What is a pension?
Understanding the basics
A pension is simply a savings scheme which offers very attractive tax benefits in exchange for you agreeing not to touch the proceeds until you are older. In other words, you put your money in, that money is invested, its value (hopefully) grows and at the end, you withdraw the proceeds.
In this case, however, you cannot touch the proceeds until you are at least 55 – and at least 75% of the value it achieves will be used to provide an income for the rest of your life.
Types of Pension
1. The State Pension
The Basic State Pension is designed to provide a minimum amount of income. This year (2011/12), the payment for each pensioner who has met the minimum National Insurance contributions is £102.15. Or, for a married couple where one partner has not met the minimum NI contributions, the amount is £163.35.
On top of this, if you were making contributions to SERPs or, more recently, S2P (the state second pension) you may also receive an earnings related top up to the state pension. The amount you receive is entirely dependent on how much you earned, how much you contributed and for how long – but for those who were earning over £40,000 a year (in today’s terms), this is currently worth a maximum of about £6,000 a year.
As you can see, however, these payments alone will not enable a wealthy and luxurious retirement. For this reason – and because, thanks to an ageing population, the Government is finding it harder and harder to meet even these levels of payment, we are being encouraged to make additional investments towards our own retirement as well.
2. Occupational pensions
An occupational scheme is a scheme set up and run for company employees and into which your employer may make some or all of the contributions on your behalf. These could be ‘defined benefit’ schemes (otherwise known as final salary) where the amount you receive depends on the number of years service you gave to the company.
Alternatively, they will be defined contribution where you and/or your employer make a fixed level of contribution and the final value depends on how well, or badly, the underlying investments you chose performed.
Thanks to volatile stock markets and additional regulation, the days of final salary pension schemes are generally considered to be all but over – save for a lucky few in the public sector or those with unchangeable employment contracts in the private sector.
3. NEST
To date, whether or not your employer offers a pensions scheme has been entirely voluntary. However, from 2012, the requirement for all employers to offer either an in house scheme or to auto-enrol employees to the new National Employment Savings Trust (NEST) is being phased in.
Not only that but, from 2014, employers will also be forced to start making a minimum contribution, rising to at least 3% of your salary. In exchange, the you will have to contribute 4% and the Government, by way of tax relief, will contribute another 1%.
For those employed in smaller companies, this might be the first opportunity they have had to get involved in formal occupational pension planning. For larger companies, however, these minimums might already be exceeded. Indeed, if you decide to contribute more than 4%, the employer may choose to match that higher amount.
4. Personal pensions
Personal pensions are pension schemes effected by the individual for the benefit of the individual. It doesn’t matter who you work for or how long you work for them, or how much you earn. You decide how much to contribute to and you decide where the money is invested. The more you put in, the more money you have to invest for your future – and the better your underlying investments then perform, the higher that value will be.
There are three basic types of personal pension:
Stakeholder pensions
The simplest pensions, these are designed to encourage lower earners to save for their future and are subject to restrictions on charging, meaning they can be a cheap and efficient way to start saving. Because of the cost limits, the range of investments might be restricted, as may some of the additional options.
Individual personal pensions
These pensions offer access to a range of different funds and may have added benefits which will make your management of them easier if you are looking to add value over a basic managed or tracker fund, or switch around different types of investment.
They are not subject to the same charging restrictions as stakeholder so the fund choice can be wider and they suit most pension requirements for most people.
Self-Invested Personal Pensions (SIPPs)
These are the most sophisticated personal pensions and allow a huge amount of investment flexibility if you are either very active in your investment allocation or adventurous in your choice. SIPPs allow investors to access funds, shares, bonds, gilts, property and cash – and occasionally some more esoteric investments as well.
They therefore allow you to build a portfolio specifically tailored to your needs and make adjustments to that portfolio whenever and however you like. As a result, compared to the choices above, SIPPs have been relatively expensive. In some cases, however, charges have reduced and a new generation of ‘low cost’ SIPPs have emerged, which offer the same switching and management flexibility but without quite the same access to the more esoteric investments.
However, as with any product in any industry, you pay for the bells and whistles. Therefore, if you don’t need them or do not have either the time or experience to take proper advantage of them, then paying for such a product could be a waste of your money.