How do pensions work?
As the cost of living rises and the State Pension age creeps ever higher, saving for retirement is on the minds of most working-age individuals – whether they already have a pension pot or not. If you’ve been procrastinating or feeling overwhelmed by the prospect of arranging a pension, then you’re probably crying out for some clear and concise advice. And if you’ve already begun saving, you might be wondering what happens next or whether your chosen pension plan still meets your needs.
Neil Marsden, Chartered Financial Planner at Alan Boswell Group, specialises in providing advice to individuals approaching and in retirement. First and foremost, he urges everyone to start saving as early as possible.
“It’s hard in your 20s and 30s, as other priorities such as saving for a house deposit, clearing student debt, getting married and having children put pressure on your disposable income. It can be a struggle to think longer term and save towards your retirement,” he concedes. “In my view, it’s important to get into good financial habits early on, as it helps you to assess what’s important and learn how to prioritise and budget. The sooner you can start saving for retirement, the easier the savings habit becomes – and the more time your investment has to grow.”
It’s important to get into good financial habits early on
With the State Pension currently amounting to just £8,546pa at most, and individuals in their 20s unlikely to receive it until they reach their 70s, planning ahead to boost retirement income is imperative. So, let’s start at the beginning…
What is a pension?
A pension plan is simply a long-term, tax-efficient saving scheme, specifically designed to provide you with an income during retirement. It tops up your State Pension, which is calculated based on your National Insurance contributions and paid by the UK government once you reach a certain age (currently 65 for men and 64 for women, but set to rise again at the end of 2018).
There are two main types of pension plan: ‘defined benefit’ and ‘money purchase’.
“Defined benefit schemes are based on your final or career-average salary. Your employer is essentially taking on the investment risk and promising to pay you a certain income from a set age,” says Neil.
These schemes allow individuals to plan for their retirement with a better idea of what their pension amount will be, but they tend to be a rare commodity these days. “Due to the cost of running this type of pension, the vast majority are now closed, and there have been several high-profile cases where employers haven’t been able to meet their liabilities, as with Monarch Airlines Ltd,” adds Neil.
‘Money purchase pensions’ include individual plans, such as personal pensions, stakeholder pensions and self-invested personal pensions (SIPPs), as well as group workplace pensions provided by employers. You can set up your own personal pension in addition to, or instead of, a workplace pension if you wish.
Contributions to these plans – made by your employer and/or you, depending on which type you have – are usually invested into ‘funds’, which hold assets such as shares, fixed interest and property. The ultimate aim is to try to boost your pension pot as much as possible before retirement.
“Over time, the value of the pension fund will vary depending on the level of contributions made, the charges taken, and how the underlying investments perform,” Neil explains.
Read more: Pension terms decoded
Does this mean pension investments are high-risk?
As with any asset-based investment, there is an element of risk. Pension fund values can drop as well as grow, according to changes in the value of the assets they are invested in. But most other forms of investment don’t have the ability to produce high-enough returns for you to live on in later life. Bank and ISA interest rates, for example, are currently struggling to exceed just 1 or 2%.
Thankfully, however, a range of investment options are usually available to choose from – each one graded from low to high risk, to give you some control over your pension funds.
“For example,” says Neil, “an individual can opt to invest in cash, where the main risk is that the interest returned could be eroded by charges and inflation – so, negative in real terms. Whereas at the other extreme, an individual could select a very high-risk investment fund in commodities or emerging markets, which could result in large losses if the investments don’t perform.
“It’s important to take into account the individual’s attitude to risk, capacity to absorb losses and investment timeframes when choosing funds. Here at Alan Boswell Financial Planners, we tend to utilise funds that invest in a number of asset classes and different geographical areas, helping to lower the overall risk,” he continues.
It’s important to take into account the individual’s attitude to risk, capacity to absorb losses and investment timeframes when choosing funds
“In the longer term, higher-risk assets, such as equities, tend to outperform lower-risk assets, such as fixed interest and deposits. However, there may be periods when equity-based investments suffer heavy losses. Individuals with a long timeframe are likely to be able to ride out these short-term losses and remain focused on their longer-term goals.”
Read more: SIPPs: Your guide to Self Invested Personal Pensions
What happens if my circumstances change?
If, for example, you move to a new job, it doesn’t mean that you lose the workplace pension you had with your previous employer. Most schemes will allow you to leave your money invested, or transfer your existing workplace pension into your new company’s pension plan or into a personal pension. If the pension provider is the same for both your old and new company, then your existing plan may restart or you just need to request an internal transfer.
If you have a personal pension plan and decide further down the line that it isn’t meeting your requirements anymore; that a fund isn’t performing as well as you’d hoped; that you need more flexibility; or that your appetite for risk has increased or decreased, then you can always move it to an alternative provider or fund.
“Before considering this, it’s important to fully understand the pension plan that you currently hold, to ensure that you won’t be giving up any valuable benefits, such as guaranteed annuity rates,” Neil points out. If you decide to go ahead and move your pension, there are many factors to consider, such as charges, fund choices, death benefits and retirement options. As such, it’s vital that you research the market fully or seek expert help.
Read more: Best private pension: how to find the right pension for you
When can I access my pension savings?
Under current rules you can’t access a pension until age 55 (or 57 as of April 2028). At this point you can take the whole of your pension pot as a lump sum if you wish, but if you want to avoid the tax implications associated with this, and to provide yourself with a regular income throughout your retirement, it’s wise to choose one of the other two options available.
The first is to purchase a ‘lifetime annuity’, which is a means of converting your pension pot into a secure, guaranteed income for life. “There are various options that need to be considered, such as providing for a spouse and whether you want your income to increase with inflation or remain level,” says Neil. “This is a very important decision and advice is essential because once a lifetime annuity has been secured, the decision cannot be reversed.”
The second option is ‘flexi-access drawdown’, which provides more flexibility but a lower level of security compared to an annuity. “With this product, individuals can remain invested and drawdown an income as and when they need it. This income is not fixed or guaranteed and can be altered to meet their changing requirements, such as by taking more income early on in retirement and less as they get older,” Neil explains.
Flexi-access drawdown does come with additional risks, however. With the funds remaining invested, you’d still be subject to investment performance fluctuations, as well as sequence-of-returns risks (involved in making withdrawals from a fund’s underlying investments) – and there’s always the possibility that you might run out of money altogether because your income isn’t fixed.
Whichever option you choose, the first 25% of your pension pot can be drawn tax-free, with the remainder taxed as income. Or, alternatively, you can take that tax-free 25% as a lump sum up front, and access the rest of your money gradually (taxed as income, of course) via an annuity or through flexi-access drawdown. “Indeed, many individuals take their pension commencement lump sum and decide not to take any income initially,” Neil adds.
Read more: Guide to pension consolidation
Who can I ask for pension advice?
If you’re just starting out and perhaps have a relatively small amount to invest, you may prefer to utilise free resources such as The Pensions Advisory Service, which offers impartial guidance (but not advice) on both personal and workplace pensions via its website and helpline. Or you could speak to the provider or scheme administrator for your workplace pension. As ever, in-depth research is key when taking out any financial product.
Alternatively – and especially if retirement is on the horizon – you should consult an experienced, independent financial adviser for a better understanding of your current and future financial position, and how your prospects could be improved.
“A good financial adviser will be able to help you articulate your financial objectives and answer the important questions, such as ‘How much do I need to have a comfortable retirement?’ and ‘How much must I save and what level of growth do I need in order to achieve this goal?’” Neil explains. “If you have existing pension arrangements, he or she will also be able to review them, determine whether they are still suitable for your individual circumstances, and simplify them if necessary.”
A good financial adviser will be able to help you articulate your financial objectives and answer the important questions
Sure – pensions can seem complicated and rather daunting. But by boosting your knowledge, seeking advice, understanding your options and actively pursuing your goals – now, rather than later – you can plan for the comfortable retirement you deserve.
The value of an investment and any income from it can go down as well as up. The past is not a guide to the future. The value of tax benefits depends on your individual circumstances and the laws concerning these can change.
Read more: Employers guide to salary sacrifice pensions