What is a pension scheme?
A pension is a way to help ensure that you have savings to fund your lifestyle later in life, especially once you have retired. Pensions are an effective way to 'save' your money. Unlike putting away money into a savings account, the money that is put into a pension is invested. In simple terms, you (and others, such as an employer) will contribute to your pension, building a 'pension pot'. Your pension benefits from tax relief or so-called government 'top-ups' and once you meet certain criteria, such as age, you can access your pension fund and savings. In this article, we will take you through the different types of pension schemes, their benefits and the tax implications of pensions.
Types of pension
The state pension
The state pension is paid by the government. It is a regular payment made by the Government that is calculated from your National Insurance (NI) record. Typically you will need at least 10 qualifying years (although not consecutively) on your NI record, such as through: working and paying national insurance contributions; getting NI credits, or; paying voluntary NI contributions. The state pension will still be paid even if an individual receives income from a personal pension or a workplace pension. The earliest you can receive the new State Pension is when you reach State Pension age (not the same as your retirement age) which you can calculate on gov.uk. Individuals in receipt of the State Pension do not have to retire but will stop paying NI. An individual might be able to receive their pension savings and retire early in the event of serious ill-health (whereby life expectancy is less than a year).
To receive your state pension when you are eligible, you must apply. The state pension is typically paid every 4 weeks in arrears (paying for the previous 4 weeks, not the upcoming) and your first payment will be within 5 weeks of reaching State Pension age. The full new State Pension is £179.60 per week.
If an employee is over 22 years of age and earning more than £10,000 a year, an employer must automatically enrol their employee into a workplace pension scheme. The employer is obligated to pay a minimum of 3% of their employees salary into their pension scheme, on time. Employees have the right to opt out of auto enrolment but this will mean that the employee will not make the minimum 3% contributions.
Auto-enrolment will not happen if you have opted out, do not meet the criteria, or in other situations, such as if you've already given notice or if you have evidence (from HMRC) of your lifetime allowance protection.
From October 2021, under the Pension Schemes Act, large companies will be obligated to allocate spare cash into pensions, as opposed to paying investor's dividends to ensure that if a company collapses employee pensions are not affected.
1. Final salary scheme pension
Final salary pensions, also known as defined benefit pensions, are less common in the private sector but are standard for those working in the public sector. This workplace pension pays an individual a fixed income when they retire, irrespective of the actual growth of the pension fund. Whilst an individual will still pay into this pension, it is the employer's responsibility to ensure that there are sufficient funds to pay the employee their retirement income. Retirement income is typically based on the length of time an individual worked at a company and their salary and are also often index-linked meaning that the amount will increase annually to reflect the changes in the costs of living.
If your employer goes bust and has insufficient funds to pay retirement income to all its members then the Pension Protection Fund steps in to ensure that members currently receiving the pension will get their full pension up to £41,461 per year or if they have not yet started receiving their retirement income they will get 90% of their expected pension from 65 years old, provided this does not exceed £37,315.
Some of these schemes also provide employees with a tax-free cash lump sum. Each scheme should set out the amount of tax-free cash that can be taken and the cash commutation factor.
2. Defined contribution scheme
The defined contribution scheme is the most common type of pension as most workplace pension schemes are now contribution schemes. The value of your pension pot under a defined contribution scheme, unlike a defined benefit pension, will depend on how much money has been put into the pension and the investment returns on it.
Under this scheme, both the employee and the employer contribute to the pension. The employer pays a percentage of the employee's salary into the employee's pension (the employer contribution) whilst the employee also pays money into the pension out of their wages (employee pension contributions). The money paid into this pension will be invested in stocks and shares which an individual can choose (with or without help from a financial advisor) or the pension provider, like AVIVA, can pick appropriate investments based on your policy.
Employees under these schemes will usually get 25% of the pension fund tax free and the pension provider will usually take a small management fee that they should make explicit.
3. Stakeholder pension
A stakeholder pension is a type of defined contribution pension that can be started by individuals. However, employers can also offer them and will choice the pension provider and often arrange for contributions to be paid from an employee's wages. If an employer is using the stakeholder pension under their automatic enrolment duties, they must contribute. Stakeholder charges low and flexible minimum contributions, chapped charges and a default investment strategy. Due to this, stakeholder pensions differ from self-invested personal pensions (SIPP) as the investment choices are less broad. Unlike SIPPs, stakeholder pensions come with default investment funds.
Stakeholder pensions have a legal limit on charges: 1.5%p/a of the value of the pension pot in the first 10 years and 1% after this. If an employer is using a stakeholder pension in line with their automatic enrolment duties the charge limit is capped at 0.75%. Stakeholder pensions must also not charge for transfers and individuals must be able to stop or start investment, without charge or penalty, at any point.
Pension providers will provide tax relief at the basic rate and this will 'top up' your pot. While your employee works, the annuity will be invested. To access this pension pot, whilst an individual doesn't have to be retired, they must typically be aged 55 or higher. An individual can withdraw up to 25% of the pension pot as one tax-free sum.
Self Invested Personal Pension (SIPPs)
SIPPs work very similarly to a standard personal pension (whereby someone sets money aside for the future) but provides individuals with more flexibility with the investments they can choose. SIPPs can be run by individuals or with financial advice from a financial adviser. Individuals can invest in company shares, property and land, investment trusts and collective investments under a SIPP. Contributions to SIPPs also receive basic-rate income tax relief at source and can be frequent contributions or lump sums. If an individual is charged a higher rate as higher rate taxpayer (40%), they should ensure that they claim extra tax relief on their tax return. However, there are limits on the amount that you can contribute and the level of tax relief an individual can receive per annum. Individuals can 'carry forward' unused tax relief from the previous three years, meaning they could contribute up to £160,000 in one year. This entitlement is particularly useful for individuals who have fluctuating income, such as the self-employed.
Whilst employers can contribute to SIPPs, this type of pension is most often associated solely with employee contributions.
Individual Savings Accounts (ISA)
Like SIPPs, individuals do not pay tax on capital gains they make from their investments less than £20,000 per tax year. However, ISAs, unlike SIPPs, do not get tax relief at source meaning that you do not receive so-called government 'top ups'.
Another key difference between SIPPs and ISAs is that once you have put your money into a SIPP you cannot take it out until you are 55 (increasing to 57 in 2028) whereas you can access your money held in an ISA at very short notice.
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Individuals aged 50 and over with a personal or workplace pension and who want to make sense of their options, can book a free appointment with Pension Wise to get specialist pension guidance. Employers who are also unsure of their automatic-enrolment obligations should seek guidance to ensure they meet their obligations as a failure to pay employees the correct contributions to their staff, on time, may results in a fine from The Pensions Regulator.
Pensions and Employment Contracts
You pension scheme might be an important pull in your offer of employment and it is important that your employee is aware of their eligibility for pension and the name of your company's Pension Scheme provider in your employment contract. Legislate's employment contract offers you the flexibility to input a pension clause, detailing the pension scheme provider, at the touch of a button.
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The opinions on this page are for general information purposes only and do not constitute legal advice on which you should rely.