This crucial part of retirement planning needn’t be a complicated tax nightmare. Here are some of the most common key terms explained in language that’s easy to understand.
When someone says the word ‘pension’, what does it mean to you? Gold-plated final salary schemes or state benefits? Sufficiency or lack? An 8% contribution through your workplace that you never think about, or something you manage assiduously yourself? A great tax perk or a complicated tax nightmare?
You get the picture. There are now so many different types of pension and ways of saving for retirement, not to mention so many complicated tax implications and ways of accessing your money when you approach retirement, that even the definition of a pension deserves some scrutiny, as what the word means now seems to be in the eye of the beholder.
To give you an idea of just how much can get lost in translation when the word pension is uttered, the interactive investor pensions team counted 12 different types of scheme – and that count was not exhaustive.
Some of these types are listed below, as well as other terms that you really want to have a basic grasp of if you are to make the most of all of the options available to you.
Hold on to your hats – this is a speedy, wild ride through the world of pensions.
Defined benefit - I’d heard this term around my newsroom, when I started out in journalism, for about five years, before finally working out what it meant.
Other terms used include final salary, because what you get as an annual income in retirement will depend on what you were earning when you stopped work.
For many people (particularly older workers), when they hear the word ‘pension’, this type is what comes to mind.
It’s a pension from a workplace that will pay you an amount set out in your work contract, that is usually based on a % of your final salary when you retire. These schemes have proved very expensive for employers to run over the years. You may have heard stories about employer pension schemes being underfunded and in deficit. It’s specifically these defined benefit schemes under discussion here (not the newer defined contribution kind, more on that below). Many of those run by large private sector employers have struggled to grow by enough to continue to pay all of their retired former employees and also serve the new ones. So they can be unsustainable, costly and risky and that’s one reason they have fallen out of favour.
But for those that have them, these schemes are a valuable perk. That’s a reason you’ll often hear them referred to as gold-plated. The amount you’d need to save yourself through your working life in a modern-style defined contribution scheme, if you want to generate the level of income that defined benefit schemes usually provide in retirement, is significant. Public sector employers, such as the police and civil service, still provide defined benefit schemes to workers, although they may be less generous than they used to be.
Defined contribution (DC – like the comic books) – the clue is in the name – it means you know what you are putting in (or rather investing), but not necessarily what you will get out on the side of retirement. They are also called money purchase, although this a slightly more old-fashioned term. You will mostly hear the term in relation to auto-enrolment and workplace schemes, ie “Joe was auto-enrolled into his defined contribution workplace scheme at the age of 24”, but personal pensions and SIPPs are also defined contribution schemes.
Workplace pension – also known as employer or occupational schemes - can lead to confusion with defined benefit employer schemes (as above). Workplace or employer schemes can be either defined contribution or defined benefit (most likely defined contribution these days). Defined contribution workplace schemes are not run by your employer, although you access them through work and your employer pays into them too. Your employer will usually use a dedicated pension provider, which could be something called a Master Trust or another type of scheme that is available to employers, like a Group Personal Pension Plan.
There may also be a specialist pension administrator behind the scenes, making sure that the occupational scheme is being run in the best interests of all the employees enrolled into it. Most employees are enrolled into the default fund, the automatic option deemed to generally best suit most people.
Hybrid – a mix of defined benefit and defined contribution all rolled into one pension. They are less common now, too, but can mean that there is a certain guaranteed income for former employees in retirement.
Automatic enrolment – what happens when you start a job – you are automatically enrolled in the pension scheme that your employer offers. This is a legal requirement. The minimum contribution amount under these rules is 4% of the employee’s annual qualifying earnings (earnings between £6,240 and £50,000 a year), plus 3% from their employer and a further 1% in tax relief, so a total of 8% of qualifying earnings.
Consolidation - if you move jobs several times in your working life (most of us do - 11 or 12 job moves is about average these days) you might end up with several old workplace pensions dotted about. Consolidation is where you put them all into one pot. This can save on fees as well as hassle. You are also less likely to forget about old pension pots, which, believe it or not, does happen.
Personal pension – this refers to a pension that is not set up by an employer but by you, for you, directly with a pension provider of your choice. An option for self-employed people, for whom no employer scheme is available. Personal or employer contributions can be made into these pensions and basic tax relief added pre-funded. They will often be the choice for the self-employed. too.
Group Personal Pension Plan – available through some employers instead of Master Trust-based schemes. They are arranged by employers but fully provided by life companies, which are old insurance companies with investment arms that traditionally manage pensions. They are similar to personal pensions. There’s usually a choice of funds to pick from, although you will go into the default fund if you don’t choose. Group Stakeholder Personal Pensions and Group Self Invested Personal Pension (GSIPP) fall under this category.
Self-Invested Personal Pension (SIPP) – available on the interactive investor platform – they offer much more investment choice than other types of pension including individual stocks, share and exchange traded products. So SIPP holders have more control and individual say over their own pensions. There are platform charges (flat fees rather than %-based on interactive investor) as well as fund charges.
SIPPS are also an option for self-employed people who are not currently contributing to a workplace pension. It is also possible to invest in a SIPP on top of a workplace scheme if you are employed (and very keen on retirement saving). If you are contributing to a workplace scheme but like the idea of a SIPP instead, you can ask your employer if it will contribute to your SIPP rather than the work scheme. Some (but not all) employers will do this.
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Full SIPP – these can include more esoteric investments, such as wine or commercial property. Available through financial advisers.
Accumulation – an industry term you might hear and wonder about, it refers to the years when you are working and building up your pension pot. You are in the “accumulation phase” if you are working and paying into a pension, pre-retirement. You are trying to maximise contributions and growth according to what you can afford and your retirement goals during this phase.
Decumulation – another industry term that refers to the phase of life when people access their pension pots to use to live on in retirement. You’re in the decumulation phase if you are retired and using your pension for income. Can involve a complicated balance of assessing how much you need, trying to maximise investment growth, minimise risk and minimise tax.
Marginal rate tax relief – when you make pension contributions, you receive tax relief up to the amount of income tax you currently pay. So basic rate taxpayers get tax relief of 20% on their contributions, higher rate taxpayers get 40%, etc. So a £100 contribution to your pension only requires you to put in £60, if you are a higher rate taxpayer. It’s the main reason pensions are such a great deal for retirement saving. It’s worth noting, though, that if you earn above a certain amount, the tax relief you get on pensions is tapered. Something called the tapered annual allowance applies for individuals with a ‘threshold income’ of more than £200,000 and adjusted income of £240,000.
Annual allowance – the maximum amount you can contribute to a pension and still receive your marginal rate tax relief, currently £40,000 a year. You can pay more in than this if you want to, but you won’t get the tax relief, just the investment growth.
Lifetime allowance (LTA) – is the maximum amount of benefit that can be withdrawn from your pension in your lifetime. This is currently £1.073 million. If you exceed this, an additional LTA Tax Charge will be applied meaning 55% tax is paid on the excess.
Annual Management Charge (AMC) – the fee a fund manager charges to manage your money, also known as an Ongoing Charges Figure (OCF). This is how those managing our pension investments make their money. The charges can vary quite a lot and make a big difference to the amount you end up with.
Annuity – a type of insurance policy that you can buy with your pension pot. It pays you a guaranteed income for life.
Drawdown – also known as income drawdown, or flexi-access drawdown. This involves investing your pension pot somewhere you can ‘draw down’ amounts from as you need them.
Crystallised – it means pension funds that you have done something with, such as putting them into drawdown or accessing them as a lump sum. By contrast, uncrystallised pension funds remain sitting in your pot, waiting for you to decide what to do with them.
Tax-Free Lump Sum – you are entitled to take 25% of your pension pot as a lump sum free of tax when you are 55 (rising to 57 in 2028). You can access more than this if you want but you would pay tax on the rest above 25%.
Uncrystallised Funds Pension Lump Sum – allows you to take partial or full withdrawals of cash from pension savings. When making partial withdrawals, 25% of each withdrawal is tax-free, with the remaining 75% of each withdrawal subject to tax.
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