Pieces of the pensions puzzle explained

When did you first start thinking seriously about your eventual retirement? Your thirties? Your forties perhaps? Maybe later. It’s very common for people to put off planning for their long-term future. After all life is busy and stressful. Your immediate needs and those of your children, if you have them, are in the here and now and tend to take priority.

Retirement planning is also complicated. Various pension types and their accompanying rules and regulations have been built up over decades, resulting in a convoluted and piecemeal system. There’s a lot to get your head around. Many people are simply left with a vague notion that they ‘need to do something’ to replace their income from employment or self-employment when they’re older but aren’t sure exactly what and how much.

Yet its vital people understand the mechanics of pensions and retirement saving more broadly. Decisions you make when you are far from retirement can make a huge difference to your quality of life when you get there. It’s also not necessarily as complex as it first appears. Peel back some of the jargon and get to the basics and it can be straightforward to make a plan. Help is also at hand. If you get stuck, consider our financial coaching service as an option.

In the meantime, to lay the groundwork let’s consider the various types of pensions you’ll encounter and their characteristics.

What are the types of pensions in the UK?

A ‘pension,’ as most people would define it, is an amount paid regularly to a person. An income in other words, either earned from past service or other qualification, or else secured using savings built up.

First off, most people will have heard of the State Pension, though much fewer really understand the rules and how much it will provide them. The State Pension is paid to those of ‘pension age’ (warning: this has changed over time and will likely continue to do so!) who have paid national insurance contributions – essentially a tax – through their working lives.

The intricacies of the State Pension system are complex, partly because it has evolved over the years and most people receiving it today will have entitlements under past rules that no longer apply. However, the basic principles are straightforward. Plus, things have got a lot simpler with the latest iteration, known as the ‘new State Pension,’ which applies to those reaching retirement age (presently 66) from April 2016.

The amount of State Pension you are paid is defined by how many years you have paid national insurance. A full new State Pension requires 35 years of national insurance contributions or credits, and those with at least ten years receive a proportionate amount. Those with a record of less than ten tax years do not receive anything. The full amount is currently worth £11,502 a year, which rises annually according to the so-called ‘triple lock’. That’s the highest of inflation, wage rises and 2%, although it’s possible this commitment might be watered down in the future – best not rely on it being set it stone!

To check your national insurance record and get a state pension forecast use the gov.uk website. This will tell you your state retirement age and how much you can expect to receive. If you aren’t on track to receive a full amount, there are sometimes options to increase it such as making voluntary national insurance contributions.

Defined benefit versus defined contribution

State Pension isn’t much to live off on its own. It’s therefore necessary for most people to make significant extra provision for their retirement with their own private pensions. Making your own pension contributions over the years is an exercise in delayed gratification. You’ll not see the benefit for years to come, and you’ve likely had to give something up in the short term, but you’ll probably be glad you did!

In the UK we broadly have two types of pension schemes – ‘defined benefit’ and ‘defined contribution’.

Defined benefit schemes, as the name suggests, are pensions where the benefits are defined. They are based on certain rules – how long you worked for your employer, your salary and when you take retirement. Your employer, or otherwise the trustees of the pension fund, must fulfil the promises made in the rules. Importantly, and reassuringly, there is no investment risk for you to bear – it’s all on them!

As such the number of defined benefits schemes remaining in the private sector is vanishingly small. However, they are still around in the public sector and many people have historic entitlements built up, even though they can’t add to them anymore. ‘Final salary’ schemes are a common variety of defined benefit pension whereby the income paid from retirement age is calculated on leaving salary and the number of years worked at the organisation.

Meanwhile, a defined contribution pension is a different beast entirely. It’s pot of invested money – a pension ’fund’ – in your name that’s built up over time. The size of this fund depends on two factors: How much you (and your employer if applicable) pay in and the investment returns you receive.

Employees are usually ‘auto-enrolled’ into a workplace pension, which is very likely a defined contribution scheme, and you should keep up your payments into such schemes as far as possible in order to receive contributions from your employer.

Personal pensions and SIPPs

Personal pensions such as SIPPs (or Self Invested Personal Pensions) are also defined contribution schemes. These can be set up by anyone eligible – UK individuals aged between 18 and 75 – so they can be useful for the self-employed who don’t have a workplace pension. SIPPs could also be of interest for anybody looking for extra retirement provision while taking full control of investments. You can buy and sell shares and other investments, which gives you a world of options.

When you reach a certain minimum age (currently 55) you can start drawing from a defined contribution pension pot such as a SIPP. That either means dipping in to take one-off or regular amounts, or converting the fund into an income that is guaranteed for as long as you live. This is known as an annuity, and it effectively turns your defined contribution pot into a defined benefit pension.

Other retirement income options

Other investments can be part of your retirement income mix. It’s common for people to consider property that provides a rental income, although the burden associated with being a landlord shouldn’t be underestimated. Plus, the income yields on UK residential property don’t tend to be attractive verses other assets.

Meanwhile, ISAs – or Individual Savings Accounts – are multi-purpose savings vehicles. You decide what they are for and when. So, they can be as much for retirement as they can other goals such as a house deposit or education fees.

ISAs don’t benefit from tax relief, which is a major benefit of pensions, but they are more flexible. With a standard ISA – which comes in two types, Cash and Stocks & Shares – you can access your money at any time. They are also tax efficient with no income or capital gains tax to pay on returns, and you can access a wide range of investments in a Stocks & Shares ISA. It’s preferable to hold investments such as shares in an ISA because in a standard Investment Account returns could be subject to tax.

Find out more: Should you save into an ISA or pension for retirement?

Need more information?

Hopefully, this has article has helped clear some of the pension fog. To make more sense of pensions download your free Guide to Pensions and Retirement to help you understand how you can plan for the retirement you want.

Guide to Saving for Retirement