What is a Pension?By Money Mage · · Tax, Pensions, What Is
Pensions in the UK are an amazing way to save for ‘early retirement’. Including super early retirement, like retiring in your 40s or 30s.
If you plan your pensions in your 20s you will be on the path to wealth generation. Neglect them until your 40s, and you are going to struggle to build enough of a retirement pot.
One obstacle is the understanding of pensions. Pensions can be confusing and difficult to get to grips with.
Contribute £250/mo every month from your 20th birthday, and you’ll have by £500,000 pot by the time you are 50. Or more if you are higher rate tax payer. And that is ignoring growth in contributions as you earn more. And employer contributions.
You can see that Pensions are a great way of investing to grow your wealth.
One obstacle is the understanding of pensions. Pensions can be confusing and difficult to get to grips with.
This Ultimate Guide to Pensions will help break them down into managable chunks.
Money Mage is not Financial Advice. It is for information and education only. Please read the Disclaimer.
Pensions are the path to early retirement.
Pensions are the stepping stones on the path to early retirement. They are the stones between tailing off paid work to the State Pension Age and beyond.
The retirement pathway for many is to work until the State Pension Age, around 65 to 68. Then retire on the Full State Pension with little else.
You can bring that age forward with pension planning. In the UK, you can use your private pension pot 10 years before the State Pension age.
That date can be nearer still if you plan your retirement with non-retirement savings & investments.
What are the types of Pension?
UK pensions can appear complex and confusing. There are different types of pension, and different tax rules.
There are three main types of pension in the UK:
- The State Pension
- Defined Benefit Schemes
- Defined Contribution Schemes
In general, everyone will receive some form of the State Pension. There are some exceptions based on your National Insurance record.
Not everyone has a Defined Benefit or Defined Contribution pension. You will have one if you have made ‘pension contributions’ via your employer or directly yourself.
Defined Benefit schemes are becoming rarer. They are more common in public sector jobs.
What is the State Pension?
The Government pays the new State Pension. It is currently (June 2020) £175.20 per week or £9,110.40 per year for the ‘full state pension’.
The minimum is £48.20/week or £2,506.40/year.
The amount you receive depends on your National Insurance record. Or the number of ‘full years’ of NI contributions you have made. You can check your National Insurance record at gov.uk
You earn £4.82/week for each full year of National Insurance record. You must have at least 10 full years, and at most 35 years.
Take the UK state pension into account when planning your retirement.
For example, the other-MM and I have expenses of less than £10k/year. We’d be able to survive on the State Pension alone for our essential cost of living (food, bills, energy & health).
What are National Insurance contributions?
Your National Insurance contributions come out of your pay under Pay As You Earn (PAYE). If you are self-employed you make Class 2 or Class 4 contributions via Self Assessment.
There are four classes of National Insurance contributions:
- Class 1 - Paid by you and your employer, as part of Pay As You Earn (PAYE)
- Class 2 - Paid if you are self-employed at around £3/week
- Class 3 - Paid voluntarily to top up your years’ contributions if you are out of work. £15/week
- Class 4 - Paid if you are self-employed if your profits are above a certain threshold.
The figures above are 2019/20 tax year and will increase with inflation.
If you have not worked for the entire year, HMRC may offer you the ability to ‘top-up’ your contributions.
You can top up via Class 3 voluntary contributions. You should top up your NI contributions, especially if you are nearing retirement age. This is even more important if you don’t think you’ll be able to achieve 35 years of full contributions.
You can backdate around 6 years of voluntary contributions.
What is the State Pension Age?
The State Pension age has recently increased. It was 65, but it has been increasing up to age 68. Your exact age will depend upon when you were born, but unless you are nearing retirement it will be 68.
Life expectancy is actually falling in the UK. Given this, I doubt it will rise again without civil protest.
You can check your exact State Pension Age on gov.uk
What is a Defined Benefit Pension?
Defined Benefit Pensions used to be common before the 1990s. Now they are only common in public sector jobs. Defined Benefit pensions are also called ‘final salary pensions’ or ‘average salary pensions’.
Your pension will pay out a fixed amount based on your earnings during your career. Or a ‘defined benefit’.
If you work in the public sector, you likely have a Defined Benefit pension. Jobs like the fire service, police, the NHS, the forces, or local councils. There may be some Defined Benefit pensions in the private sector at larger companies. They are becoming much rarer.
How do Defined Benefit Schemes work?
You and your employer contribute to the scheme. The scheme ensures there are enough funds for it to keep operating.
The amount you earn from a Defined Benefit scheme depends on your ‘length of service’:
- Pensionable Service - the number of years you have been in the Defined Benefit Scheme
- Pensionable Earnings - this might be your final salary, a ‘career average’ or some other function of your earnings.
- Accrual Rate - The proportion of your earnings you’ll get for each year you were a member of the scheme. Usually 1/60 or 1/80
When you reach State Retirement age, you can take your Defined Benefit scheme at it’s full amount. You can usually retire up to 10 years early for a reduced amount.
Can I take a lump sum from my Defined Benefit Scheme?
When you retire you may be able to take a 25% lump sum from your Defined Benefit Scheme Tax-Free. You may be able to take the entire pension depending on your circumstances but tax may be due.
This will reduce the amount your Defined Benefit Scheme pays. Check with your provider.
How much will my Defined Benefit Scheme pay?
Calculate or find out your:
- Pensionable Service
- Pensionable Earnings
- Accrual Rate
Take the following example:
- Your Pensionable Service was 20 years,
- Your scheme is final salary and you retire on £43,000
- Your scheme’s accrual rate is 1/60
This would give you a pension of 20 years multiplied by £43,000 = £860,000
Divide £860,000 by your accrual rate of 60 = £14,333
This would give you a pension of £14,333 per year.
You may find your scheme increases with inflation or other factors. Check with your provider.
What is a Defined Contribution Pension?
A Defined Contribution Pension is a ‘pension pot’. You and your employer contribute to your ‘pension pot’. The size of your pot depends on total contribution and investment performance.
Contributions are placed in investments, within a pension scheme. Over the years the size of your pot grows with investment performance. Your growth is also reinvested leading to compounding. Investments in Defined Contribution schemes can also fall. Like during the 2008 financial crisis and 2020 COVID-19 pandemic.
Defined Contribution schemes are very common in the private sector. Auto-enrollment means many people working in the private sector will now have one.
How do Defined Contribution Schemes work?
With Automatic Enrollment, most people are now members of a Defined Contribution Scheme.
There are two stages to Defined Contribution Schemes:
- Stage 1. Contributions & Growth whilst you are working.
- Stage 2. Access your pension when you retire.
Stage 1: Contributions and Growth whilst you are working.
Your employer makes a contribution as a percent of your salary. You also make a contribution.
The statutory minimum from 2019 is:
- 3% employer contributions
- 5% employee contributions
For a total of 8% of your gross salary. You can contribute more, but your employer does not have to match those contributions.
If you earn £19,000:
- Your employer has to contribute £570
- You have to contribute £950
- For a total of £1,520
This £1,520 is then invested in a Pension.
Your employer might offer to pay more than 3% on a ‘matched’ basis. For example, your employer may match contributions up to 12%. In which case, your employer would pay 12% and you would have to pay 12% for a total of 24% of your gross salary.
During this stage, the goal is to grow your pension pot as large as you need. Where ‘need’ is enough to sustain your expenses when you retire. When calculating this, you should take into account other savings & investments. Including the State Pension.
Defined Contribution pensions are an investment. You can choose how to invest your pension.
If you are not comfortable with investing you can use an off-the-shelf fund, or a Financial Advisor. A default investment choice is a managed balanced fund. A managed balanced fund aims for growth alongside protection against loss.
There are often other ‘default’ funds provided. Ranging from ‘very cautious’ to ‘adventurous’. Cautious funds offer safer investment choices but less opportunity for growth. Adventurous offers more opportunity for growth but a higher risk of loss.
Pensions providers default funds sometimes rebalance the nearer you get to retirement. This rebalancing moves more of your investments to ‘fixed income’ the older you get. This reduces risk of loss as you near retirement.
If you are more comfortable with investing, you can how to invest your pension. If you are with a provider, you can chose any of their funds. Speak to your provider or check the literature provided with your pension.
Stage 2: Access your pension when you retire.
When you reach 10 years before State Retirement Age, you can start to take your pension.
There are many ways to draw down your Defined Contribution Scheme, which is quite complex.
You can also delay this drawdown and continue to contribute to your pensions during Stage 1 up till the age of 75.
How much will my Defined Contribution Scheme pay?
Defined Contribution Schemes are more complex than Defined Benefit Schemes. Especially when you reach retirement.
There are many choices when it comes to Defined Contribution drawdown. The choices can be complex. You may wish to seek Independent Financial Advice at this stage.
There is free guidance available from:
Here are some options:
- Guaranteed Income. Like a Defined Benefit Scheme, you can use your pension pot to buy a guaranteed income for the rest of your life. It’s called an Annuity. An Annuity is an insurance product that pays you a guaranteed income until you die. Some Annuities will also pay your spouse an income when you die.
- Adjustable Income. Also known as ‘Flexi Access Drawdown’. You can take a lump sum of 25% tax-free. The remaining 75% remains invested to provide you with an income that you can take as and when you need, at a rate you need.
- Take Cash In Chunks. Also known as ‘Uncrystallised Funds Pension Lump Sum’ or UFPLS. Compared to Flexi Access Drawdown, your 25% lump sum isn’t taken all at once but used over time. Each time you take a lump sum, a part of your original tax-free 25% lump sum is used. The rest remains invested, you take as and when you need, and income will be taxed at your marginal rate.
- Take your whole pot in one go. The first 25% is tax-free, and the remaining 75% is taxed at your marginal rate. Do remember a large pot will tip you into a higher rate income tax band if you do this.
Which Drawdown option should I choose?
There is no one-size-fits-all answer to which Drawdown option you should choose. Which option depends upon:
- The size of your pension pot
- Your appetite to risk
- Your expected income in retirement
- Whether you are happy to pay a large chunk of tax
If you are risk-averse, the guaranteed income of an Annuity may be the preferable option.
Let’s say you have a large pot and are a savvy investor. You may choose to leave your pot invested and use Flexi Access Drawdown. You take part of your investment growth each month, quarter or year, and your pot remains in tact until you die.
Defined Contribution Pension Drawdown is a complex area of financial planning. Check Pension Wise or talk to a Financial Advisor.
Can I take a lump sum from my Defined Contribution Scheme?
When you retire you may be able to take a 25% lump sum from your Defined Contribution Scheme Tax-Free. You may be able to take the entire pension depending on your circumstances but tax may be due. Check with your provider.
Can I take a lump sum and reinvest that in another Pension?
The simple answer is yes. You can take your 25% lump sum and invest that in another pension benefitting from further tax relief.
There is a mechanism known as the Money Purchase Annual Allowance. The MPAA limits the amount you can contribute back into a pension. The limit is £4,000 per year once you have triggered a drawdown ‘event’.
Drawdown events are complex, so you should check with HMRC or a Financial Advisor.
What is a SIPP?
A Self Invested Personal Pension is a self-managed pension. It’s tax-efficient wrapper for your pension investments.
It is a Defined Contribution Pension where you manage your own investments on your own.
You can hold a SIPP alongside other pension savings, so if you have existing Defined Benefit or Defined Contribution schemes from your employment, you can also open a SIPP.
Opening a SIPP requires a degree of investing knowledge. You will need to choose how to invest your funds. Not comfortable with this? It might be simpler to contribute to your existing pensions.
Monevator has a great list of SIPP providers and their fees.
Can I consolidate my Pensions?
If you have had a number of jobs over the years you may end up with quite a few pension schemes.
It is possible to merge these into a smaller number of pots. You can do this using transfers between schemes. Often people wish to merge to reduce the number of pension pots they have or to reduce fees.
You can start a transfer by speaking to the provider you wish to transfer into.
Consolidation of pensions can be complex. You may lose out on benefits you were unaware of. Do be careful. Are you sure you want to transfer out of a Defined Benefit scheme? Are you sure you are not going to lose out on benefits from older schemes? If you are nearing retirement or your pots are large, you may wish to consult a Financial Advisor.
What is an In Specie Transfer?
When you combine pensions, sometimes you can transfer the underlying asset or investment. Known as an In Specie Transfer.
Otherwise, your old provider has to sell your underlying investments. Then transfer the cash. Then your new provider has to buy new investments. This comes with a degree of risk as the markets may change during this transfer.
Speak to your providers to find out if an In Specie Transfer can be undertaken.
How much can I contribute to my Pension?
As of March 2020, you can contribute up to £40,000 into your pension each year. This is known as the Pension Allowance, one a number of [tax allowances]/what-is-a-personal-allowance/) in the UK. Your pension allowance may be reduced if you are a very high earner with income above £150,000.
Your pension pot also has a limit called the Lifetime Allowance, which is £1,073,100 as of June 2020. Anything above this would incur additional tax when you take a lump sum or drawdown.
The Lifetime Allowance increases with inflation. By the time you reach retirement age, the Lifetime Allowance will be higher.
How does Tax Relief work on a Personal Pension?
Contributions to your Personal Pension benefit from Tax Relief. You can make contributions to your pension up to your Pension Allowance, which is £40,000 per year. Or less if you earn over £150,000/year.
Depending on how your contributions are made, or what you earn, you may need to claim this tax relief back from HMRC or on your Self Assessment.
One confusing aspect of Tax Relief is you actually receive a top-up of 25% if you are a basic rate taxpayer. Why not 20%?
A tax of 20% of £10,000 is £2,000, leaving you with £8,000. But £2,000 is 25% of £8,000. So your ‘top-up’ is 25%. Higher Rate relief benefits even further, with a top-up of 66% from HMRC.
Higher Rate Tax Relief
If you are a Higher Rate Tax Payer you may need to claim higher rate relief. If your contributions come from your net salary, you may only be receiving 20% relief.
The higher rate of relief is not claimed by your pension provider.
If you contribute via Salary Sacrifice Scheme scheme, you are OK. If you don’t you may need to claim higher rate relief.
Check with HR or payroll at your company or your pension provider.
What is Salary Sacrifice?
Your employer may offer a ‘Salary Sacrifice’ scheme. Your pension contributions come from your gross salary. Your employer then makes all your pension contributions on your behalf.
This means you receive full tax relief immediately.
Some employers also offer extra contributions under Salary Sacrifice. Due to the reduction in employer’s National Insurance contributions. They pass some of these savings on to you. Speak to HR or payroll at your employer to see if they do.
When can I withdraw from my Pension?
You can start to take your pensions 10 years before your State Pension age. Currently 55 but increasing to 57.
In some cases, you can withdraw from your pension early, such as a terminal diagnosis. Speak to your pension provider.
What is the Safe Withdrawal Rate?
When drawing down a Defined Contribution pension, your pension pot will remain invested.
Big questions are ‘How much should I withdraw?’ and ‘Will my pension run out?’
There is no one-size-fits-all answer to how much you can withdraw without your pot running dry. It depends upon:
- Your appetite to risk
- How early you are retiring
- The size of your pot
- Your expenditure requirements
- Confidence in your investing strategy
- What other income you have in retirement
Withdrawing too much increases your Probability of Failure (POF). A general rule of thumb has been to pick a Safe Withdrawal Rate (SWR) of 4% of your pension pot each year.
If you hold investments in volatile assets like equities your pension pot can lose value. This month markets have seen a 15% to 20% drop.
The above chart depicts a £400,000 pot, drawing down at 5% with an expected growth rate of 3%. You can see that if your investments do perform at 3% or better, you are good for over 25 years. But if your investments perform at 0% or drop, this pot will fail after around 20 years.
You can decrease your SWR to around 3% to lower to reduce your POF. Or you can increase your SWR to around 5% to have more income but increase your POF.
An alternative is to pick a first-year withdrawal rate of say 4% in year 1, then increase by inflation each year.
Another alternative is to change your withdrawal rate and expenditure. Based on your investment performance. So when you investments do well, you take more, and when they do less well, you take less.
If you are retiring early, you may need to bring your withdrawal rate down to 3% or lower.
Do also take into account State Pension and your ability to use this income when you hit State Pension Age.
Does discussion about the Probability of Failure and Safe Withdrawal Rates panic you? If so, you might find buying an Annuity so you have guaranteed income is a better choice.
When can I retire?
The simple answer is ‘when you have enough passive income to sustain your expenses’.
You may be able to retire at 30. Living in Thailand off your dividend portfolio!
A more standard approach is to utilise your tax-efficient savings and investments. Then plan a pathway and bridge to retirement.
Consider the following four stepping stones:
- Step 1: Growth. Between ages M and N.
- Step 2: Super Early Retirement. Between ages N & ~57
- Step 3: Early Retirement. Around age ~57
- Step 4: Full Retirement. Around age ~68
Step 1: Growth
In this Step, we are of working age & we’re driving our income as much as we can.
We’re adhering to the Principles of Financial Independence. We’re growing our income, diversifying our income, reducing our unnecessary expenditure. We’re planning our savings and investments for our future Financial Independence.
Step 2: Super Early Retirement or Semi Retirement
In Step 1 we’ve built up a solid investment portfolio. We have invested in property and have an income stream from our property portfolio. Or we’ve invested in passive index tracker funds, tax-efficiently in our ISA. There are many ways of skinning the problem, each to their own.
We can check the income from our savings and investments. If you are lucky, your income from your savings & investments grows. If income from investments is beyond our expenditure, we can safely retire Super Early.
I am not a fan of Super Early Retirement. I can’t quite picture myself sitting on a beach doing nothing.
I also believe the FIRE community has made the whole concept a little hyperbolic for effect. In reality, most are actually not ‘retired’ at all. Instead, people are Financially Independent and doing their own thing. Where that thing drives income. That isn’t ‘retirement’ it’s ‘semi-retirement’!
Being Financially Independent well before Pension Drawdown Age is an awesome goal. But many will not achieve it.
We are aiming for this state in our mid to late 40s. Our FI number is currently predicting early 50s but we expect and hope to be able to bring that in.
Step 3: Early Retirement
At Early Retirement, you retire from most of your work and take retirement. Some find they still prefer to work to a degree. Called Semi-Retirement.
This is often at Pension Drawdown age. Age 57 in the UK.
You start to use your Defined Benefit or Defined Contribution pension schemes.
You can get a guaranteed income for the rest of your life, either with a reduced Defined Benefit or an Annuity bought from your Defined Contribution pot.
Or you can flexibility draw down your Defined Contribution pension as and when you need.
Step 4: Full Retirement
Full retirement in the UK kicks in when you hit State Pension Age. For us, this will be aged 68.
You now have income from your UK State Pension.
If you have planned everything right, your Step 2 and Step 3 funds are now running low. But your state pension has kicked in. giving you the income you need to last the rest of your happy, retired life.
You may have over-cooked things. In which case your Step 2 and Step 3 funds are still going strong. In this case, you can increase your standard of living and/or inheritance plan.
‘You shouldn’t focus on your pensions!’
Many in the FIRE community frown upon pension planning. There is a hyperbolic focus on Super Early Retirement. Instead, contributing to your non-pension-wrapped investments to bring forward ‘Step 2’.
In some cases, it’s downright damaging.
Imagine you are a higher rate earner in your 20s. You can enjoy 40% tax relief on your pension contributions. Not only that you enjoy 30+ years of compounding on that tax-relief. This can amount to hundreds of thousands of pounds.
Significant contributions to pension pot at an early age actually accelerates early retirement.
Get your pension going and on track in your 20s. You can then focus on your Financial Independence plans in your later 20s and early 30s.
But, no matter your age, and no matter your financial situation, pension planning will help your journey to retirement. As will the Principles of Financial Independence, clearing your debt, and mortgage freedom.
Sources and Attribution
- Charts (c) Money Mage https://www.moneymage.net/calculators/