What is a pension?
A pension is a type of investment that aims to provide an income when an individual retires. In the UK, individuals can have a private pension, employers can provide a workplace pension, and the government may also provide a state pension, as long as certain criteria are met.
In the UK, pensions can either be classed as ‘defined contribution’ or ‘defined benefit’.
Defined contribution pensions allow an individual to accumulate a pension pot that is then used to provide an income during retirement. The income at retirement will vary depending on how much you have paid in, how well the funds have performed and your circumstances at retirement.
Defined benefit pensions are rarer these days than defined contribution pensions, as they provide an income based on how long you worked for an employer and how much you earned during that time.
What is a defined contribution pension scheme?
Defined contribution schemes are often the most familiar type of pension that people are paying into at the moment - either personally or more likely via your employer. Typically, the pot accumulates by your employer deducting a percentage of your pay (the amount you personally contribute), plus any additional contributions they make, plus any tax relief (government contributions) on your personal contribution, and additionally by any investment growth over time.
A defined contribution scheme can either be one your employer has enrolled you in (a group personal pension or stakeholder pension) or you can set up your own personal pension (SIPP).
Defined contribution pensions typically have two stages:
Stage 1 is when you are working and the money paid in is invested in funds, shares and other investments with the objective being to grow and accumulate a larger fund for use when you retire. There may be many decisions to make over time and the value of the pot can go up and down.
Stage 2 is from age 55 onwards when you are able to access the pension pot. At this point you could:
Take the entire pot as cash in a single lump sum, with 25% tax-free and the remainder taxed as normal income.
Dip in and take lump sums when you need them. Each lump sum will be 25% tax-free and the remainder taxed as normal income.
Take 25% of the pot as tax-free cash and use the remaining 75% to provide an income. This could be any combination of variable income (that depends on the performance of the investments) and an annuity (that pays a guaranteed income).
What is SIPP?
A SIPP, or self-invested personal pension, is a type of personal investment account (a wrapper) that holds your retirement investments until you retire, although the funds are only accessible from age 55 (rising to 57 from 2028). A SIPP works in a very similar way to those offered by employers, including receiving tax relief on your contributions, however, you have significantly more control and freedom over the investments you hold.
A typical defined contribution pension scheme offered by an employer offers a limited selection of managed funds for you to choose from, whereas in a SIPP you can invest your retirement savings in a broad range of funds, shares, trusts, securities, accounts, commercial property and more.
Clearly, this freedom means that you may face increased charges on your investments, the volatility may be higher and there could be a greater degree of risk you are exposed to.
What is a defined benefit pension scheme?
A defined benefit pension pays an income that is based on how long you worked for an employer and how much you were earning. As the name suggests, the income is not dependant on the performance of an investment (the employer is responsible for ensuring there is enough money in the scheme) and the income will typically increase each year to keep pace with inflation. Another benefit of a defined benefit scheme is that they often continue to pay an income (albeit reduced) to your spouse, civil partner or dependents when you die. These days defined benefit pension schemes are only available to those that have worked for very large companies or in the public sector (e.g. the NHS, military or schools).
To work out what your pension income could be from a defined benefit scheme you need to:
Take the number of years you worked for the employer,
Multiply this number by your final salary,
Divide this by the accrual rate (typically 1/60th or 1/80th).
For example:
You worked for your employer for 37 years,
Your final salary was £40,000, so 37 x £40,000 = £1,480,000,
Your scheme accrual rate is 1/80, so divide £1,480,000 by 80 = £18,500 each year.
There are different types of defined benefit pension scheme which will use alternative calculations, but this covers the most common of these types of scheme. Your annual pension statement will give you an indication of your projected income based on your current earnings, how long you’ve worked for the employer and what happens if you stay working there until the scheme’s normal retirement age (often 65).
Some schemes will also allow you to take a tax-free lump sum when you retire (which in turn normally reduces the amount of income you’ll receive), however, the income will be taxed as regular income.
What is the state pension?
The state pension is a benefit paid out to eligible recipients in the UK. This eligibility changes, depending on when you were born but is typically based on the number of years you have paid National Insurance (NI) and you need 35 years of NI payments and to have reached state pension age to receive the full amount. At the time of writing, the full state pension is just over £175 per week, or £9,110 each year. You can check your state pension forecast online, whatever age you are.
Your state pension age is the earliest age you can start receiving your State Pension and is currently set at age 66 for anyone reaching this age after 2018. This age is set to increase to 67 and then 68. The government is currently reviewing state pension ages, and they propose a new, shorter, timetable for a rise to 68, in line with continuing increases in life expectancy. You can check your own state pension age on the government website.
Why do I need a pension?
The basic aim of most pensions is to provide you with an income when you retire. Essentially, you are setting aside a percentage of your income whilst you are working to maintain your lifestyle when you are older. If you’ve been used to earning a reasonable salary over your lifetime, a sudden drop in income to the state pension of slightly over £9,000 each year (or less for some) could come as quite a shock and may leave you unable to stop working.
How much income do I need in retirement?
A useful yardstick to working out how much income you need in retirement is to multiply your current salary by 60%. To illustrate, if your salary is £20,000 you may need your pensions to pay £12,000 each year in income when you retire.
£30,000 earners may need at least £18,000 income in retirement.
£50,000 earners may need at least £30,000 income in retirement.
£80,000 earners may need at least £48,000 income in retirement.
£150,000 earners may need at least £90,000 income in retirement.
£200,000 earners may need at least £120,000 income in retirement.
As you can see, the state pension income of about £9,000 a year is unlikely to meet the income requirements of someone that retires earning £20,000. Therefore, there is a serious shortfall to fund and this is why pension saving from an early age is crucial.
What’s next?
If you are interested in reading how early investing can dramatically affect your retirement savings, you can read our article on compound interest. If you need help or advice with your finances and investment decisions, you can talk through your options with one of our Financial Advisors right here in Tunbridge Wells.
This article offers information about investing and should not be taken as personal advice. Remember that investments can go up and down in value, so you could get back less than you put in.