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Pensions FAQ
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What is a pension?
A pension is a tax-efficient means of providing for an income in retirement. The amount of income that the pension will provide will depend on the type of pension, the amount of contributions and how long a period those contributions have been made over.Pensions have traditionally been held by working people, but stakeholder pensions now allow for anybody to now possess and contribute to a pension.
What is the difference between a pension and other savings schemes?
A pension is essentially a long term savings scheme. In fact, it is probably the longest investment you will ever make. Once you invest money in a pension it is locked in place usually until you are over the age of at least 50, and it is very difficult, if not impossible, to release it early. It is obviously in the country's best interests for retired people to not be dependant on state benefits. Hence the government make putting money into pensions very attractive by offering tax relief on these contributions. The more tax you pay, the more attractive this is. Part of the price you pay for gaining this tax relief today is that you cannot get at your pension until a defined point in the future.
What types of pension are there?
There are various different types of pension: employers', personal, stakeholder and state. In addition to these there are also various ways of "topping up" an inadequate pension: Additional Voluntary Contributions (AVCs) or Free Standing Additional Voluntary Contributions (FSAVCs).
Do pension schemes offer any additional benefits?
Pension schemes may also include additional benefits such as insurance for death in service or even disability benefits should you be unable to work. These are generally features of employers' schemes, although personal pensions may also offer them in return for increased premiums.
Employers' Pension Schemes
Do all employers offer pension schemes?
Traditionally there has been no obligation on an employer to offer the benefit of a pension scheme to its employees. However all employers, with more than five employees, now have to at least offer a stakeholder scheme. There is still no obligation on the employer to contribute to your pension, so the benefit here is more one of convenience in having your pension contributions deducted directly from your salary.
What are the different types of employer's scheme?
There are three different types of employer's (occupational) pension scheme, - final salary (defined benefit); money purchase (defined contributions) and group personal pensions.
How does a final salary scheme work?
Final salary schemes pay a pension based on your salary at retirement (final salary) and the number of years service you have with the employer. Final salary schemes are typically based on either 60 or at worst 80 qualifying years. Your total years of service are divided by the number of qualifying years and the result multiplied by your final salary.
For example, in a 60th scheme, if you retire on a salary of £18,000 with 20 years service then you will receive 20/60 x £18,000 = £6,000 p.a.
What is the definition of Final Salary?
The definition of final salary varies between schemes. Overtime and bonus payments; cash-in-lieu of benefits etc. may not be included in the final salary calculation. The details of your individual pension scheme should be checked with your employer. Typically your final salary will be defined as your highest earnings in the five years prior to retirement or leaving the employer.
How does a money purchase scheme work?
A money purchase scheme is used to build up a "pot" of money which is ultimately used to buy an annuity. This "pot" is known as your pension fund. Over the course of the pension the fund is invested, hopefully achieving long term growth. Although investment decisions are usually made by appointed fund managers, some schemes may offer employees the choice of investment options. Annuities are products sold by insurance companies which guarantee you an income for life. Any pension benefits earned after April 1997 must be used to purchase an annuity which provides "limited price inflation" - Retail Price Inflation capped at 5%.
How does a group personal pension scheme work?
Group personal pension schemes are more similar to personal pensions than traditional occupational schemes. Hence they are governed by the same rules as personal pensions rather than those which apply to occupational schemes. As with personal pensions and money purchase schemes, contributions are invested and used to purchase an annuity at retirement. An employer will agree with a pension provider to offer the scheme to its employees. Employees will have their contributions deducted directly from their salaries and paid into the scheme. It is usual for the employer to also make some form of contribution, although there is no obligation for them to do so. Charges in a group personal plan tend to be lower than with a personal pension because of the economies of scale, hence may be better value.
What is the difference between final salary and money purchase schemes?
Essentially risk. With a final salary scheme your employer guarantees the level of your pension - it is a percentage of your final salary. This is regardless of your contributions over the years and how well they are invested. With money purchase schemes the employee takes the risks of how well their contributions are invested and what annuity rates are at retirement.
How much will it cost me?
This will vary depending on your employer's scheme. Generally, employees are required to contribute a fixed amount of their salaries into the scheme, typically around 5%. However there are some "non-contributory" schemes where employees are not required to contribute to the scheme and the employer bears the full cost. Non-contributory schemes are usually only offered by public sector employers.
How much will my employer contribute?
Again this will vary depending on the scheme. It is estimated that employers typically contribute around 14% of salary towards a final salary scheme, whereas they typically contribute about 6% towards a money purchase scheme.
How much may I contribute to my employer's pension scheme?
The most you may contribute to an employer's scheme (including AVCs or FSAVCs) is 15% of your earnings. This maximum is capped. In 1995/1996 the maximum value which you could contribute would be £11,790.00 (corresponding to 15% of a salary of £78,600.00).
Is there a limit to how much pension I may receive?
The maximum amount that you may legally receive from an occupational pension, whether money purchase or final salary is 2/3rds of your final salary. This limit also applies to additional pension benefits you may have purchased via AVCs or FSAVCs.
Personal pension schemes
What is a personal pension?
Personal pensions are designed for people who work and are not members of an employer's scheme. This may be because the worker is self employed, the employer does not offer a pension scheme, the employee is not eligible to join the employer's scheme, or the employee chooses not to join an employer's scheme. Generally employees would be advised to join an employer's scheme if one is available although in certain circumstances this may not always be correct.
How does a personal pension work?
A personal pension works by building up a "pot", or fund, of money which is used to purchase an annuity at retirement. The investment strategy for the fund is usually chosen by the worker, thus they offer a high degree of flexibility. Usually the only contributions which are made to a personal pension are made by the worker. However it may be possible to persuade your employer to contribute to your personal pension, although there is no obligation for them to do so. If your employer does not contribute to your personal pension, then you will have to make up these "lost" contributions yourself if you wish to receive the same sort of benefits at retirement if you were in an employer's scheme.
A personal pension attracts the same generous tax relief as employers' schemes do.
How much may I contribute to my personal pension?
The following table shows maximum contributions allowed into a personal pension plan. The maximum amount of salary to which these figures apply is capped at £87,600 for the tax year 1998/99.
Age % of earned income
To 35 17.5%
36 - 45 20%
46 - 50 25%
51 - 55 30%
56 - 60 35%
61 + 40%
How is my personal pension invested?
The advantage of a personal pension is that usually you will be given a wide choice of investment options. You will have to balance risk against potential return. Generally as people approach retirement, when their fund is at its largest, they become more risk averse.
What happens if I change employer?
Personal pensions can move with you as you change employer.
Is there a limit to what personal pensions may pay out?
There is no maximum amount of pension which may be provided by a personal pension - unlike occupational schemes. However because usually only the employee is contributing to the scheme it would probably be difficult to attain much greater than the 2/3rds final salary limit imposed on occupational schemes.
Charges on personal pensions
What are the charges on a personal pension?
These vary from scheme to scheme and it is important that you check which are in place in your scheme. High charges may reduce significantly how your scheme grows, and "front end" charges (higher charges during the early years of a pension) may mean that it will take many years before the transfer value of your fund is worth even the same amount as the contributions which you have made.
What are the different types of charges on a personal pension?
Bid/offer spread
Your contributions may be used to buy units. These have a buying and a selling price. You buy them at the offer price and ultimately sell them at the bid price. These two values are not the same. The units which you buy will typically be 5% more expensive than the sell price in operation at the time. This effectively has the result of lowering your pension fund by this value - i.e. 5%. This is often called an "initial charge" which may seem slightly misleading as it is charged each time you buy units - i.e. monthly.
Plan charge / policy fee
This is often a monthly charge taken from your contributions. It may only be a few pounds but it may also increase over time.
Allocation Rates
It is very important to check how much of your premiums are actually being invested in your pension - the allocation rate. This may initially be as low as 60%. The allocation rate may also change over the life of your pension. With "front loading" it is possible during the early years of your pension you will not experience the growth that you expected. Check before you commit to a personal pension.
Annual Charge / Management Charge
A percentage of the value of your units will most probably be subject to an annual charge. This is typically between 0.5% and 1.5% per annum. Although this does not sound like a lot, remember this is charged on the whole "pot" every year.
Some units which you may purchase are called "capital units". These are special units normally bought during the early years of a pension. These have higher annual charges - up to 8%. As above these will be payable for the life of the pension.
How can I find out about the charges on my personal pension?
Due to the bad reputation many pension providers have given themselves through mis-selling scandals, high charges etc., all pension providers must now provide you with a "key features" document. This will show you an estimate of how your fund will grow, the effect of charges and the amount your Financial Advisor is being paid for providing you with advice. Even if you do not totally understand the charges highlighted above, the key features document will allow you to see how much of your contributions are invested in your pension.
Are there any other charges?
The examples above assume that you take out a personal pension and continue to regularly contribute to it. However you may have to stop contributions though illness or redundancy, or you may wish to transfer the pension because it is under performing. It is important that you find out about the following topics before committing.
Paid-up status
There may be a minimum period, or value, before you may cease making contributions. Stop before this level is reached and you may lose all your contributions.
Charges
As stated above, if you stop your contributions early in the life of the pension, high initial charges may reduce the transfer value of your pension - possibly to less than you have contributed.
Premium holidays
Some schemes may penalise you if you need to take a break from paying your premiums. Find out how long a break you may take without penalty.
Portability
If you decide to join an employer's scheme, you are not legally allowed to contribute to an employer's pension and personal pension simultaneously. Check what the penalties are for transferring the pension to another type, i.e. an FSAVC, which would be allowed.
Transfer Values
Are there any penalties if you wish to take a transfer value from your existing pension provider to transfer to a new one?
Stakeholder pensions
What is a stakeholder pension?
Stakeholder pensions are money purchase schemes which adhere to a set of guidelines set by the government. They were introduced in April 2001.
Who are they for?
Stakeholder has been introduced primarily for the low-paid - those earning between £9,000 and £18,500 p.a. Non-earners, including children, are also allowed to have stakeholder pensions and an individual may contribute to another's fund.
What types will there be?
It is planned to introduce personal and occupational schemes. Personal stakeholders will be taken out by individuals. Occupational stakeholders will be offered by companies to their employees.
What if I already have a pension?
If you already have a personal pension, you may also contribute to a stakeholder pension, as long as you do not exceed the contributions limits.
If you are in an occupational scheme (either final salary or money purchase) you may contribute to a stakeholder pension, as long as you earn less than £30,000 per annum. Your total pension contributions must not exceed the 15% of earnings maximum allowed.
How much can I contribute?
Contributions will be limited to £3,600 p.a. This includes any contributions an employer may make on your behalf. The normal tax relief rules are applicable on contributions. The minimum contribution is £20.00 per month.
What are the charges?
Charges on stakeholder pensions have been capped at a maximum of 1% of your total fund p.a. There must be total flexibility over starting and stopping contributions (with no penalties for doing so). However it is possible that you may have to pay separately for the advice which you are given when buying a stakeholder pension because of the low charges.
The UK State Pension
What is the state pension?
The state pension is, as its name suggests, a state-administered pension scheme. It is funded by National Insurance contributions made by those in employment or, for some who are unable to work, made by the state on their behalf.
Who is eligible to receive the state pension?
As things stand at time of writing, men qualify for the UK state pension at the age of 65 and women qualify at the age of 60. In 2020 state pension age will be equalised at 65. This will be achieved by a phased change over the preceding ten years.
What is it worth now?
The value of the state pension for an individual depends on several factors. There are three possible elements to the state pension: the basic state retirement pension, graduated retirement pension and a contribution from SERPS (the State Earnings-Related Pension Scheme).
What is the value of the basic state pension?
As of February 2002 the basic state pension is worth £3770 p.a. Married women are able to claim an additional £2257 p.a. based on their husband’s National Insurance contributions. The pension is payable for men from age 65, for women from age 60. As of 2020 the state retirement age is being harmonised at age 65 for both sexes.
Will I receive the full basic state pension?
Most people believe they will automatically receive the full state pension. This is not automatically the case. To receive the full value (£3770) men must have contributed sufficient amounts of National Insurance for 44 years, women for 39. If you contribute for less years than this your state pension will be reduced according to a published scale. If you contribute for less than 10 years, you will receive no state pension.
What happens if I don't work and can't contribute?
There are credits available for certain periods when you are not employed. Children at school until age 18 are credited with contributions as though they were working (however, students in higher education are not). Credits are also provided for those who receive Jobseekers Allowance, are registered as unemployed or receive sickness benefits. Men over 60 who have stopped working will receive credits automatically until they are 65.
Home Responsibilities Protection (HRP) has been available since 1978 and is intended to protect the basic pension of those people who take time off work to care for children or for someone who is sick or disabled. When the basic pension is calculated, the number of years for which you were given HRP is subtracted from the number required to obtain a given pension level. For a full basic pension HRP cannot be used to reduce the number of required qualifying years to below 20.
Is it possible to work and not contribute towards my pension?
Part time and/or low-earnings workers may not have to make NI contributions. The effect of this is that it is possible that time spent in such work may not qualify as contributing years. However, it is then possible to voluntarily contribute for that time to ensure that your NI record is sufficient to qualify for a state pension.
Married women in the past (and some to date) have been able to pay reduced NI contributions (the "married woman's stamp"). However, these reduced contributions conferred no pension entitlement. A married woman can claim under her husband's NI record, but is only entitled to a spouse's pension (worth 40% less than the single person's pension). This spouse's pension is not available until her husband has reached state pension age and begun to claim his own pension.
What is Graduated Retirement Pension?
People employed between April 1961 and April 1997 earning more than around £9.00 per week will have paid graduated NI contributions which entitle them to a graduated pension benefit. The value of the benefit depends on the number of units of graduated contributions paid at the time and the value of the units when the pension is claimed. As at the current time (February 2002), for every £7.50 (male) or £9.00 (female) of graduated contributions paid, you would be entitled to 9.06 pence of graduated pension benefit.
What is SERPS?
The State Earnings-Related Pension Scheme (SERPS) was introduced in 1978 to provide all employees with an additional income-related pension. It is funded by National Insurance payments. It is due to be reformed in 2002 by the State Second Pension: any SERPS entitlement already accrued will be protected.
SERPS is paid out at normal state retirement age and generally will pay out a maximum of 20% of your average earnings throughout your working life.
It is common for pension schemes to be contracted out of SERPS. This results in the DSS paying the SERPS portion of relevant NI payments into the contracted out scheme. The employee will not then be entitled to SERPS at retirement, but should received an enhanced payment from the "contracted out" pension. The rationale behind this is that it is thought non state schemes will perform better than SERPS.
How can I supplement my state pension?
(1) It is possible to make up missed months or years of National Insurance contributions by paying voluntary NI contributions to fill the gaps.
(2) Delaying your retirement will increase the pension you ultimately receive. Each year you defer claiming your pension it will be increased by 7.5%. Currently it is possible to defer for up to 5 years but after April 2010 it will be possible to defer indefinitely (and the annual increment will be increased to 10.4%).
(3) The basic state pension is less than the Income Support level, so if your only income is a state pension it is possible to claim Income Support to supplement it, and it may be possible to claim other means-tested benefits.
Tax Relief on Pension Contributions
Tax relief is available on employee contributions, at the highest rate that you pay tax. This means that if you are a basic rate taxpayer (22%) for every £78 you contribute the tax-man contributes an additional £22. For top rate tax payers the figures are £60 and £40 respectively. If you are in an occupational scheme, including AVCs, then tax relief is given immediately on your contributions. With personal pensions and FSAVCs then the pension provider will reclaim the tax from the Inland Revenue. The net result is the same.
Changing Employer
What happens if I change jobs?
If you leave an employer's pension scheme then there are a number of options as to what you may do with your pension fund.
1 Leave it with your old employer.
2 Take a transfer value and invest it in a new employer's scheme, personal pension or insurance contract.
3 Have your contributions returned to you. (Only if you have been a member of a scheme for less than two years.)
Leaving your pension
What happens if I leave my pension in a final salary scheme?
If you leave a final salary scheme and choose to leave the fund with your old employer then your final salary will be calculated as of the date you left the employer. For example if you are 40 years old, have been contributing to an employer's final salary scheme for 10 years and leave on a salary of £18,000 then it is relatively simple to see that you will ultimately receive a pension of 10/60 x 18,000 = £3,000. Since 1991 this must at least increase in line with inflation (capped at 5%), however there is no legal upper limit and some schemes (typically public sector) apply the full rate of inflation. The problem with this is that historically wage inflation has outstripped the RPI. For an example of what changing employers may mean to your final pension see the information available here. This shows that an employee who regularly changes employer may lose up to 25% of the benefits they would expect to receive if they did not move.
What happens if I leave my pension with a money purchase scheme?
This is very similar to what would happen if you had stayed in the scheme apart from there will be no further contributions made to your fund. Your fund will continue to be invested, and hopefully grow. At retirement you will use this fund to purchase an annuity.
Transfer values
What happens if I take a transfer value from a final salary scheme?
If you choose to take a transfer value then the scheme's actuaries will perform a calculation as to what this value will be. This works as follows.
1 The total amount of the pension to be paid following retirement will be forecasted. This will involve taking into account inflation and life expectancy.
2 The amount of money that needs to be invested today to provide the benefits in step 1 is then calculated. This is the transfer value.
The transfer value is not related to the amount of your contributions.
What happens if I take a transfer value from a money purchase scheme?
This is simpler than with a final salary scheme. Your transfer will equate to your fund value (total contributions x investment growth) less any charges levied by the scheme.
Alternatives
Return of contributions
If you have been a member of an occupational scheme for less than two years you may be offered a return of your contributions. Tax will be charged on these at 20% to offset the tax relief originally given on these contributions. If the refunded money is used to purchase a personal pension to cover the working time from which the refund has been made, then tax relief will again be given.
Transferring into a new employer's scheme
If you choose to put your transfer value into your new employer's scheme you may be offered a number of options:
1 The opportunity to buy added years
2 Transfer into AVCs or a money purchase scheme
3 A fixed amount of pension on retirement or death
Buying years
When buying years the pension actuary will calculate the number of years your transfer value will buy in the new employer's scheme. However even if you have transferred jobs on a similar salary it is unlikely that you will be able to buy as many years in your new scheme as you had accrued in the old scheme. This is because your transfer value was calculated using a forecast of Limited Price Inflation but the amount of years you may purchase will be calculated using a forecast of wage inflation. As wage inflation typically will be higher than Limited Price Inflation the number of years you may purchase will be lower.
Transfer into AVCs / money purchase scheme
A transfer into AVCs or a money purchase scheme is less complicated. These schemes work on a 'pot' of money which you accumulate over your working life. Hence you transfer into your new 'pot' the transfer value from your old scheme.
Transfer into a personal pension
You may take your transfer value and transfer it into a personal pension.
Transfer into an insurance contract
This is known as a section 32 buy-out bond. They are offered by insurance companies and in the case of benefits accumulated prior to April 1997 can be used to purchase a guaranteed pension at retirement. Benefits accumulated after this date will be invested and ultimately used to purchase an annuity at retirement.
Topping up a pension
How can I "top-up" my pension?
Whether you are in a company or private scheme you may feel that your pension provision is inadequate. Hence you will need a method of "topping" up your pension. This is known as AVCs and FSAVCs - Additional Voluntary Contributions and Free Standing Additional Voluntary Contributions. The difference between the two is that AVCs are offered by an employer, FSAVCs are offered directly to you by a pension provider.
Can I buy extra years towards my pension?
It is possible that if you are in a final salary scheme your employer may offer you the opportunity to purchase extra years towards your final pension. This means if you have contributed for 20 years to a final salary (60ths) scheme and have purchased an additional 5 years you will receive a pension of 25/60ths of your final salary. The opportunity to purchase extra years is usually only offered by public sector employers.
How do AVCs work?
In most situations an AVC will work on a money purchase basis. It is possible that if you are already in a money purchase scheme your contributions will be added directly to your pension fund. If not an additional scheme will be set up for you. AVCs are generally considered to be better value than FSAVCs because of economies of scale they carry lower charges. However you may not continue to contribute to an employer's AVC scheme once you leave their employ. In this case you will be dependent on the pension trustees choosing the best scheme on your behalf.
How do FSAVCs work?
FSAVCs also work on a money purchase basis. They are a contract made directly between yourself and the provider. Their advantage is that they will generally move with you from job-to-job and that you will have more choice over provider and investment options.
How are my AVC/FSAVCs invested?
You will usually be given a choice of investment options. You will have to balance the risk of the investment opportunity against its potential return.
How much can I pay into an AVC / FSAVC?
The amount of money which you may invest in an AVC or FSAVC depends on your current pension provision. If you are in an employer's scheme then you may invest up to 15% of your earnings split between your employer's scheme and (FS)AVCs. Hence if you currently contribute 5% to your employer's scheme then you may put a further 10% into AVCs.
If you are not a member of an employer's scheme then you may make up your FSAVCs contributions in line with your normal maximum personal pension contributions. Hence a 48 year old who currently contributes 15% to a personal pension may add a further 10% in FSAVCs taking them up to the maximum of 25% for their age.
What happens if I overpay my AVCs?
If you are in an employer's scheme then you are still subject to the pension limit of 2/3rds your final salary. It is possible to overpay with AVCs to take you beyond this limit. If this occurs your overfunding will be returned to you as a cash lump sum. This will be taxed, at a rate of at least 33%, to make up for the tax relief given on your contributions.
Are AVCs subject to tax relief?
Tax relief is paid on AVCs and FSAVCs at the highest rate at which you pay tax.
Can I top up a personal pension?
Rather than purchasing an FSAVC, if you have a personal pension you may carry forward or carry back your contributions. Carrying back involves offsetting this year's contributions against last years tax allowance. This is very useful if you were paying a higher rate of tax last year compared to this. Carrying forward allows you to top-up previous year's contributions up to a maximum of six years. You may only do this if you are currently paying your maximum allowable contributions and did not do so in any of the preceding 6 years. However, carrying forward is about to be abolished (April 2000).
Investment Options
Unlike other forms of pension, personal pensions, AVCs and FSAVCs often give you the flexibility to choose how your fund is invested. If one provider does not offer the type of investment you prefer, choose another which does. Investment options is a huge subject but we have highlighted the main types below.
Managed funds
These attempt to beat the general rate of return in the stock market, by shrewd investment - hence they are described as managed. Your "pot" will be invested in a number of areas, and you will probably be given a choice of where to invest. i.e. UK, Far East, technology, ethical etc. Whether they in fact beat the general rate of return i.e. the FTSE is a moot point. Recent research suggests that only 10% of managed funds out perform the FTSE.
Index tracking funds
These funds track the general movement of the stock market by investing in the shares which make up the FTSE. The principle is that if the stock market rises by 15%, then your fund should rise by 15% also. This may not always be the case as it depends on how closely your fund "tracks" the stock market.
With profits funds
These funds are made up from a mixture of investments and hence spread the risk. Bonuses are paid annually and on termination of the policy and are designed to smooth out fluctuations which may occur on the stock market.
Cash funds
These are similar to building society accounts and are almost risk free but will provide a lower rate of return.
How do I choose a fund?
Put simply the higher the potential return the higher the chance of losing money. Lower risk investments produce lower returns. When deciding how to invest your pension you should take into account a number of factors. The most important of these is your age and your attitude to risk. If you have a long time to retirement then you will probably be more inclined to invest in riskier options such as the stock market. This has been proved over the long term to provide the highest rate of return, but obviously carries with it the highest degree of risk. If you are young then you will have time to survive a short term decline and still be able to take advantage of the longer term growth. Older workers may not wish to take the same degree of risk and hence choose to invest in safer, if lower return, investments.
What is an annuity?
An annuity is a product offered by insurance companies whereby a single payment is made for a regular income for life - usually paid monthly.
Why do annuity rates vary?
The rate of return from an annuity depends on a number of factors including: age at retirement; type of annuity; and life expectancy. However the most important factor is the prevalent interest rates at the time of annuity purchase. Annuity rates are linked to gilt values and at present they are much lower than they have been in the past. See the table below for examples of annuity rates as of 29/04/2001 for a male aged 60:-
Life Invested Sum Yearly return -
No inflation proofing Yearly return - 5% p.a. inflation proofing
Single life male aged 60 £10,000 £791 £468
Single life female aged 60 £10,000 £732 £427
Joint life male and female aged 65 £10,000 £722 £427
Figures taken from The Observer 29 April 2001.
What are the different types of annuity?
Annuities fall into various categories. Typically they are level. escalating, single life and joint life.
Level annuity
With a level annuity a rate of return is set at the time you purchase the annuity i.e. £7,500 p.a. in return for a £100,000 pension fund. You will be paid this amount every year until you die.
Escalating annuity
With an escalating annuity an initial rate of return is set at the time you purchase the pension. However this amount is increased each year, usually by limited price inflation. The initial amount will be smaller than with a level annuity - however your pension is at least partially protected against inflation.
Single Life & Joint Life
With a single life annuity the pension is paid until the pensioner's death. With a joint life annuity an agreed percentage of the pension (generally 50%) will be paid to your partner after your death. Joint life annuities are more expensive than single life due to the increased risk the insurance company is taking.
What will annuities do in the future?
At present annuities cannot be described as a good deal. Very few people would choose to purchase them if they possessed a large cash lump sum. Unfortunately you are ultimately forced to invest the majority of your pension fund into an annuity, so have no choice. It is possible that annuity rates will increase again in the future. However people are living longer, retiring earlier, government policy is to keep inflation and hopefully interest rates low. These factors do not bode well for future increases in annuity returns, and we believe that annuity returns are unlikely to improve significantly in the near future.
Retirement
Options at retirement
Options at retirement are relatively simple. Generally you choose between taking a full pension, or a tax free lump sum and a reduced pension.
Final salary scheme
If you choose not to take a lump sum then your pension is worked out as final salary x (years service / 60 or 80 depending on the scheme).
The maximum lump sum you may take is 3/80ths of your final salary multiplied by the number of years service. This is capped at a maximum of 1.5 times your final salary.
e.g.
If you retire after 20 years on a salary of £30,000 you may take up to:
3/80 x 20 x 30,000 = £22,500
However taking a lump sum has the effect of reducing your pension. This will vary from scheme to scheme but is usually calculated by reducing the yearly pension by around 10% of the lump sum.
e.g.
In the example above if you chose not to take the lump sum you would expect a pension as follows:
20/60 x 30,000 = £10,000
If you take the maximum lump sum of £22,500 then this will reduce your pension as follows:
10% of £22,500 = £2,250. £10,000 - £2,250 = £7,750.
Hence you have a choice. Take a full pension of £10,000 or take a tax free lump sum of £22,500 and a reduced pension of £7,750.
Inflation
Once the pension starts to be paid it must increase yearly in line with inflation (retail price index) to a maximum of 5% p.a. This is known as Limited Price Inflation (LPI). This only applies to contributions earnt after April 1997. Before this date there is no obligation for the pension to increase at all - so it is best to check with your employer as to what your situation is.
What happens if I die after I start to take my pension?
After April 1997 final salary schemes must now provide spouses pensions of 50% after the death of the pensioner.
Money Purchase Scheme
If you are in a company money purchase scheme then by the time you retire you will have built up a pension fund with which to purchase an annuity. As with final salary schemes, the maximum lump sum you may take is 3/80ths of your final salary multiplied by the number of years service you have. This is capped at a maximum of 1.5 times your final salary. However doing this will obviously reduce the size of annuity you may purchase. Your employer may allow you some discretion in which annuity they purchase for you, in which case you should shop around and choose carefully - the difference between the best and worst annuity rates may be as much as 20%. If you are given no choice then the pension trustees will purchase an annuity on your behalf.
As an example of the effect of taking a lump sum, we have estimated that an employee retiring on £30,000 with 20 years service in a money purchase scheme will have accrued a pension fund of around £100,000. This has assumed 4.5% wage inflation, 10% contributions to the pension fund and 10% compound growth.
Hence you may take a full pension and use the £100,000 to purchase an annuity. Assuming an 8% annuity rate for a sum of this size then you will receive a pension of £8,000 p.a.
If you would rather take the maximum lump sum the figures are thus:
3/80 x 20 years service x £30,000 = £22,500
This will reduce the pension pot of £100,000 to £77,500. At 8% this will buy an annuity of £6,200.
Therefore the choices are:
A full pension of £8,000 p.a. or
A lump sum of £22,500 and a reduced pension of £6,200.
Inflation
Any pension benefits acquired after April 1997 must be used to purchase an annuity which rises with limited price inflation. These give less return but at least give a degree of inflation proofing.
Can I take a transfer value at retirement?
The final option with a company scheme (final salary or money purchase) is to request a transfer value at retirement. This will be calculated in the same way as if you had transferred employers and you will be provided with a large lump sum to invest. Unfortunately there are restrictions as to what you can do with this. Your options are essentially the same as somebody with a personal pension.
Personal pensions
A personal pension must be used to purchase an annuity at some point between the ages of 50 and 75. Up to 25% of the fund may be taken as a tax free lump sum. However doing this will obviously reduce the size of annuity you may purchase. You may then purchase your annuity from the open market to find the best deal for yourself. The type of annuity you purchase is your own choice. Unlike money purchase schemes, there is no obligation to take into account inflation proofing, or even to provide for your partner after your death.
Delaying purchasing an annuity
The final option with a personal pension is to delay the annuity purchase using an income drawdown scheme. The rationale behind this is that the fund will often produce a better return from other forms of investment rather than purchasing an annuity. General annuity rates may increase whilst you wait. You will be older when you finally purchase your annuity (to a maximum of 75) and therefore will receive a higher rate than you would if you purchased it at a younger age. Obviously there are considerable risks in waiting to purchase an annuity, such as annuity rates may worsen or your fund may under perform what you could have expected from purchasing an annuity. Generally income drawdown schemes are only recommended to those with funds of at least £100,000. If you choose to use an income drawdown scheme then there are various options you should consider.
What type of plan
There is no obligation to remain with your original pension provider. You may feel more secure in investing your fund across a broader range of investments than your current pension provider offers. Self Invested Personal Pensions (SIPPs) offer this flexibility of breadth of investments. However once you have started an income drawdown scheme you cannot then move the fund.
Taking a lump sum
You may only take a tax free lump sum (up to 25% of the fund's value) before you start an income drawdown scheme. If you do not take it at this point the option is lost forever.
Taking income
Once you start to take an income from your drawdown scheme (including a tax free lump sum) you must take a sum between 35% and 100% of the amount of income which a single life level annuity would provide for the fund.
You must purchase an annuity before you reach your 75th birthday.
If you die whilst using an income drawdown scheme then there are a number of options.
1 Your spouse may continue to use the drawdown scheme until either they are 75 or you would have been 75 - whichever is earlier. At some point before this date they also must have purchased an annuity.
2 The whole fund may be returned to your spouse / estate less 35% tax.
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