How Personal Pensions work
The fundamental idea behind a personal pension plan is simple. You put money into a savings fund and it hopefully grows in value. At retirement, you have several options which are usually designed to replace some (or all) of your employment income.
These notes apply to an individual who is looking to establish a personal pension or stakeholder pension.
1. PAYMENTS IN
You can typically save into a pension plan in one of two ways:
- Regular instalments - The pension payment can be taken automatically each month by Direct Debit. Once you start making regular contributions in this way, and become accustomed to the regular payments going out of your account, you may find it easier to plan your monthly budget.
- One-off investments - Some people prefer the flexibility of making one-off investments at a time of their choosing, rather than commit to regular monthly contributions. Providers usually place minimum contribution amounts on single premium payments. This method can be useful where earnings/income for the tax year aren't known until closer to the end of the tax year.
It is your responsibility to make sure that the contribution is made.
- A combination of the above - This provides both the discipline of regular investments and enables one-off investments to also be made so that the best use of the available tax relief can be made.
2. TAX CONSIDERATIONS
Tax relief is granted on pension contributions within allowable limits. Currently, the basic rate of tax is 20% and higher rate is 40%. The additional rate is 45%.
For individuals contributing to a personal pension or stakeholder plan, the contribution is made net of basic rate tax. If you invest £80 into a personal pension, the provider will add the remaining £20 and invest £100 on your behalf (claiming the tax relief back themselves from HMRC).
If the investor pays tax at higher rates, it is possible to claim back the marginal rate via a tax return (higher and additional rates) or via a tax code adjustment for higher rate relief. In the example above, £100 is declared on the self-assessment tax return. The tax office will then credit you with the additional £20 of tax relief (so £20 of tax relief is paid into the pension plan and £20 is credited to the investor).
Self-employed investors also receive 20% tax relief immediately and claim any higher rates of tax relief via their tax return. As the income of a self employed person may be unclear until the tax year has ended, care should be taken to understand the effect on self-employed tax assessments when making pension contributions..
The tax treatment is dependent on individual circumstances and may be subject to change in future.
Restrictions on payments
The total amount you (and your employer or other third parties) can save each year toward a pension, without suffering a tax charge, is limited to the 'annual allowance'. The annual allowance for the tax year 2018/19 is £40,000 for most people (but can be less for those with high income). You may be able to carry forward unused annual allowance from the previous three years (ie. back to 2015/2016 for 2018/19).
In addition to the annual allowance, your personal contributions that are eligible for tax relief are limited to 100% of your earnings or £3,600 if greater. You can invest up to £3,600 per year gross in a personal pension (and still receive the 20% tax relief) even if you have no earnings. As the person making the contributions does not have to be the same as the person benefiting from the pension, this facility can be helpful in providing a pension for a non-working spouse - or for children and grandchildren as part of inheritance tax planning.
You will have to decide on the type of fund in which you invest your money. Most pension providers have a wide range of funds available - some have literally hundreds. Essentially, funds break down into two categories:
- Unit Linked funds – These are pooled funds, linked to the performance of underlying investments - usually equities (ie. stocks and shares). The money is used by the fund manager to purchase more of the fund's underlying assets. The price goes up and down in line with the investments held. If the market falls, so does the unit price. This can be good news for people investing with a long time to go (a new cash investment will buy more units), but bad news for people about to use their fund to provide retirement benefits. Those approaching retirement tend to switch funds into less volatile investments to avoid this risk.
The value of units can fall as well as rise, and you may not get back all of your original investment.
- With Profit funds – These also invest in stocks and shares and other assets, but the fund manager tries to smooth out the peaks and troughs of unit linked funds by holding back some of the growth as a reserve. This can provide a smooth increase in value in your investments.
A Market Value Adjustment might apply on encashment. The value of this policy depends on how much profit the company / fund makes and how they decide to distribute that profit.
When projecting pension fund values, certain growth assumptions are made by pension providers. These are currently 0.5%, 2.4% and 5.5%.
A better way to predict growth is to try to allow for inflation and establish ‘real growth’. In other words, if a fund achieves 5.5% per annum growth but inflation has been 2.5% per annum, the real growth is 3.0%. This more realistic real growth assumption is now the norm.
From 6 April 2015 new "Pensions Freedom" legislation came into effect, and consequently, at retirement, there are now many new options as to how you take your pension. For further details please refer to our "Your Retirement Options and Pensions Freedom" article.
5. HOW MUCH SHOULD I INVEST?
You should invest as much as you can comfortably afford, as soon as you can, within allowable limits. You should not overstretch yourself. Most modern pension plans are flexible in terms of allowing contributions to be increased, decreased or temporarily stopped as circumstances dictate.
The actual amount you should invest will be different for each individual. Once you have arrived at a figure, it is useful to try to link it to salary. If you have decided that you can afford £100 per month and you earn £20,000, a quick calculation will show this amounts to around 6% of salary. Try to maintain that link in future years.
You may choose to calculate the level of savings necessary to achieve a certain level of income (in today’s terms) at your chosen retirement date. This target funding is then reviewed on a regular basis to account for revised objectives, investment performance and changing market conditions.
6. WHAT ABOUT STATE BENEFITS?
The new State Pension is a regular payment from the government that you can claim if you reach State Pension age on or after 6 April 2016.
You can get the new State Pension if you’re eligible and:
- a man born on or after 6 April 1951
- a woman born on or after 6 April 1953
If you reached State Pension age before 6 April 2016, you’ll get the State Pension under the old rules instead. You can still get a State Pension if you have other income like a personal pension or a workplace pension.
The full new State Pension is £164.35 per week (2018/19). How much you get will depend on your National Insurance record. You’ll usually need 10 qualifying years to get any new State Pension. Furthermore, you may need around 35 years to qualify for the full new State Pension.
The amount you get can be higher or lower depending on your National Insurance record. It will only be higher if you you have a pre 6/4/16 National Insurance record including a certain amount of Additional State Pension.
7. WHAT ABOUT OTHER FORMS OF SAVINGS?
Obviously if you are serious about retirement planning, you should not necessarily concentrate all your savings into the one area of personal pensions. However, personal pensions will certainly form part of your overall strategy.
If you are considering starting saving for your retirement, ask yourself:
- Is the level of savings you are proposing realistic from a retirement and state pension perspective?
- Do you want the discipline of a monthly investment or could you make lump sum payments from time to time (or both)?
- How much would you need to live on, if you retired today? It’s then possible to begin calculating the cost of achieving that objective.
A pension is a long term investment. The fund value may fluctuate and can go down. Your eventual income may depend on the size of the fund at retirement, future interest rates and tax legislation.