Pensions explained

What is a pension?

Pensions are tax efficient savings products that are designed to help you save money for your retirement. Pensions can be complicated, especially when it comes to all the rules and regulations that surround them.

The pension landscape has changed significantly in the last 20 years or so, as the way in which people work has changed.

In previous years, it was much more common to take a job with a company that you would stay with from the day you were employed until the day you retired.

Now, people change jobs much more frequently, and many are also self-employed, all of which makes a difference to the type of pension that you will probably have.

What type of pension do I have?

Aside from the state pension, there are two main types of pension available: defined benefit or defined contribution. Each has its benefits and drawbacks depending on your personal circumstances

What is a defined benefit pension?

A defined benefit pension (sometimes called final salary pension or career average earnings pension) share one common and highly valuable characteristic - at retirement they promise to pay you a secure income for life

it is often referred to as a final salary pension as the amount of pension you receive depends on your salary and the length of time you worked for the employer; the underlying performance of the investments does not dictate how much pension you receive.  

These are considered the gold standard for pensions, but have become increasingly rare as the financial burden of meeting the pension liabilities falls heavily on the employer.

The employer is duty bound to make up any shortfall, which with an ageing population is a tall order, and is one of the main reasons why these pensions are rarer than they were.

What is a defined contribution pension? 

A defined contribution pension (also known as a money purchase scheme) can be a private or workplace pension, whereby you and/or your employer contributes towards your retirement fund. The amount you receive from your pension depends on the amount of money there is saved in your pension pot when you retire. The investment performance of these pension funds therefore becomes much more important to the individual than in a DB scheme.

This type of scheme can be a private pension or workplace one, involving you and often your employer contributing to your retirement fund. Indeed, since the introduction of auto-enrolment in 2012, anyone in employment is likely to have been enrolled into a workplace pension. 

A workplace pension is simply another form of a defined contribution designed for more than one person to use for their pension savings.

But the premise remains the same, the amount contributed by you (and your employer) and the performance of the underlying funds is directly linked to the amount of money you will receive at retirement.

Pension contributions and tax relief

Do pension contributions reduce your taxable income?

The money you put into a pension attracts income tax relief at your marginal rate of tax, which could be basic rate at 20%, higher rate at 40% or additional rate at 45% (different rates apply to Scottish taxpayers), but it is not without limits.

Currently, the maximum pension contribution you can make into a pension and still receive income tax relief on your pension contributions is £40,000 per annum, providing you have paid enough tax in the year to qualify for that relief.

The taxman will not give you back more than you have paid in for a single tax year.

If you have already started taking your pension, then you may be limited to as little as £4,000 a year in contributions that attract tax relief. These limits are for the entire pension, no matter who is contributing to it.

The lower £4,000 limit will apply if you have taken more than the 25% tax free lump sum from your pension.

If you have paid more than this annual allowance into a pension, then you will be penalised and have the additional amounts paid taxed as income at your highest rate. 

How to carry forward pension allowance?

It may be possible to carry forward any unused annual allowance from the previous three tax years, but there are certain rules you must adhere to. You must earn at least the same amount as you want to contribute in total in this tax year.

The exception to this would be if your employer was making the contribution for you, either way, you should get advice before attempting carry forward to make sure you are working within the rules.

If your taxable income from all sources, combined with any pension contributions paid by your employer, exceed £240,000 a year then you may lose the annual allowance available to you at the rate of £1 for every £2 over this threshold until you reach a minimum allowance of £4,000.

Where to invest your pension fund

The way in which you invest your pension will largely depend on your attitude to risk, and how far away from retirement you are.

If you are very close to retiring and will be dependent on the income from your pension to pay your bills, it is not wise to take excessive risks with your pension pot, because if markets turn against you then there is likely to be too little time for your fund to recover. 

If you are a long way from retirement then a more aggressive strategy is likely to yield higher returns, which should give you a bigger retirement fund to draw on when you finally stop working.

The strategy for your pension should be discussed with your adviser, and your options could depend on the type of pension you have.

For example, if you have a scheme provided by an employer, you may have no say over how the fund is invested, while if it is with an insurance company, you may have a number of fund options to choose from.

If you have your money in a Self-Invested Personal Pension (SIPP) or a Small Self Administered Scheme (SSAS) you will have the widest range of investment options available but this in itself can cause difficulties, as more choice does not necessarily make choosing easier.

Dealing with your pension investments is a highly personal thing, and you should take advice on the best strategy for you.

What is lifetime allowance? 

The Government not only restricts the amount you can put into your pension each year, it also limits the amount you can have in your personal pension pot overall , this is known as the lifetime allowance.

For the 2022/23 tax year, the Lifetime Allowance as it is called is capped at £1,073,100 (and will remain frozen at this level until April 2026). This may sound a lot, but remember this also includes any employer contributions and any investment returns you have achieved over the time you have had your pension invested.

If you breach this limit, then any amount over this level will be taxed between 25% and 55% depending on how you extract this extra capital from your pension fund. 

When can I take my pension? 

Once you have reached normal minimum pension age, which is currently set at 55. You can choose: to take your pension pot as a lumpsum; convert your pension pot into an annuity or drawdown your pension flexibly using phased retirement or other retirement income products.

Note: These options are not available to defined benefit pension schemes and the age at which you can take your pension will be scheme specific. 

There have been a number of changes to the way you can extract money from your pension plans in recent years.

The pension options described above generally apply only to defined contribution (money purchase) pension pots such as personal pensions, group personal pensions, self-invested personal pensions (SIPPs), and stakeholder pensions. These options are not normally available to defined benefit pension schemes.

Making the right choice means taking into account the risk factors in connection with each type of withdrawal and deciding if this is right for you. The value of investments and the income derived from them can fall as well as rise. You may not get back what you invest.

Although some pension providers will allow you to access your pensions without the benefit of financial advice you are making an irreversible decision which could have long term consequences for the standard of living you can enjoy in retirement.

If you would like to find out more about how we can help you with your pension, get in touch to arrange a free consultation.

Arrange a free consultation