Guide to Pensions
We hope our Guide to pensions will assist you - click on a link to read more information on that subject:
- What is a Pension?
- How do I earn one?
- What are the advantages and disadvantages of pension saving?
- What sorts of pension are there?
- How do I know how well my pension fund is performing?
- What can I do about it if it's not performing?
- What risks are there to my Pension Fund?
- What happens if I change jobs?
- When can I get at it?
- What are stakeholder pensions?
- What are my options at retirement?
- Supplementary State Pensions
- Divorce
- Disclaimer
1. What is a pension?
A pension is a sum of money payable to you for life. Perhaps the best known is the State Retirement Pension but there are in addition occupational and private pensions.
2. How do I earn one?
Entitlement to a State Retirement Pension is achieved by paying or being credited with National Insurance (NI) contributions. Typically they are paid through PAYE on your employment income but they are also paid by the self-employed and are given by way of credit in some circumstances e.g. for bringing up children.
Occupational and private pensions arise from contributions made either by you alone or with additional contributions by your employer.
Broadly speaking an occupational scheme is a scheme that is run by your employer and a private pension is one that is run by a pension provider on your behalf alone.
In any event, it is dangerous to your financial future not to have some sort of pension arrangement. If your employer offers you access to their scheme you are strongly encouraged to join. If not then make arrangements to start a private pension – but do not delay, procrastination is more than just ‘a thief of time’, in a pensions context it is a thief of money! Long-term saving means saving for a long term.
3. What are the advantages and disadvantages of pension saving?
No sane policy maker would penalise any sort of saving – but too often they do and pensions are no exception.
For some years now pensioners earning below a minimum amount have had their income topped up by Pension Credit, but it is means tested. The result can be that pension savings can be wasted if your income from all sources in retirement, including the pension saved for, is less than the minimum amount, in which case it is topped up to the minimum in any event.
The effect is that had you not saved for your pension and merely consumed it in living expenses you would be no worse off. It is in fact a disincentive to saving. However, our view is that saving for oneself has the overriding advantage of greater certainty than the vagaries of government pension policy; reliance on the state is never wise - a measure of independence has much to recommend it.
Pension Credit is intended to be short-term and on past evidence future policy cannot be anything other than a matter of speculation. It should also be borne in mind that these remarks apply equally to a whole range of means-tested benefits which may be lost or restricted as a result of pension saving. There is no practical means by which their impact at retirement can be assessed. (The short-termism and muddled inconsistencies of UK public policy as regards pensions generally is nothing short of deplorable.)
Thus, in choosing to save for a pension you do so in the full knowledge that some or all of your savings may be wasted; it simply depends upon what the means-testing rules happen to be at that point, to which benefits they apply and whether those benefits are or would otherwise be available to you – none of which is foreseeable.
4. What sorts of pension are there?
Generally speaking there are two types of pensions:
- Occupational Schemes:- These are provided by employers and can be salary related or cash related.
- Private or Personal Pensions:- These are individual arrangements run by insurance companies or investment houses, available to employees and the self-employed alike. They are always cash related.
Occupational pension schemes normally have a contribution from the employer (there are presently proposals afoot to make such contributions mandatory) and a contribution by the employee. The employee’s contribution is taken at source from his wages and is usually tax deductible i.e. it is paid from pre-tax rather than post tax-income.
Occupational pension schemes themselves can be broadly distinguished between Defined Benefit schemes (sometimes referred to as Final Salary Schemes) that typically provide a certain proportion of final earnings in retirement for each year worked, and Defined Contribution schemes (sometimes referred to as Cash Schemes) which simply build up a fund.
Under a Final Salary scheme the employee will be entitled eventually to a proportion of his final earnings calculated by reference to his length of service. Most such schemes in the private sector have been closed to new entrants and they are largely now only to be found in the public sector.
The fund built up under a Cash Scheme, whether occupational or private becomes available to buy a pension, properly known as a pension annuity, upon retirement. In exchange for the fund an annuity provider undertakes to pay you a sum of money annually until you die.
Many employers pay contributions to private pension schemes rather than run occupational schemes themselves. Although there are still large numbers of occupational schemes around, many are now being closed and the liabilities to the members bought out through various arrangements.
5. How do I know how well my pension fund is performing?
This question is only relevant to Cash Schemes.
Within reason it matters not how the Final Salary scheme is performing since ordinarily the employer undertakes to meet the obligations of the scheme (but see the paragraph on risk below).
If your private pension is with a reputable provider and it is unit based, by which is meant the funds are invested in one or more unit trusts, then the value of the units is quoted daily in the financial press.
A particular type of fund known as a With-Profits fund however is fearfully difficult to value since so much of the value eventually attributed to your investment in the fund is in the form of terminal bonuses and that sum cannot be known until retirement.
Unfortunately, many banks and other financial institutions, who manage their own in-house funds, choose not to release performance details which makes it very difficult to judge performance.
However, all providers are now obliged to issue annual reports indicating progress (or lack of it) together with a projection of benefits to your chosen retirement date.
6. What can I do about it if it's not performing?
It depends upon the particular provider and the terms of the contract. Investment performance of some funds is dire. The in-house funds of High Street banks commonly so.
The investment may have been set up such that it is all directed to one fund or it may be allocated over a range of different funds. In the latter case switches between funds may be the solution but in the former the only solution may be transfer it to another provider.
Charges can have a surprising impact upon investment growth. Many "old style" contracts have high charges. More recent personal pensions often have lower charge rates designed to compete with stakeholder pensions (see below).
In reviewing a pension plan we check the charges as well as its performance. We also check that the fund(s) is suitable for your particular risk profile.
7. What risks are there to my Pension Fund?
For defined contribution schemes (personal pensions and the like) the risk is largely one of investment risk (see our Investment Guide - Risk, a Guide and Our Approach to It), where the value of your fund can fall as well as rise depending upon market and plan performance, and the price of pension annuities when you reach retirement. (Annuity Rates fluctuate for a variety of reasons, including changes in anticipated lifespan - people living longer.)
The risks of theft involved in saving with a reputable provider are minimal. You are purchasing units in a trust, the managers of which invest in a portfolio of assets selected in accordance with their investment policy to meet the objectives of the trust, typically to achieve income or capital growth, as laid down by the trustees, to whom the managers report and in whom the assets of the trust are vested on your behalf and who are responsible to you and the other unit holders for their safekeeping. Such providers are subject to a regulatory regime designed to ensure that the funds are safely maintained on your behalf. You actually own the plan, so no one else may access any of the benefits.
Defined Benefit / Final Salary schemes are also subject to investment risk but also to other risks. Bigger companies often maintain the scheme directly through their own pension fund trustees and may have a very considerable influence over the investment policies and management of the scheme. Inevitably, such a close relationship will result in abuse, of which perhaps the best known example is the theft of the Mirror Group Newspapers pension fund by Robert Maxwell. A more common risk however is that the employer finds itself unable to fund the scheme sufficiently to meet all its liabilities. There have been quite a number of well-reported pension fund shortfalls which have resulted in the government establishing a pension lifeboat scheme funded by a levy on other more successful schemes. To what extent it can be relied upon to make good such shortfalls is an open question, quite apart from the issue of whether it is fair that funds belonging to other pension savers should be siphoned off to meet the demands of the luckless members of a failed scheme. Although defined benefit schemes are subject of strict regulation and are supposed to maintain adequate funding at all times, the measure of adequacy is an extremely complex matter. It involves severely difficult valuing and forecasting exercises to determine the adequacy of the funding of such a scheme.
If a member is particularly concerned about the safety of his occupational pension scheme then there are specialist firms around who will (for a fee) provide a report.
8. What happens if I change jobs?
If it is a Final salary/defined benefits scheme, one will normally have the opportunity to either leave the built- up benefits where they are or transfer them to the new employer’s scheme. However, the value of the entitlement to benefits acquired has to be established and that involves complex calculations and an element of forecasting and judgement. Considerable care should be taken before doing so. Consulting qualified advisers is recommended.
If it is an occupational Cash scheme then it is relatively easy for the pension trustees to place a value upon the fund and transfer it across.
If however, the pension fund is merely a personal pension, then the only change is that the former employer stops making contributions to it and the new one begins to do so.
9. When can I get at it?
Occupational pension schemes will normally indicate a normal retirement date (NRD). In the event of retirement on ill-health grounds the trustees may consent to the pension being paid from an earlier date. Retirement before NRD will normally involve a reduction in the benefits receivable (an actuarial reduction) to reflect the fact that the member will be making fewer contributions while at the same time to be expected to be retired longer.
For private personal pension holders the normal minimum pension age is 50 (up to 5th April 2010) at 55 thereafter. That does not mean however that the member has to retire at that date. It is possible to continue to work and contribute to such a pension or indeed take the benefits of the pension and work at the same time.
Since April 2006, it has also been possible to withdraw up to 25% of your fund in cash (tax free) without having to take your pension from it.
10. What are stakeholder pensions?
These are merely a particular form of personal pensions introduced by the government some years ago and which were intended to encourage pension saving by providing a ‘no frills’ pension contract.
Unfortunately, but for a variety of reasons the scheme was a dismal failure (despite government spin to the contrary).
At the time of writing however they may be given a new lease of life by a proposed requirement for all employers to make a minimum contribution and employees too by means of ‘automatic enrolment’ i.e. employees have to opt out if they do not want to save.
Oddly, automatic enrolment means that no note whatever is taken of the possible loss of means-tested benefits referred to above (another example of the dire standards of policy-making with regard to pensions generally).
11. What are my options at retirement?
If it is a Final Salary or defined scheme then the only choice that you are likely to have to make is whether to take the maximum tax-free lump sum (the commutation) and a lower pension or vice versa. The benefits themselves will have been calculated by reference to your years of service and your salary – hence ‘defined benefits’.
Members of Cash schemes, whether occupational or private pensions, have options that are markedly more problematic and will often need advice. They will have a fund that has a value. They will normally have a tax-free cash entitlement, typically up to 25% of the fund, and the balance of the fund may be utilised to buy a pension (see What is a Pension? above). Careful consideration must be given to the type of pension purchased (level, increasing, with or without guarantees or dependant’s benefits etc). Further complexity is added by issues arising from the hideously complicated rules governing the (mandatory) supplementary state pensions in their various guises over the years (see below). Considerable investigation and explanation can be necessary.
Such a pension annuity does not need to be bought from the pension provider, you have the right to take your fund around the market to achieve the best pension payable under what is known as the ‘Open market Option’.
In a few circumstances for certain individuals, it may be appropriate to defer the purchase of a pension (it may be deferred until age 75) and leave the fund invested, possibly accessing only the tax-free cash or drawing-down a sum in lieu of pension (see below).
Whatever the type of scheme you have, we are able to assist you in reviewing your options, choosing the most appropriate and ensuring that your fund buys you the best possible pension.
12. Supplementary State Pensions
It is probably fair comment to say that for the better part of 40 years government policy with regard to supplementing the basic state retirement pension has been deplorably bad.
We have seen graduated pensions (if you can remember those you are showing your age), the state earnings related pension scheme (SERPS) and now the state second pension (SSP). All those schemes have been the subject of endless tinkering, changes in funding arrangements (usually reductions) and policy changes of one sort or another, eventually reaching a point where the public has largely lost all belief either in the schemes or the competence of government to run them. Some commentators do not shrink from accusing the government of cheating pensioners.
In any event, endless rule changes gave rise to such complexity in the pensions environment, that a ‘simplified regime’ took effect 6th April 2006. (Readers may care to note that the simplification was only a simplification of the endless complexity introduced by the government itself.) Inevitably, the simplified regime is anything but and there are any number of transitional issues which will be with us for many years, but fortunately only relatively few people are affected by them. Nevertheless some issues have a significant impact upon pension entitlements and the following terms are commonly to be found amongst pension documentation: -
- Guaranteed Minimum Pension (GMP)
Occupational pensions schemes which met certain standards were entitled to contract out of the State Earnings Related Pension Scheme. (See contracting out.) One requirement was that the scheme guaranteed a minimum pension equal to that which would have been provided by the SERPS scheme. That part of the fund representing the GMP element is ring-fenced for certain purposes and is subject to the same restrictions as Protected Rights (see below). - Protected Rights
An individual not in a contracted out occupational scheme (see contracting out) could contract out by taking out a private pension called an Appropriate Personal Pension. The government provided a rebate of National Insurance contributions directly to the personal pension provider (it was the reduction by the government in the level of the rebate which caused the contracting out furore). In any event, that part of the fund arising from the DSS NI contributions rebated is ring-fenced from the personal contributions a 50% dependants pension must be provided (if a dependant exists). The old restriction on Tax Free cash has, since April 2006, been removed and you may, as is the case with all other pension arrangements, take up to 25% of the fund as a Tax Free lump sum - Section 32 Transfer Bonds
Upon leaving a Defined Benefits scheme any guaranteed minimum pension element must continue to be ring-fenced and a Section 32 Bond is a ‘buy-out insurance’ arrangement which does just that, thereby enabling the funds to be transferred from an occupational pension scheme which held contracted out status into an individual contract issued to the employee. - Contracting Out
Some years ago in an effort to reduce the anticipated burden on the public finances while recognising the need to improve pensions in retirement, a compulsory State Earnings Related Pension scheme, or SERPS, as it generally came to be known, was introduced, from which there was an opt out available for those already in occupational pension schemes of sufficiently good quality. Such qualifying schemes enabled employees to opt out of SERPS and thereby pay lower contributions (they will already have been paying contributions to their occupational pension scheme). Those who were not members of occupational pension schemes could contract out by joining an appropriate pension scheme. Both arrangements received rebates of NI contributions which gave rise to the ring-fenced GMP/Protected Rights funds referred to above.
The question of whether or not to contract out was problematic from the outset. The government of the day produced guidelines which chiefly revolved around age and gender but any such decision had to be necessarily subjective since its wisdom or otherwise could only be determined upon eventual retirement when (theoretically) the additional pension obtained through the contracting out arrangements could be compared with that which would have been received under SERPS. Typically, the SERPS scheme was the subject of endless political tinkering and rule changes and, most significantly a fall in the promised level of rebates with the result that many individuals who contracted out (and were encouraged to do so by the state) may have been, with hindsight, wiser to remain in the SERPS scheme. But benefits under the SERPS scheme have also been reduced and the arguments as to the respective rights and wrongs of any such decision or advice given in connection with that decision are many and different views may tenably be held.
Perhaps once again, all that can be said with safety over the whole sorry story is that the old adage: ‘never trust governments’ is particularly apt.
13. Divorce
Pension funds and entitlements will be taken into account by the court in determining divorce settlements.
There are two common methods: sharing and splitting; the former involves (with the consent of the pension trustees) a transfer of part of the fund from one spouse to the other and splitting involves the benefits receivable under the scheme being split between the spouses at the point of payment.
Taken together with the complexities of pensions rules generally and the guaranteed minimum pension/protected rights issues referred to above, there can be very considerable complexity.
Seek specialist advice.
14. Disclaimer
While we hope the above has been found to be useful it is intended only as a general guide, may not reflect the very latest developments and cannot be a substitute for professional advice.
We cannot accept any responsibility for loss occasioned to any person acting or refraining from acting as a result of material contained in this guide.