National Pensions Awareness day came and went last month, with no apparent impact on people’s understanding of one of the best ways of saving for retirement. The Bank of England’s media-savvy chief economist Andy Haldane said in May that even he was unable to understand pensions because the system is so complicated.
This situation is not helped by some of the jargon that plagues the industry. When fewer people are using financial advisers and we are being asked to take greater responsibility for our retirement income, this is no good thing.
So with the aim of making a marginal dent into the ignorance, here is an A-Z of some of the most commonly-used pension jargon.
The maximum amount an individual can contribute tax-free into a pension each year, currently up to 100 per cent of your earnings in a year up to £40,000. Those on very high incomes (over £150,000) have their annual allowance “tapered”, so that they lose £1 of allowance for every £2 of extra income they receive. Those on £210,000 or more can contribute only £10,000 a year tax-free into a pension.
Benefit crystallisation event
The total size of all your pensions will be tested against another allowance – the lifetime allowance (see W) – at points known as benefit crystallisation events. There are a dozen circumstances when this can happen, but for most people it will be when they take a lump sum (see T), when they draw an income (see I), or when they reach 75.
You can carry forward unused portions of your annual allowance from any of the previous three tax years under the carry forward rule. There are conditions: you must have had an open pension in each of these years, and the total amount you contribute cannot exceed your income in the year in which you contribute.
Defined contribution pension
The most common form of pension today, in which the individual makes contributions (plus tax relief), their pension pot grows, and then they can access the money when they turn 55.
The government now requires employers to enrol employees in a pension scheme under a system known as auto-enrolment. This is different from a final salary pension scheme (see F), as the employer only has to make contributions based on the employee’s qualifying earnings (see Q) rather than pay a certain income at retirement. Compulsory contribution rates are set to rise in the coming years.
Final salary (or defined benefit) pension
These pensions pay an income in retirement based on a proportion of your final salary at work. No longer offered by most employers, final salary pensions are often described as “gold plated” because of their generosity (though the yawning deficits of many of these schemes suggest trouble ahead).
Group personal pensions
A type of defined contribution pension offered by some employers. Your pension pot still builds up based on any contributions you or your employer makes, plus investment growth.
The government has signed an agreement with 11 of the largest pension providers to build a new pensions platform to help people better monitor their investments. The ostensible reason for it is that people are increasingly accumulating multiple pension pots from different employers (see L), so the pensions dashboard will make it easier to keep track of them all. Some also think the platform will increase competition in the industry, by giving consumers another way to compare charges and performance over time.
Under the new flexible rules brought in by George Osborne’s pension reforms, you now have a variety of options for taking money from your pension after 55. Alongside leaving your money untouched, taking the whole lot in one go (see Z), simply taking small amounts out in cash, and buying an annuity (see N), it’s also possible to enter income drawdown. In simple terms, your provider will move your investments into funds designed to pay whatever income you wish. Be warned that this won’t provide a guaranteed income for life, and if you take too much out, it is unlikely that you’ll be able to make up the difference while in retirement.
Even children can have pensions these days. Just like a grown-up pension, junior pensions cannot be accessed until the child turns 55, but are an excellent way to give them a head-start in life. You can contribute up to £2,880 gross a year (which is topped up with 20 per cent tax relief), and investments held in the pension grow tax-free. Because children have such long investment horizons, some argue that children should be looking to purchase riskier assets that have the potential for strong capital growth over the long term.
Collec(k)tive pension schemes
Also known as Dutch-style pension schemes, former chancellor Osborne expressed interest in the last Parliament in encouraging employers to offer these to their workers. Best thought of as half-way between a defined contribution and defined benefit scheme, while employers and employees make contributions into the fund like the former, the employee will receive an income from the fund at retirement that is not directly connected to the value of their contributions plus investment growth. Often containing thousands of people, some say moving to these types of schemes would result in larger pensions for recipients.
By the time you finish your career, you’re likely to have accumulated multiple pension pots at your various employers (see H). There is therefore a case for consolidating them into one pot – you may be able to cut fees, you won’t lose track of any one of them, and you will be better able to monitor how your investments are performing.
You’re unlikely to need to worry about this one, but may hear mention of it. A master trust is an occupational pension scheme for multiple different employers.
Although they’ve recently fallen out of favour due to extremely low interest rates, annuities will still have a part to play in many people’s retirement planning. Offered by insurance companies, they provide a guaranteed income for life based on how much money you have and a complex assessment of how long you are likely to live. Annuities come in a variety of flavours: some will seek to protect your income against inflation, others will offer benefits to spouses. You can buy an annuity at any point in retirement (they can be useful if you no longer wish to take any responsibility for managing your pension investments, for example), but once they’ve been bought it’s hard to get your money back. Plans for a secondary annuity market have just been scrapped – disappointing some pensioners.
Auto-enrolment isn’t compulsory. If you wish, you can opt out – though that does mean you won’t receive contributions from your employer (and tax relief).
Pension Input Period
Confusingly, in the past, the tax year (from April to April) was not necessarily the period over which your pension contributions were tested against the annual allowance (see A). The government has now aligned pension input periods so that they run for 12 months from 6 April.
For the purposes of auto-enrolment, the government requires employers to make contributions into an employee’s pension – but only on qualifying earnings. For the 2016-17 tax year, they must pay a percentage on income between £5,824 and £43,000.
Since 2011, there has been no compulsory retirement age in the UK (it used to be 65). This means employers can no longer require employees to move on, and more over 65s are in work today than ever before. You can access your private pension pot from 55 (sometimes earlier if you’re in poor health), and your state pension in your 60s (you’ll need to check when you’re likely to be eligible, because there is a timetable in place for steadily increasing the state pension age to keep up with rising life expectancy). One way to boost your state pension, however, is to delay taking it. For every nine weeks you defer, your state pension increases by 1 per cent.
Self-Invested Personal Pension
A Sipp is a type of private pension in which the individual takes responsibility for choosing the investments. Proponents say that Sipps can be cheaper and they often have a wider range of investment options than a managed pension, but you should only choose this option if you’re comfortable doing your own research. You can still take independent financial advice if you have a Sipp.
Tax-free lump sum
At any point after 55, you can take 25 per cent of your total pension completely tax-free and many use this sum to pay off mortgages or other debts, or to help their children onto the property ladder. While there is some uncertainty over whether this particularly attractive aspect to pensions will last future pension reform, previous speculation that it might go has been shot down as an attack on middle England savers.
For those with very small defined benefit pension pots, it can be possible in some instances to take the full amount tax-free.
When you leave a pension scheme at one employer, you are still entitled to any benefits accrued and can transfer them to another pension scheme. The administrator or pension provider will provide you with a transfer value – a calculation of what you are entitled to. For defined contribution schemes, this value could be volatile due to volatility in the underlying investments.
Currently £1m, this is the maximum amount you can hold within all of your pensions without facing punitive tax charges when you reach a crystallisation event. The level has been brought down several times over the past few years, and industry figures have criticised these moves for penalising those who have saved a lot into their pension and/or made very good investment choices. There are a few ways of protecting yourself if you breach the lifetime allowance, which you should seek financial advice on.
Governments have long sought to incentivise pensions saving, most notably by offering significant tax relief on pension contributions. Think of it as deferred taxation: you pay nothing up-front on the sums you contribute, and then you pay income tax on money you take out of it (beyond the 25 per cent you can withdraw tax free (see T)). Tax relief is based on your so-called marginal rate of income tax. If you pay 40 per cent income tax, you will receive a 40 per cent boost on what you contribute; 20 per cent tax, 20 per cent relief. There are other forms of pensions tax relief, however. Investments held within the pension are free of income and capital gains tax, and there can be significant inheritance tax exemptions if you die before exhausting your pension funds.
Lifestyle funds or investment strategies change the mix of investments inside your pension based on your age, with the general aim of moving you progressively out of riskier assets as you approach retirement. There are downsides to this approach, however. If you delay retirement, you may find that you are invested in inappropriate assets that may not grow as quickly as you need.
The noise a Lamborghini makes. When Osborne announced the end of the compulsory purchase of annuities – allowing everyone to cash in their entire pension if they wished – then pensions minister Steve Webb said: “If people do get a Lamborghini, and end up on the state pension, the state is much less concerned about that, and that is their choice.” Whatever you do take from your pension is taxed at your marginal rate of income tax, however, discouraging big withdrawals. A Lamborghini will set you back over £200,000, meaning you would have to withdraw considerably more to account for the 45 per cent income tax payment.