also revealed the considerable gap between what people expect to receive upon retirement and the reality of their financial situation. One research project found a 30-year-old starting to invest for retirement would need to put away a quarter of their salary to achieve a £20,000 pension[7]. Others have suggested a pension pot upwards of £600,000 is needed to guarantee a comfortable standard of living during retirement[8].

Many people believe they will rely on a state pension as their main form of regular income when they retire. However, the amount is unlikely to be enough on its own and if the eligibility age continues to rise then many will find themselves working long after they planned to. One recent survey suggested two-thirds of people are already continuing in employment past state pension age[9]. Taking steps to potentially offset this risk by investing in a workplace pension or a personal pension plan is therefore a very important consideration.

A common mantra in investing circles is ‘the sooner you start the better’. As well as the investment growth you can hope for from your pension pot over the full course of its investment lifecycle, you’ll also benefit from the power of compound interest – that is, the interest you earn not just on the money you’ve put in, but on the investment gains you have already accumulated.

 

Sources:

[1] ‘Final salary pension members ‘£149,000′ better off’ The Telegraph:

http://www.telegraph.co.uk/finance/personalfinance/pensions/10012343/Final-salary-pension-members-149000-better-off.html

[2] ‘Draft legislation – The Taxation of Pensions Bill’ Gov.uk:

https://www.gov.uk/government/publications/draft-legislation-the-taxation-of-pensions-bill

[3] ‘Osborne sets new rules pension revolution 18 million told hands retirement lump sum’ Daily Mail:

http://www.dailymail.co.uk/news/article-2699494/Osborne-sets-new-rules-pension-revolution-18-million-told-hands-retirement-lump-sum.html

[4] ‘Defer your State Pension’ Gov.uk:

https://www.gov.uk/deferring-state-pension/what-you-may-get

[5] ‘Statistical bulletin: Characteristics of People and Households Without a Private Pension’ Office for National Statistics:

http://www.ons.gov.uk/ons/rel/pensions/pensions-short-stories/characteristics-of-people-and-households-without-a-private-pension/characteristics-of-people-short-story.html

[6] ‘HSBC: UK worst in the world at saving for retirement’ Money Marketing:

http://www.moneymarketing.co.uk/hsbc-uk-worst-in-the-world-at-saving-for-retirement/1066367.article

[7] ‘Want a £20,000 pension? You’ll have to put aside a quarter of your salary’ The Guardian:

http://www.theguardian.com/money/2012/may/25/20000-pension-quarter-salary-retirement

[8] ‘Pensions: £600,000 needed for decent retirement pot’ The Independent:

http://www.independent.co.uk/money/pensions/pensions-600000-needed-for-decent-retirement-pot-8631647.html

[9] ‘Working into old age becoming the norm: Two-thirds continue to toil beyond state pension age’ This is Money:

http://www.thisismoney.co.uk/money/pensions/article-2725037/Working-longer-s-norm-two-thirds-continue-work-state-pension-age.html

Risk warning: As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Pension rules apply and tax rules may change in future. If you need help with pensions, seek independent financial advice.

 

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Stephen Desmond

Stephen regularly contributes to the Nutmegonomics blog – writing about investment and personal finance.


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