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Just what exactly
is a pension?

A pension is a government-incentivised, tax-efficient savings scheme that enables you to save money for your retirement. Because there are lots of different pensions and a large variety of investments you can save into, and rules and regulations to comply with, pensions might seem complicated.

 

In reality, they are simply a vehicle you can use to accumulate wealth during your working life and generate an income for yourself in retirement. 

Over the past two decades, pensions have changed significantly, as has the way we work. Today, the average person is likely to change jobs 11 times during their lifetime, and that number is on the increase. The onus is on you to keep track of your hard-earned savings and ensure your money is working as well as it possibly can be for you. 

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What types of pension are there? 

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

Defined benefit

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 aging population is a tall order, and is one of the main reasons why these pensions are rarer than they were.

Defined contribution

defined contribution pension (sometimes called money purchase pension) can be set up privately by an individual or set up by an employer as a workplace pension scheme. The fundamental difference between these schemes and a defined benefit pension is that the amount you receive from your pension at retirement depends on how much your pension pot is worth. This means your income is not guaranteed and depends on how much you (and/or your employer) pay into your scheme and the performance of the investments that your contributions go into. 

Nowadays, the majority of company pension schemes and all private schemes are defined contribution pension schemes. 

What types of pension are there?

How much can you contribute to a pension? 

How do pension contributions reduce your income tax? 

To incentivize retirement saving, the money you put into a pension attracts income tax relief from the government at your marginal rate of tax. That means if you are a basic rate taxpayer, for every 80p you contribute to a pension, the government top-up your contribution to £1 (basic rate of tax is 20% in the tax year 2021-2022). 

As of now, the maximum pension contribution you can make and still receive income tax relief is £40,000 per annum, assuming you have paid enough tax in the year to qualify for that relief. The government will not give you back more than you have paid into your pension 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 whether you or your employer are 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. 

Can you carry forward pension allowance?

It is possible to carry forward your unused annual allowance from the previous three tax years, however, certain rules apply. 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 to carry forward to ensure 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.

How much can you contribute to a pension?

What happens to your pension contributions?

This depends on the type of pension scheme you have.

If you are an active member of a defined benefit pension scheme, your contributions go towards paying for your accrual of benefits in line with the scheme’s rules – the pension you will receive when you retire. 

Defined benefit pension schemes are most commonly found in the public sector (teachers, civil servants, doctors, for example). They are rare in the private sector because of the financial burden they put on businesses.

Defined benefit pension schemes are only available from employers and cannot simply be set up by individuals.


If you have a defined contribution pension scheme, your pension contributions are paid into a pension pot, which you can access at the minimum pension age (currently 55). You usually have a choice over how your money is invested, subject to the restrictions placed on the scheme by the trustees usually there to safeguard you. 

Some schemes, especially group pension schemes, limit your choice of investments. Other pension schemes offer a wide variety of assets that you can invest in. 

Can you get my pension contributions back?

Pension contributions can only be refunded under very limited circumstances. Normally, once you make a contribution to a pension scheme you will not be able to access the pension funds until you have reached the minimum pension age, which is currently 55 and increasing to 57 in 2028.

Accessing your pension before this can trigger very punitive tax charges and you should not attempt this without seeking proper advice.

What happens to your pension contributions?

How is your pension invested? 

How you choose to invest your pension will depend on your circumstances, objectives, your attitude to risk, and how far away from retirement you are.

When you are nearing retirement and will soon be depending on your pension income to meet your living costs, it is not recommended to take excessive risks. If your investments perform poorly you may not have enough time to make up for this and it could result in you having to delay your retirement or retire with an impaired income. So near retirement, it is recommended to be prudent and cautious with your investment choices.

 

If you still have plenty of time before you plan to retire, a more aggressive strategy is usually recommended. This is because it will likely yield higher returns, which means your pension pot will grow bigger. 


In addition to the above, the type of pension you have may limit or restrict the choice of investments that you are able to hold in your plan. For example, with some company pension plans, you might have no say whatsoever over how your money is invested. Pensions offered by insurance companies often only allow access to a limited selection of funds. 

If you want the widest choice of investments, a Self-Invested Personal Pension (SIPP) or Qualified Recognised Overseas Pension Scheme (QROPS) are good options, depending on your circumstances, and often recommended when you are consolidating a number of older schemes. However, more choice does not necessarily make choosing easier.

The investment strategy and choice of investments for your pension are very important and should be discussed with a properly qualified financial adviser. 

How is your pension invested?

What is the lifetime allowance? 

As well as restricting the amount you can put into your pension each year, the government also limits the total amount you can have in your pension pot over your lifetime - this is known as the Lifetime Allowance (LTA).

For the 2021/22 tax year, the Lifetime Allowance is capped at £1,073,100. The allowance will remain frozen until April 2026). While this may sound like a lot of money, this also includes any employer contributions and any investment growth within your pension pot. Often people's pension schemes grow over time and breach the Lifetime Allowance threshold. If this happens, any amount over this level will be taxed between 25% and 55% depending on how you extract this extra capital from your pension fund. 

There are other tax-efficient retirement planning products that you can utilize if you have used up your LTA, or you can consider crystalising your LTA by transferring your pension to a QROPS. Speak to an Independent Financial Advisor for more information. 

What is the lifetime allowance?
When can you take your pension?

When can you take your pension? 

In recent years, there have been a number of changes to the way you can extract money from your pension plans. If you have a defined contribution pension, such as a personal pension, group personal pension, self-invested personal pension (SIPP), or a stakeholder pension, when you reach the minimum pension age, which is currently set at 55 but may soon rise to 57, you will have the option to take your pension as a lump sum; convert it into an annuity or drawdown your pension flexibly, using phased retirement or other retirement income products.

If you have a defined benefit pension, the above options will not be available because the age at which you can take your pension and the benefit you will receive are scheme specific. 

When determining when to take your pension, you need to 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 that 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.

What is Flexible Drawdown?

What is Flexible Drawdown?

The Pension Freedoms Act was a fairly radical piece of legislation, introduced in the UK in 2105. Under this new legislation, you can now draw down your retirement pot under flexible access rules at whatever level of income is required. It is important to understand that any money drawn down will be taxed as income at your highest marginal rate after the Pension-Commencement Lump Sum (PCLS) has been used up. It is possible to draw a combination of income and PCLS, so as to minimise your income tax liability. If you are living abroad, it is important to ensure that you are fully aware of the tax consequences in your country of residence before accessing your pension.

If you have a personal pension, such as a SIPP, you can begin taking benefits at any time between age 55 and 75. The minimum age is likely to be increased to 57. 

What are the Pension Freedoms rules?

The Pension Freedoms Act has changed the game for many people planning their retirement. Pension Freedoms, was introduced to help people with pension savings accounts to be able to access those savings in a more flexible way. Previously, defined benefit pensions were only accessible to retirees through the purchase of an annuity. While it’s still possible to buy an annuity with your entire pension pot, it’s no longer mandatory. Long-term, low-interest-rates make for low annuity rates - this has severely impacted the retirement incomes of retirees forced to purchase an annuity with their proceeds of their pension pots.

The Pension Freedoms Act was introduced in 2015 to combat some of the concerns of existing and future pensioners. Pensions Freedoms legislation means you are now able to access your pension pot in a way that best suits you. This might include options like flexible income drawdown and the ability to transfer your pension pot to a personal pension plan, such as a SIPP, which gives access to a much wider investment choice. These schemes give retirees the ability to generate an income from an investment portfolio instead of taking an annuity. 

Although ideally, everyone should make provisions to ensure their retirement income lasts their lifetime, the flexible drawdown of pension benefits also enables you to access your entire pension fund as a lump sum. This created some controversy and bad press as a few individuals rushed to cash in their pensions in order to purchase boats, fund exotic holidays, or settle debts. The risk is that people will be left destitute in their retirement. Withdrawals above the 25% tax-free Pension Commencement Lump Sum (PCLS) are also taxable as income at the individual's marginal rate. 

What are the Pension Freedoms rules?

What is the next step?

Pensions are complex and you need to ensure that you are armed with the correct information, based on your personal circumstances and objectives, in order to make an informed choice when choosing, or transferring, any pension plan. It is recommended that you take professional financial advice to ensure that you have the correct plan to meet your needs and that you are on track to meet your retirement goals.

Connect with an expert through our network of UK-qualified Independent Financial Advisors. Through our introduction, you will be entitled to a free, no-obligation pension review. 

What is the next step?
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