A good starting point to understand the fundamentals of pensions
We know we must have a pension, it’s important isn’t it? We see the amount on our payslip, feel like we’re doing some proper “adulting” and yet, if some know-it-all asked us how we claim higher rate relief or whether our pension will allow us to retire at 60 most of us would probably quickly change the subject to chat about the weather, Netflix or some pandemic or another...
Couple of things about pensions….
- They’re boring
- They’re important
It’s a really tricky mix.
We’re in this together, we’ve got your back, let’s figure it out and have an answer for the know-it-all (who undoubtedly has matching lids for all their tupperware).
A pension is a tax efficient way to save money for when we’re older. It’s a long term savings plan that we pay into whilst we’re working, to make sure that we can afford to live when we stop, be this stopping work completely or reducing our hours.
It’s all about security for when we’re older.
When the time comes to take money out of a pension there are several different options, maybe taking a tax free lump sum and a regular income.
What is a Pension Fund?
That know-it-all (you know the sort, he’s got a special cover to protect his Mondeo during winter nights) would ponder whether we mean that a Pension Fund is the amount of pension savings you’ve got, or the way it’s invested. Well, we mean your very own pension pot - the fund (money) that you’ve built up, be this with one pension provider, through one employer, or multiple pots from various places.
Your pension pot (and it is very much yours, you own it, you are the master) belongs to you, it builds up in your name and it is your nest egg for the future. This pot will hopefully increase in value in two ways:
- By the regular contributions paid in by you and your employer (unless you’re self employed of course)
- By growth in the investments that your hard earned contributions are paid into
It’s always possible that the value could go down if the investments behind the scenes reduce in value, but we’ll talk about this another day.
We’ve all got apps for our banking now. We’re acutely aware if there’s too much month left at the end of the money. This is where our pension mindset should be too - a knowledge of how much is in our fund, and that it’s on target to meet our future needs.
How much do you need to retire?
Our friends at the Pensions and Lifetime Savings Association (PLSA) have provided interesting research into how much we might need to retire - it’s called the Retirement Living Standards
These standards give a good indication of what sort of income we might need to retire on. As with everything, the longer you save, the more you’ll hopefully accumulate, so there’s two ends to that scale - start saving into your pension as early as you can and think about what age you want to retire. The more we can feed into the pension fund now, the more it could produce for us at retirement. Considering the targets set by the Retirement Living Standards, think about the conversation future-you would have with today-you… Does future-you go on holiday, even once a year? Do they regularly visit family and friends? Can they have that take away on a Saturday night, the hobbies they want, the heating on?
A good starting point is to ask your pension providers for a “projection of benefits” - this will show you how much your pension will be worth at a certain age (maybe 55, 60, 65) and the income that this could produce. Compare that figure to the Retirement Living Standards targets.
If you have lots of pension pots, you’ll have lots of projections to request - it’s not an impossible task, but simpler if you consolidate your pots into one.
With your projected benefits figures in hand, don’t forget to include the State Pension too - https://www.retirementlivingstandards.org.uk/
How the State Pension works
HMRC describe the state pension as “a regular payment from the government most people can claim when they reach State Pension age. Not everyone gets the same amount. How much you get depends on your National Insurance record”
So how does it work? Currently, the full amount of the State Pension is set at £179.60 a week. This amount normally goes up every year. However, this is the full amount - the amount we receive depends on how many years of National Insurance contributions we’ve made (or been credited with) and our State Pension Age.
The State Pension Age for most people is now age 66. However, it is gradually rising to age 67 for anyone born after 6 April 1960 and to age 68 if you were born after 6 April 1977.
If you were born before 6 October 1954, your State Pension age is between 60 and 66 depending on when you were born and whether you are a man or woman.
Rather than deal with that riddle, it’s easier to go to the HMRC state pension age calculator and see what your state pension age is. I’ll be 67 (ouch), and whether I meet you in the food bank or on the beach will depend upon my National Insurance contributions…
The State Pension you will receive will normally be based on your own National Insurance contributions only.
To receive any State Pension at all, you’ll need to have made or been credited with at least 10 years of qualifying contributions on your National Insurance record. To receive the full amount, requires 35 years of qualifying contributions or credits.
You’ll receive a proportionate amount if you have between 10 and 35 years of qualifying contributions or credits.
To find out where you are with your National Insurance record, again you can go to the HMRC link that provides you with your personalised details
Even with the full pension of £179.60, it’s fair to say that we all need to look to our own pension provision to bolster this sum.
What makes saving into a pension so tax-efficient?
One of the best features of choosing a pension to save for retirement is tax relief. When we pay into your pension, some of the money that would have been paid as tax, goes towards our pension instead. This not only helps reduce the amount of tax you pay but it also boosts your savings for the future.
This ‘tax relief’ given is based upon the rate of income tax that you pay at the time.
However, depending on how your pension scheme works, if you don’t pay tax you might not get tax relief.
Equally, you might have to claim extra tax relief not claimed by your scheme.
What's a Defined-Benefit Pension Plan?
A defined benefit (DB) pension scheme is one where the amount you’re paid in retirement is based upon how many years you’ve worked for your employer, and the salary that you’ve earnt.
At retirement, DB pensions pay out a secure/guaranteed income for life which increases each year. They usually continue to pay a pension to your spouse, civil partner or dependants when you die too. These guarantees are what make DB pensions so appealing.
Your employer, and maybe you, contribute to the scheme and it is the employer’s responsibility to ensure that there’s enough money at the time you retire to pay your pension income. You might have a DB pension if you’ve worked for a large employer or in the public sector.
What's a Defined-Contribution Pension Plan?
Generally speaking, a defined contribution (DC) pension plan can be a:
- workplace pension set up by your employer, or a
- private pension set up by you.
A DC Pension Scheme is a type of pension where the amount you get when you retire depends on how much you put in and how much this money grows. We talked about this earlier in What is a Pension Fund?
Your pension pot is built up from your contributions and your employer’s contributions (if applicable) plus investment returns and tax relief.
It makes sense to think of DC pensions in two stages; 1) while you’re working and 2) when you come to retire.
Stage 1 – while you’re working
The size of your pension fund when you come to retire will depend on what happened whilst you were working, including each of the following elements:
- how long you save for
- how much you pay into your pension
- how much your employer pays in
- how well your investments have performed
- what charges have been taken out of your pot by your pension provider.
Stage 2 – when you come to retire
You don't actually have to stop working to begin taking money from your DC pension pot, but you must normally be at least 55 years old (57 from 2028).
When you start to take money from your DC pot, up to a quarter (25%) of your pension pot can be taken as a tax-free lump sum. The rest can be used to provide a taxable income, or one or more taxable lump sums.
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