Standard Pensions

A pension is essentially a pot of money that you and your employer pay into, upon which you receive tax relief.  The money sits in the pension and grows over the years.  This serves as a means of saving up for your retirement.  

In broad terms there are two main types of pensions schemes: defined contribution (sometimes called money purchase) and defined benefit (final salary) schemes.

Defined contribution

With a defined contribution pension scheme, once you reach retirement age you can either begin withdrawing the money from the pension pot.  Alternatively, you can exchange all or part of the pension pot with an insurance company in order to obtain a guaranteed income until death, this is called an annuity.

Defined contribution schemes are the most common type of pension scheme these days.  They work on the basis that you and your employer both contribute a fixed amount into the pot (usually a percentage of your earnings).  As the name suggests, the contribution that you’re both making is defined, however the end result of how much money is in the pot by the time you retire is a variable. This factor depends on how the pension funds are invested and how they perform over the years.
In April 2015 the pension freedoms act was introduced.  This allows you to access your pension plan more flexibly, taking as much or as little cash as you like, whenever you like.  This freedom only exists for “defined contribution” pension schemes that have been setup since April 2015.  If you have an older style scheme, it may be worthwhile reviewing the options it gives you.  If you’d like help reviewing your past or current pensions, complete our contact form to speak to one of our advisors. 

Pros

  • You can choose how much you pay in
  • You can choose how long you pay in for
  • With most schemes you can choose how the money is invested
  • At age 55 you can access the money
  • You can take 25% of the pot as completely tax free cash
  • You can take as much or as little of the pot as you need and change how much your taking at anytime.
  • The funds within the pension are outside of your estate for inheritance tax purposes, meaning they can be passed on to you beneficiaries in the event of you death without losing any of the remaining fund.

Cons

  • There’s no guaranteed income from the scheme, unless you purchase an annuity.
  • The size of the pot at your retirement is dependent on investment performance, not guaranteed.
  • If you’re drawing down from the pot as your income in retirement, the money can run out if you don’t plan accordingly.

Defined benefit

Defined benefit schemes (more commonly called “final salary” schemes) are much rarer these days.  They work on the basis that the benefit you receive when you reach retirement age is guaranteed.  Although you still make your own contributions into the scheme, the responsibility of the fund lies with the pension provider to ensure there are sufficient funds to pay you the benefit you have been promised.  

Defined benefit schemes traditionally work on what is called an “accrual rate”.  This means that the longer you are a member of the pension scheme the more years you “accrue”.  The most common accrual rates used are 1/60th and 1/80th.  

To give an example of how this works using the 1/60th system:

  • Your pension scheme has a retirement age of 65
  • Your salary at age 65 is £50,000.
  • You have worked for your company and been a member of the final salary scheme for 30 years.

This means you have accrued 30/60th of the pension which gives you a final salary pension of £25,000 guaranteed for life.

Pros

  • Guaranteed income for life, no concerns over the money running out.
  • Usually some kind of spousal or dependents benefit meaning a partial guaranteed income for your spouse or children in the event of your death.

Cons

  • Although the income is guaranteed it may be a relatively low annual income compared to the value of the pot itself.
  • Can’t necessarily access the pension from 55 or get a 25% tax free lump sum.
  • Other than partial death benefits in the event you pass away the main pension fund is lost.