Pensions

Types of Pension

Overview

There are a range of different employer and private pension arrangements, each of which was historically governed by different rules, relating to contribution and benefit limits. However, from 6 April 2006, in theory, one set of rules should now apply to all schemes. In practice, things are not quite that simple, as there are certain transition arrangements and concessions for specific situations. Nevertheless, for most people with earned income, pensions are indeed now simpler and permit significantly higher levels of tax-efficient contribution.

Anyone eligible to contribute to a pension (broadly speaking UK residents aged less than 75) can receive tax relief on contributions up to the level of 100% of their earnings, subject to not exceeding the annual allowance (£235,000 in 2008/09). Those with annual earnings below £3600 (including those with no earnings at all) can receive tax relief on contributions up to £3600 a year.

The State Pension

State pension payments are dependant on the National Insurance Contribution record of the individual. For 2008/09, the full basic state pension is £90.70 per week for a single person and £145.05 per week for a married couple. There have been different generations of additional state pension (graduated pension, SERPS and currently, the state second pension, S2P), which provide additional pension income for employees.

Occupational Pensions

The advantage of being a member of an occupational pension scheme is that your employer contributes to the cost of providing your retirement benefits. As an employee, you may also be required to contribute.

There are two types of occupational scheme: - final salary (defined benefit) and money purchase (defined contribution). In both cases, it is possible to exchange some of your pension for a tax-free lump sum.

Final Salary :Your pension is based on your salary and the number of years that you have been a member of the scheme. For example, in a '60ths'scheme, you would receive 1/60 of your 'final salary' for each year in the scheme. You would therefore need to be a member for 30 years to receive a pension of half of your salary. The precise definition of 'final salary' varies between schemes.

Money purchase : The employer contributes a defined amount (usually a percentage of salary), which is then invested in funds from a pension provider. You can usually choose from a range of funds available. Please refer to the section on 'private / personal pensions' for more details about how money purchase arrangements work.

Private/Personal Pensions

Many employees have 'contracted' out of SERPS and / or S2P using personal pension plans. These plans do not receive direct personal contributions; they receive the National Insurance Contributions which would otherwise be used to provide credits towards the additional state pension benefits. This type of personal pension is sometimes called 'protected rights', to distinguish them from the normal 'non-protected rights' personal pensions, which receive contributions from employees and / or employers.

Private pensions work on a 'money purchase' basis, which means that contributions are used to establish a pension fund, which purchases assets, which are usually units in funds provided by the pension provider. The value of the pension fund should grow as more contributions are made and as the value of the assets (hopefully) increases. The fund is ultimately used, at retirement, to provide an income for the rest of the pensioner's lifetime. Please refer to the section on 'options at retirement', for further details.

Pension providers offer a range of funds, with different risk profiles, investing in different asset classes and geographical sectors. Clients who do not wish to take an active role in investment decisions can choose 'managed funds', which offer a spread of different investments. However, for those who wish to have more direct control in investment selection, SIPPs (Self Invested Personal Pensions) are becoming increasingly popular. These permit tax-efficient investment in a range of assets, including stocks and shares and commercial property, all within the pension tax wrapper. This type of pension is even able to raise a mortgage, to allow property purchase.

It is difficult to know what level of retirement income will be provided by a particular level of pension contribution. The ultimate pension will also depend on a number of other variables, including: -

• net investment returns of the fund;
• interest rates / annuity rates when benefits are taken;
• the type of pension taken (e.g. level or indexed);
• the age at which the pension is taken;
• the level of inflation (this will impact on the 'real value').

If you would like an approximate idea of the impact of different levels of funding, you may find our Pension Calculator helpful. You can use this to investigate different scenarios, using alternative combinations of lump sum contributions (which could represent the value of your current funds), future regular contributions and timescales.

What are the tax benefits of pensions?

The main benefit of investing in a pension, rather than an alternative investment, is that pension contributions attract tax relief. Basic rate tax relief (currently 20%) is given automatically, even for someone without earnings. This means that for every £80 invested personally, the Inland Revenue adds £20, to make a total investment of £100. For higher rate taxpayers, there are even greater benefits, as they qualify for tax relief at 40%.

Pension funds grow extremely tax-efficiently. They are free of capital gains tax and of income tax on interest and rental income. They are, however, unable to reclaim the tax-credit on dividend income from UK shares.

Any lump sum available (typically 25% of the fund value for money purchase arrangements), when taking benefits from a pension, is payable tax-free, although income taken from a pension is taxable.

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