Pension schemes, not often a hot topic at a dinner party, they’ve had a bad rap over the years, and rightly so, with their over-complicated rules and lack of flexibility. But, it’s time to let go of that stigma and realise the benefits your pensions can bring. Whatever stage of retirement planning you are at, you’ll want to know what the different types of pension schemes are and how they can help you have the retirement you deserve.
There are three main components to financial planning for retirement. The first and most universal is the state pension. For a large proportion of the UK, the state pension is their primary source of post-retirement income. The second is the defined contribution pension scheme, typically set up by you or your employer, into which you make contributions. And the third is the defined benefit scheme, set up by your employer, and you accumulate benefits based on earnings whilst a scheme member.
We explore all three pension schemes in a little more detail below.
The State Pension is a weekly payment from the government when you reach State Pension age, which is currently 66. However, the State Pension age is continuing to increase to 67 between 2026 and 2028. And again from 67 to 68 later.
The amount you receive depends on your National Insurance record. To qualify, you need a minimum of ten years’ worth of contributions. And to get the full state pension, you need 35 years on your record. You could have gaps in your record because of periods of unemployment, time off for childcare or illness, or living abroad. You can check your entitlement on gov.uk and make up missing years if there are gaps.
The full single-tier State Pension currently stands at £179.60 per week or £9,339 per year. For many, this is not enough to supplement the lifestyle they want in retirement. The Pensions and Lifetime Savings Association have released the Retirement Living Standards, which provides a handy indication of the different levels of income needed for a comfortable retirement.
The State Pension increases annually in line with the triple lock – the highest of inflation, average earnings and 2.5%. However, Rishi Sunak has hinted at a suspension of the triple lock to counteract artificially inflated wages due to the pandemic and resultant recession.
Moral of the story: Whilst the State Pension provides a decent boost to your retirement income, unfortunately for many, it just isn’t enough. Your retirement savings will be one of the most important investments you make during your lifetime, and we explain a bit more below about the different pension schemes you can do this through.
Defined contribution (or money purchase) pension schemes
Over time you build up a pot of money within a defined contribution scheme, and the size of that pot determines the amount of income you get in retirement. The amount accumulated depends on your contributions and investment performance. So the more you pay and the better the funds perform, the bigger the pot you have to play with at retirement.
The majority of pension schemes in the private sector are now defined contribution (DC). Defined contribution pension schemes can be:
Workplace pension schemes set up by your employer
In a workplace pension, your employer will pay a fixed % of salary, and you’ll pay a minimum % of salary but can pay more.
By law, every employer should have an auto-enrolment scheme and automatically enrol eligible staff into the pension scheme. Auto-enrolment is a government initiative designed to allow easier access to a workplace pension scheme, enabling workers to save towards their retirement above and beyond the State Pension.
The government has also set the minimum contribution levels, which currently stand at an overall total contribution of 8% of your qualifying earnings (made up of 5% employee contribution and 3% employer).
Your employer calls the shots with the pension scheme. They choose the provider and also the default investment choice, although you can select something different.
Private pension schemes set up by you
If you’re self-employed or a business owner, you’ll have had to set up a separate pension scheme just for yourself, as you won’t have access to a workplace pension. Or maybe you want to pay in more than what’s allowed through your workplace scheme. If that’s the case, you’ll need to look at opening a Personal Pension or a Self-Invested Personal Pension.
With private pension schemes, you make all the decisions. You pick what contribution you make, and when, what funds they go into, and the provider.
With both workplace pensions and private pensions, you can take the money from the scheme any time from the age of 55 (increasing to 57 from 2028). And since 2015, defined contribution schemes have a lot more flexibility when taking benefits.
You have six choices:
- Leave it (remains invested)
- Seek a secure income for life (annuity)
- Take a flexible income (drawdown)
- Take chunks at different times (Uncrystallised Funds Pension Lump Sum (UFPLS))
- Cash it all in
- A mix of the above
Although pension schemes are very tax-efficient, they aren’t tax-free. So be careful before you make any choices and consider the tax consequences.
You can read more about DC schemes and how to take money from your pension on the Money Helper site here.
Defined benefit (or final salary) pension schemes
Defined benefit schemes give you a secure income for life, which rises each year. The amount you receive in retirement depends on a few factors; the scheme rules, earnings, and time in the scheme.
Members of these schemes have typically worked in the public sector or for a large employer.
Historically, most workplace pensions were final salary pension schemes, whereby your pension was calculated by multiplying your final salary and length of service, then dividing this by a fraction – either 1/60th or 1/80th – of your pensionable pay. Typically 40 years of service would give you a pension of 40/60, which is 2/3 of your final salary. Very good in the days when jobs were for life.
The majority of ongoing schemes are now CARE (Career Average Revalued Earnings) schemes. An amount of money gets added to your eventual annual pension figure each year you work. Career average schemes are based on the average of your pensionable earnings while you’re a member, revalued in line with inflation each year.
The scheme sets a retirement age. If you choose to access your benefits before then (but still over the age of 55) and commence taking the income, it will be at a reduced rate.
Defined benefit schemes are the “gold standard” of pension schemes, hence the ongoing debate about whether people should transfer out of these schemes or not. If you’d like to hear our two cents, you can read our list of pros and cons of transferring out of a defined benefit pension scheme.
You can read more about DB schemes on the Money Helper site here.
Your pension pot is your most tax-efficient savings account, but you should still know what the limitations are on this tax relief.
Your pension savings will usually be subject to tax charges if your pension pots exceed:
- Your annual allowance – typically £40,000 but can be lower if you are a high earner or you’ve flexibly accessed your pension benefits already
- The lifetime allowance – £1,073,100
- 100% of your annual earnings
If you don’t earn, you can still save £2,880 per year in a pension pot. Tax relief then gets added, making it £3,600, which isn’t bad!
When you take your pension benefits, they will be subject to income tax. You can usually take 25% of your pension pot tax-free, and the rest is taxable at your highest marginal rate. So you must plan how you structure your retirement income and the way you access your benefits.
If you have a defined contribution scheme, you can have a bit more flexibility over your income. Defined benefit schemes don’t.
Defined contribution schemes can also be a very tax-efficient way of leaving money to your dependents, as whatever you don’t use for your retirement passes on to them. And depending on the age at which you pass away, the funds might go to them tax-free. Your beneficiaries then have a choice as to taking it as a lump sum, or as income, or leaving it until they need it.
Actions to takeaway
When it comes to pensions and retirement, we recommend you do the following:
- Think seriously about what you want to do with the rest of your life, not just financially
- Check your State Pension entitlement and fill gaps if necessary
- Think about other possible sources of retirement income – part-time work/business/rental?
- Think about where you want to live – downsize, move abroad?
- Collect together details of all your existing pensions – Pension Tracing Service can help – and other investments
- Read our beginners guide to retirement planning
If you have any questions regarding your pension schemes or retirement planning, feel free to get in touch with us to have a chat with one of our independent financial planners.