Planning for retirement is an exciting yet complex adventure. As you embark on this path, understanding the different types of pensions becomes paramount. Whether you’re a seasoned professional or just starting out, our comprehensive guide will demystify the world of pensions.
With many different products out there and a minefield of information, we have taken the 6 main pension types and looked at them all individually.
Personal Pension (Money Purchase/Defined Contribution Pension)
These are the most common type of pension available today. Whether you’re part of a workplace pension scheme or have a personal pension that you took out yourself, this kind of retirement plan involves saving up a pot of money over many years. This pot is built through a combination of your own contributions, those from your employer, and tax relief provided by the government.
Personal Pensions are a type of Defined Contribution, or Money Purchase Pension.
Here’s how it works:
- You own a pension, with a value based upon the worth of the funds it is invested in. You can select the funds it is invested in and there is usually a range of options available, at differing levels of risk.
- You and your employer can pay into a Personal Pension, through monthly contributions or lump sums.
- Because the pension is invested in funds, the value can change each day. Essentially, a Personal Pension is another type of investment but with certain tax benefits.
- All pensions are free from Inheritance Tax and the income/growth within a pension is free from income tax and capital gains tax. You can benefit from income tax relief on amounts paid into pensions.
- When you come to retire, 25% of the pension can be withdrawn as a tax-free lump sum. The remainder can remain invested, as a ‘Flexi-Access Drawdown’ pension (another version of a Personal Pension), and accessed flexibly in monthly withdrawals or lump sums. Withdrawals from the Drawdown Pension are treated as income and subject to income tax.
- The entire pension can also be withdrawn as one lump sum, with 25% tax-free and 75% treated as taxable income.
- It is also possible to buy an annuity (see below) using the value of your Personal Pension – usually after the 25% tax-free lump sum has been taken.
- On your death, the remaining value of your Personal Pension, or Flexi-Access Drawdown Pension, can be transferred directly to your beneficiaries.
Self-Invested Personal Pension (SIPP)
A Self-Invested Personal Pension (SIPP) is like a bespoke home for your retirement savings. The difference is, you choose how your hard-earned savings are invested.
This is another type of Personal Pension, the difference being that this can hold commercial property investments too.
It offers the ability to borrow money, up to 50% of the pension value, to purchase commercial property.
Group Personal Pension (GPP)
When you are part of a bustling workplace, as well as your salary and other additional work-related benefits you are automatically enrolled into your workplace pension (age and salary dependant). You have the option to opt out if you choose to, but if you decide to continue with the pension your employer will contribute to your pension alongside you.
A Group Personal Pension scheme is essentially your own Personal Pension held within the company’s pension scheme.
Because it is offered as part of the Group scheme, you are likely to receive discounted fees.
When you leave the company, this becomes your own Personal Pension.
Final Salary or Defined Benefit Pension
Next up we have the Defined Benefit Pension, these are like the rare gems of the retirement saving realm as they are not as common as they were some years ago. These pensions offer a steady and dependent income stream and instead of how well your investment has performed and how much you have saved, the key factors here are how many years of service you have given and what your salary was when you retired.
These types of pensions work quite differently from Personal Pensions because you do not have your own pension ‘pot’ value. Instead, you build up a pension entitlement according to the rules of your employer’s pension scheme, based on your salary, length of employment and inflation.
Final Salary Schemes are a type of Defined Benefit Pension where your pension and initial lump sum are calculated based on your salary when leaving. The other type of Defined Benefit Pension is a Career Average Pension Scheme, which calculates your pension based on the average of your salary over a certain period.
You will likely need to contribute from your monthly salary towards the pension and your employer will also be funding the remaining cost required to pay out the agreed pension.
The pension income provided is guaranteed for the rest of your life and usually includes a spouse’s pension (typically around 50%) payable on your death. Some will pay this pension on your death to someone you are cohabiting with or to a financial dependent.
Government-funded Defined Benefit Pensions such as the Teachers, Civil Service and NHS pensions cannot be transferred. However, most other Defined Benefit Pension schemes will offer the option of transferring your pension entitlement out, into a Personal Pension. Because your pension doesn’t have an easily defined value, the Pension Scheme Administrator Actuaries will, on request, provide you with a transfer value quote, usually available for a set period, and this value is the amount transferred into the Personal Pension.
For these transfers, it is important to get advice from a qualified adviser, who will consider the pros and cons of you giving up the guaranteed pension for a Personal Pension pot.
Stakeholder Pension
This is a pension that is usually personal, with some employers offering them too. They offer lower charges, flexibility, low minimum contribution levels with as little as £20 a month and some come with additional security features. They also have trustees to keep an eye on things.
This is another type of Personal Pension, but with a limit on the fees paid at 1.5% per year for 10 years, then 1% after this. Partly due to the limited fees, these pensions usually offer a minimal range of funds and tend to be less popular than a regular Personal Pension.
Pension Annuity
One option on retirement is to use the value of your Personal Pension to buy an annuity. An annuity is a guaranteed (taxable) income, which the annuity provider will base on your age and health.
Annuities turn your pension pot into a steady source of income, so you know exactly what you will receive each month. But there are some considerations to explore.
Various options can be chosen for the annuity income, which will affect the amount you receive, including:
- Frequency paid (e.g. monthly, quarterly or annually)
- Paid in advance (paid straightaway) or in arrears (payments start after one month/quarter/year)
- Increasing or level
- Fixed-term or lifetime – an annuity paid for a certain period before providing a remaining pension value, or paid for the rest of your life
- Spouse’s annuity – paying 50% or 100% of the income to your spouse, on your death
- Guaranteed period – if you pass away within a certain period, the annuity will continue at 100%
The amount of income offered can vary between different annuity providers. Typically, an annuity is an option chosen by those who are older and whose outgoings are more regular and they want more certainty. An annuity may not be suitable if you already have other guaranteed pensions or you want the flexibility to draw different amounts at different times.
Summary
Understanding pensions is crucial for securing your financial future, whether you are decades away from retirement or nearing the golden years. Remember though, planning for retirement is a marathon, not a sprint, seek professional advice as early as possible, stay informed and make educated decisions about your pension.
Please contact us if you would like to explore your pension circumstances with a qualified adviser, committed to helping you live the life you want.
Risk warning
Please Note: This communication should not be read as giving specific advice regarding your personal circumstances. This would only be given following a detailed assessment of your individual needs. The value of investments may fall as well as rise; you may get back less than invested. Past performance is not necessarily a guide to future returns.
