29th January 2019
Pensions. Everyone’s heard of them. It’s a source of income at retirement and could sometimes be the only one. But what exactly is a pension and what benefits do they offer?
According to Aviva (2018) and Legal & General (2018), a pension is a “tax-efficient way of saving for your retirement” and can normally only be accessed from age 55. It offers a number of benefits, such as tax relief and employer contributions, in addition to the power of compounding (The Money Advice Service, 2019).
Tax relief is given if an individual is paying into a workplace pension scheme, which is provided by the employer, by deducting the contributions from their salary which reduces the amount of income tax they pay. If an individual is paying into a personal pension scheme, the government will add the tax they would have paid to the contribution for basic rate taxpayers. For example, for every £80 an individual contributes to their pension £100 is added; the government adds the additional £20 to make it up to £100 (Anker, 2019). For higher rate taxpayers and additional rate taxpayers, tax relief is claimed via self-assessment. As well as tax relief, employers can make also contributions to the pension pot, which can substantially increase the final amount of the pension. However, there is an annual limit of £40,000 gross that can be contributed towards the pension, which includes employer contributions, and if this amount is exceeded there will be a tax charge. There is also a lifetime allowance for most people, currently £1,030,000 in 2018/19 which is the total value of all the pensions you have (excluding the state pension). If this allowance is exceeded there will be a tax charge.
There are a lot of different pensions but the three main types, and the ones that will be covered here, are the defined benefit scheme, the defined contribution scheme and the state pension.
A defined benefit scheme is where the final income of the pension is based on an individual’s earnings and how long they’ve been part of the scheme (Legal & General, 2018; The Pension Advisory Service, 2019a). The two most popular types are a ‘final salary’ scheme and ‘career average’ scheme, where the earnings that the final income is based on is the final salary or the average salary over the career of the individual respectively (Gov.uk, 2019a). However, the defined benefit scheme is becoming less popular in favour of the defined contribution scheme (Stittle, 2018).
A defined contribution scheme, also called a money purchase scheme, is where the final income of the pension depends on the contributions made by an individual, their employer and how the investments have performed over the period (Legal & General, 2018; The Pension Advisory Service, 2019a; Gov.uk, 2019b).
A workplace pension could be either a defined benefit scheme or a defined contribution scheme, however the defined contribution scheme has become increasingly more popular (Nest, 2019) to reduce the liability on the employer. However, personal pensions are most likely to be a defined contribution scheme, and can be used by the employed, self-employed or unemployed (The Pension Advisory Service, 2019b).
In addition to the above pension schemes there is a state pension which is provided by the government. National Insurance (NI) contributions must be made (or credited) for 35 years during the working life of the individual, making them eligible to receive the full basic amount currently £164.35 per week (Anker, 2019; Citizens Advice, 2019).
Anker, G. (2019) Personal Pension Need to Knows Available at: https://www.moneysavingexpert.com/savings/discount-pensions/ (Accessed: 21st January 2019)
Aviva (2018) What is a Pension? Available at: https://www.aviva.co.uk/retirement/pensions/aviva-personal-pension/what-is-a-pension/ (Accessed: 20th January 2019)
Citizens Advice (2019) State Pension Available at: https://www.citizensadvice.org.uk/debt-and-money/pensions/types-of-pension/state-pension/ (Accessed: 21st January 2019)
Gov.uk (2019a) Types of Private Pensions Available at: https://www.gov.uk/pension-types (Accessed: 20th January 2019)
Gov.uk (2019b) Personal Pensions Available at: https://www.gov.uk/personal-pensions-your-rights (Accessed: 20th January 2019)
Legal & General (2018) Pensions Explained Available at: https://www.legalandgeneral.com/retirement/saving-for-retirement/pensions-explained/ (Accessed: 20th January 2019)
Nest (2019) Types of Pensions Available at: https://www.nestpensions.org.uk/schemeweb/nest/members/about-pensions/types-of-pension.html (Accessed: 21st January 2019)
Stittle, J. (2019) Britain’s Great Pension Robbery: How Defined Benefit Schemes Became a Thing of the Past Available at: https://www.independent.co.uk/news/business/analysis-and-features/pension-retirement-defined-benefit-contribution-funds-risky-a8479426.html (Accessed: 21st January 2019)
The Money Advice Service (2019) Why Save Into a Pension? Available at: https://www.moneyadviceservice.org.uk/en/articles/why-save-into-a-pension (Accessed: 21st January 2019)
The Pensions Advisory Service (2019a) Workplace Pension Schemes Available at: https://www.pensionsadvisoryservice.org.uk/about-pensions/pensions-basics/workplace-pension-schemes?moreInfo=2 (Accessed: 20th January 2019)
The Pension Advisory Service (2019b) Personal Pensions Available at: https://www.pensionsadvisoryservice.org.uk/about-pensions/pensions-basics/contract-based-schemes/personal-pensions (Accessed: 20th January 2019)