What is a pension? - A guide to the pension and retirement options in the UK
Tuesday 3rd August, 2021
I was recently confronted with this question by one of my clients, who explained that in my articles I frequently assume a level of knowledge amongst my readers that simply isn’t there.
I was shocked to hear this and quite frustrated with myself. Here I am, happily making articles and videos about the more complex areas of pensions, investments and Inheritance Tax planning, when it had never occurred to me to put together an article explaining the basics of what pensions actually are, what they do and the options they offer. We do have a free pension guide available under the resources section of our website, but this is largely a users guide to defined contribution pensions, with little focus on the other pension options available, like the State Pension and Defined Benefit Pensions.
In order to address this oversight, I have put together this article where I will look at the most commonly asked questions I come across relating to pensions.
In the article I will look at the following areas:
• What is a pension?
• The State Pension
• Defined Benefit (Final Salary) Pensions
• Defined Contribution (Money Purchase) Pensions
When looking at the pensions, I will consider:
• What they are
• How they work
• Your retirement options
• What happens to the pension when you die?
What is a pension?
A pension is an income that is paid out to an individual at retirement.
There are vehicles that allow you to build up an entitlement to a particular level of pension income upon reaching a specific age, such as the State Pension and Defined Benefit Pensions. Then there are also vehicles that allow you to build up a pot of money that can be used to either purchase a pension income for life, or generate an income through investment on retirement.
The government generally provides certain tax incentives to encourage individuals to save for their retirement, such as tax relief on contributions, or the ability to take a portion of their pension tax free.
In the UK there are three main pension options. These are:
- The State Pension
- Defined Benefit Pensions
- Defined Contribution Pensions
As a general rule, a retiree will rely on a combination of the above to provide for their income needs in retirement.
The State Pension
Within the UK there has for centuries been a general acknowledgement that the elderly (or at least some elements of the elderly) should have access to some sort of income should they become too infirm to continue working. All the way back in 1670, the Royal Navy introduced a pension scheme for officers, to ensure that these stalwart servants of the crown did not fall into penury in their dotage.
The majority of the support for the elderly came from the so called “Poor Laws”, which compelled parishes in England and Wales to assume responsibility for the poor and needy, including the elderly, who were collectively termed the ‘impotent poor’. This system was cruel and ineffective and was often worse than no care at all, with local councils sometimes loading the elderly and poor in carts and dumping them into other parishes in order to avoid the responsibility of caring for them.
Since then, there have been a number of different legislative safety nets introduced to ensure that the elderly would have some form of income and support in their retirement. Many of these were woefully inadequate, but represented an underlying recognition of the importance of ensuring that those no longer able to work were able to maintain themselves, even if it was only in the most rudimentary sense of the word.
The biggest change came in 1948 when the National Insurance Act introduced a contributory State Pension for all, to be paid from the age of 65 for men and 60 for women.
As a result of these gradual changes, the State Pension has become a basic expectation for those who are retiring, with many timing their retirement with their State Retirement Age. Even growing up in South Africa, I was aware of this wonderful benefit that British pensioners are entitled to.
There are two types of State Pension running in the UK at the moment:
- The Basic State Pension – available to men born before 6 April 1951, and to women born before 6 April 1953.
- The New State Pension - men born on or after 6 April 1951, and to women born on or after 6 April 1953.
The reason we have these two iterations of the State Pension is because many people felt that the old Basic State Pension was too complicated. It consisted of two elements, the Basic State Pension and the Additional State Pension, which all got rather complicated. The government therefore embarked on a radical remodelling of the State Pension, introducing the New State Pension on 6th April 2016. This simplified matters dramatically, as it combined the two elements of the Basic State Pension into a single, larger amount.
Many of you may be concerned that you may receive less of your State Pension entitlement as a result of this, but the government has gone to some lengths to ensure that you will receive roughly the same amount under the New State Pension, as you would have under the old system.
State Pension Entitlement
Our entitlement to the State Pension is based largely on our National Insurance (NI) contribution history. In order to qualify for the minimum level of the New State Pension, you will need at least 10 years’ worth of NI contributions. In order to qualify for the maximum amount, you will need a full 35 years’ worth of NI contributions. Previously, under the old system, you only required 30 years for the full State Pension.
Some people may have gaps in their contribution record, resulting in a potentially lower State pension. Under certain circumstances it may be possible for them to claim NI credits, if they were unable to work because of illness or disability, or if they were a carer or unemployed. For example, they would be able to claim NI credits if they:
- Claimed Child Benefit for a child under 12 (or under 16 before 2010)
- Received Jobseeker’s Allowance or Employment and Support Allowance
- Received the Carer’s Allowance
Pensioners receiving the full Basic State Pension will receive £137.65 per week in the 2021/22 tax year, whereas recipients of the full New State Pension will be entitled to £179.60 per week.
The State Pension increases annually in line with one of three things:
- the rising cost of living seen in the Consumer Prices Index (CPI) measure of inflation
- increasing average wages
Whichever one of those three figures is highest is then used to increase the state pension. This is known as the triple-lock, and the Government’s manifesto pledged to keep it until at least 2024. However, the impact of COVID 19 has resulted in the government coming under heavy pressure to abandon this triple-lock commitment.
State Pension Age
You can only start claiming your State Pension benefits when you get to the State Pension Age (SPA). Many moons ago this was 60 for women and 65 for men. This has now been equalised and since October 2020 has been age 66 for both men and women. A further increase to 67 will be phased in between April 2026 and April 2028. An increase to 68 is due to be phased in between 2044 and 2046. However, the Government has, on more than one occasion, indicated that this could be brought forward - the latest review suggesting it could be phased in between 2037 and 2039.
The reason why the government keeps increasing the State Pension age is that providing the State Pension is expensive. People are living longer and the length of time that the government has to provide it to individuals is increasing far beyond what was expected by those who originally legislated for it. At that point it was unusual for retirement to last longer than a few years before the retiree shuffled off this mortal coil. The average life expectancy now can easily see a retiree living to their mid-eighties, a situation unforeseen in the heady days of altruism when the foundations of the State pension were first laid.
In addition to the increasing numbers of pensioners, there is the problem of falling numbers of workers due to lower birth rates and automation of roles, thus reducing the flow of NI contributions being made. All of this makes the State Pension more and more difficult to maintain.
In an age where questions are being raised about a levy for later life care, it is difficult to see where a request for higher NI contributions will be funded from.
Deferring your State Pension
You do not have to start taking your State Pension immediately. You also have the option to defer it.
If you decide to do this, your pension will be increased, depending on how long you defer the pension for. By deferring for 52 weeks, you’ll get an extra £10.42 a week (£541.84 for the year) when you start taking your pension.
The benefit of doing this is dubious, as you are sacrificing £9,339.20 worth of income in order to increase your pension by £541.84 per year. You therefore have to receive approximately 17 years’ worth of pension before you break even. This is not a strictly accurate calculation, as the State Pension increases in line with certain inflationary measures, but the point remains that you would have to wait some time before deferring your pension would become profitable.
What happens to your state pension on death?
This is a very interesting question, as the loss of a pension income can have a considerable impact on the ability of a surviving partner to make ends meet.
The reality is that your State Pension benefit effectively dies with you. You cannot leave it to your partner. There are circumstances where they may be able to increase their own State Pension based on your NI record, and they may inherit any additional State Pension you are entitled to, but the majority of your pension will die with you.
This can result in a substantial loss of income from the household. It is therefore very important that you take this into consideration when doing any planning for the future.
Defined Benefit Pension
You may have heard of Defined Benefit or Final Salary pensions before. These are the gold standard of pension provision and if you have one, it is generally best to hang on to it.
“What is so great about Defined Benefit (DB) Pensions?” you may ask?
Well, let’s just say that if heaven had a pension scheme, it would be a DB pension. DB pensions provide retirement nirvana.
The reason I say this is that a DB scheme is provided and paid for by the employer. The theory behind a DB pension is as follows:
- The employee works for the employer until they retire
- During this time the employer and employee will make contributions to a communal fund that will be used to provide an income for all the scheme members when they retire
- When the employee retires, the pension scheme starts to pay an income to the employee in line with the number of pensionable years the employee worked at the company, and the employee’s final salary (hence the moniker, “Final salary Pension”).
- The employer commits to ensure that there are sufficient funds to provide the pension income for the whole of the employee’s life
- The pension income is increased each year, in line with an agreed measure of inflation, to ensure that the pension income retains its value in real terms and the employee does not have to be concerned about bring unable to meet their income requirements in the future
As you can see, the employee is able to retire comfortably, knowing that the employer carries all the risk for ensuring that, month on month, their retirement income is paid.
So, what went wrong?
As you can see, this is a fantastic arrangement, as long as the employee has the common decency to die after 5 or 6 years of retirement.
Now this is where the cracks start to show in the DB pension world. People started living far longer in retirement than they were expected to. This meant that schemes became more and more unaffordable for the parent company.
It also made companies unattractive on the mergers market, if they were dragging along a £1bn commitment to fund their employee’s DB pension scheme.
A problem also arose when companies went insolvent, as often happens. Who would be responsible for the pension then?
This resulted in the Financial Assistance Scheme and the Pension Protection Fund to take over the pension schemes in situations where the company was no longer able to meet their financial responsibilities to the scheme. These schemes still offer considerable benefits to the scheme members, subject to caps on the benefits, but are generally not as attractive as the original scheme.
However, as a result of the considerable financial burden created for companies by the DB schemes, the majority of companies decided to wind down their DB schemes and replace them with more affordable hybrid schemes or Defined Contribution Schemes.
Over time, it has become more and more rare to find one of these schemes still operating. Most public service schemes (the Armed Forces, the Civil Service, NHS, Teachers, Police and Firefighters and the Local Government Pension Scheme) are all DB schemes. However, you would be hard-pressed to find such a scheme on offer in the private sector.
How is a DB pension income calculated?
There are a number of factors that are taken into consideration when calculating your retirement income from a DB scheme. These include:
- The number of years you have paid into the scheme
- Your salary – this might be your final salary when you retire or your average salary across your career
- The pension scheme's 'accrual rate'
The first two options are fairly straight forward, but what is meant by the accrual rate? Well, this is the rate at which your pension accrues benefits. The accrual rate is expressed as a fraction of your income and is multiplied by the number of years you have been in the scheme, in order to help determine the proportion of your final salary you will be entitled to. The accrual rate is normally 1/60th or 1/80th.
Let’s look at an example to see how this works in practice.
- Your final salary when you retire is £50,000.
- You've worked at your company for 30 years.
- Your company uses an accrual rate of 1/60th.
- Your annual pension would be approximately £25,000 (30 (years) x 1/60th (accrual) x £50,000 (final salary).
When can I start taking my DB pension?
Most DB pensions will have a Normal Retirement Age of 60 or 65. You can normally take your pension earlier than this if you want (provided you are 55 or older), but your income will be reduced in line with a specified commutation factor to reflect the fact that the pension was taken early.
You may also have the option of taking your pension early if you are severely ill. In these cases, there may not be a reduction in income.
Can I take a tax-free lump sum from the DB pension?
Many schemes will offer the option to take a tax-free lump sum in return for a reduced income. The income will be reduced in line with a commutation factor determined by the scheme actuaries.
The benefit of taking the tax-free cash lump sum is debatable. It really depends on your reasons for doing this. It is unlikely that the amount you receive will be equal to the market value of the income you are giving away, so from a purely actuarial stance, it doesn’t make sense. However, you would normally need to live for quite some time before the higher income paid out more than the lump sum you have given up. if you die earlier than expected, then you will lose this money completely.
What happens to my DB pension when I die?
The majority of DB pensions make provision for a spousal pension of between 50% and 75% of the full DB pension income received by the pension member. DB pensions also often makes provision for a dependent’s pension, but it differs from contract to contract. After the spouse or dependent dies, the pension payment stops completely and all benefit is lost.
For many people, this loss of at least half their pension entitlement upon death is hard to swallow. They also struggle with the idea that there is unlikely to be any residual pension to pass to children and other loved ones. The members of these pension schemes feel like their whole life’s savings is lost completely upon death and find this very unpalatable.
However, it is important to remember that when you die, the household costs fall. Furthermore, if you have lived in line with the average life expectancy, your spouse may well be elderly with low living costs and requirements. In such a situation, a 50% spousal pension might be more than sufficient to meet their needs.
In addition to this, the simplicity of a pension that pays out each month like clockwork, without their input, might be exactly what they need. In such circumstances, the reduced DB spousal pension may be exactly what the doctor ordered.
Defined Contribution Pensions
This is the last pension option that we are going to look at and, in many ways, it is the simplest.
Most of us who are still working have at least one Defined Contribution (DC) pension. These are normally provided by our employers, as part of our employment package.
In fact, the law now requires employers to provide access to a pension and contribute 3% of the value of your pensionable salary to the scheme. In return, you are required to contribute 5% of your salary to the scheme, making up a total annual contribution of 8% of your salary. You do however, have the option to opt out of this.
It is now estimated that, on average, we will work for 11 different employers during the course of our careers. I have quite often met clients with 11 or 12 different pensions. It just shows how much society has changed from the days when we simply worked for one company our whole lives.
The DC pensions provided by employers are quite frequently very basic, with a minimal level of funds and retirement options, in order to keep the cost of the scheme down.
You can also take out a personal pension, which you can fund in your own capacity. These often have access to a far greater range of funds and investment options, but have additional costs as a result.
How is the value of my DC pension determined?
The contributions made to your pension are invested into various investment funds, which look to achieve growth over time. The value of your pension at retirement depends on the level of contributions you make to your pension while working, as well as the amount of growth achieved over the time the funds have been invested.
Why would I invest into a DC pension?
In order to encourage people to save for their retirement, the government has provided a number of tax incentives and benefits on contributions made to a pension. These include:
You can claim tax relief on pension contributions at your highest marginal percentage rate of income tax. If you are a basic rate taxpayer and wanted to make a gross contribution of £100, you would pay £80, receiving £20 tax relief at source. For higher rate taxpayers, you still pay £80, receiving £20 tax relief at source, and then claim the further £20 through your tax return, so the net cost is effectively £60 which is a significant uplift to your contribution.
Tax free growth
Your savings grow in a tax-free wrapper and over the long term your funds benefit from the effects of compound interest which can add a significant amount to your total pension pot.
25% Tax free lump sum
You can take up to 25% tax-free cash from your pension and the remaining 75% is subject to income tax at your marginal rate. The 25% tax-free lump sum can be very useful if used efficiently. For example, it could be used to pay off an outstanding mortgage if that is suitable for your individual circumstances and makes sound financial sense.
In most cases a pension does not form part of your estate for inheritance tax purposes. What’s more, you can transfer a pension to someone else upon death, and if done correctly, you can transfer the value free from IHT, Income Tax and Capital Gains Tax.
What are my retirement options with a DC pension?
If you have a defined contribution pension, you have two main pension options at retirement. You can either purchase an annuity or use Flexi Access Drawdown; these are the two most popular options.
1. Purchase an Annuity
An annuity provides a guaranteed fixed income for an agreed period or for life. However, the benefit of security is offset with lower rates compared to other pension options. This means you typically need a large pension fund to purchase a fairly moderate income. What’s more, any remaining capital or income is usually lost upon death and cannot be transferred to beneficiaries. An annuity can be a great option for those who would prefer income security and to be safe in the knowledge that they will receive a fixed amount of money.
2. Flexi Access Drawdown
If you choose Flexi Access Drawdown you can withdraw funds as and when you need them and the rest of your pension will remain invested and can continue to grow. However, this also means that you are exposed to investment risks and could see the value of your pension rise and fall throughout retirement. Drawing an income from your pension in a bear market can have a much bigger negative impact on the value of your funds and it would take longer to recover as you are no longer contributing to your pension, but are drawing from it. With Flexi Access Drawdown you can leave any remaining pension funds to your beneficiaries upon death, free from inheritance tax.
What happens to my DC pension when I die?
It really depends on a number of things including:
- Have you taken your pension benefits yet and how did you take them?
- Are you under 75 or over 75 when you die?
If you have taken your pension and used it to buy an annuity, then the death benefits available to your beneficiaries will depend on the benefits you selected when you purchased your annuity. These can include a spousal pension, a guaranteed lump sum or guaranteed payment period. However, all of these benefits reduce the income you would be entitled to from your annuity. As a result of this, there are quite often no death benefits chosen and the annuity simply stops.
If you have used drawdown to provide your retirement income, then the value of your pension at your death will be left to your beneficiaries, as a general rule. They will have the option to take this as lump sum, or leave it in the pension, or use it to purchase an annuity.
If you pass away before the age of 75, DC pension death benefits are paid out tax-free. If you die after the age of 75, the benefits will usually be taxed at the recipient’s marginal rate of income tax.
If you haven’t taken your benefits yet, you will generally be able to leave the value of the pot to your selected beneficiaries. They will have the option to take this as lump sum, or leave it in the pension, or use it to purchase an annuity. Similar to the case with drawdown, if you pass away before the age of 75, DC pension death benefits are paid out tax-free. If you die after the age of 75, the benefits will usually be taxed at the recipient’s marginal rate of income tax.
I hope the above paragraphs provide you with a far greater understanding of what a pension is, the main types of pensions and the options available to you from each.
The majority of people have to rely on providing for their retirement from a mixture of these pension options.
As DB pensions are gradually phased out and the State Pension becomes less affordable, it is clear that the onus will fall more on us as individuals to fund our retirement from DC pensions.
It therefore becomes more and more important that we each understand the options available, to ensure that we are best prepared to make the right decisions for us when the time comes to eventually retire.
It is a complex area, fraught with pitfalls. What may be suitable for one person, may not be suitable for another. Therefore, it is crucial that you take advice on any decision you need to make, in order to ensure that is the right one for you and your family.
If you would like further information, please don’t hesitate to ask us for our more complete guide on pensions and retirement available through our website under the resources tab at www.atticusfp.co.uk. There you will also find guides on:
• Inheritance Tax and Estate Planning
• Investments and tax planning
• Pensions and divorce
You can also book a free initial consultation with us, by phoning on 01420 446777.