Interactive Investor

Workplace pensions: a guide

14th May 2020 18:26

Rachel Lacey from interactive investor

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Find out more about the type of scheme your workplace offers and how it works with our guide.

The easiest and cheapest way to save for your retirement is by taking advantage of your employer's workplace pension.

In addition to tax relief on your contributions, you also get the benefit of contributions from your employer so, irrespective of the type of scheme offered, the quality of the funds it invests in, or its charges, it usually makes sense to participate. Ignoring it is equivalent to turning down a pay rise.

Pension rules explained

Here we take a look at defined contribution and defined benefit pensions (also known as money purchase schemes and final salary schemes respectively).

If you don't know what type of pension your employer offers talk to your HR department straightaway.

Money purchase or defined contribution schemes

Also known as defined contribution schemes, these pensions are the norm in the private sector. In most cases the schemes are essentially personal pensions into which you pay in every month, the only difference being that they are set up by your employer and contributions are taken direct from your salary (this is why they are also known as group personal pensions). Some people may be offered a trust-based scheme, in these cases the pension fund is managed by a board of trustees.

In addition to your contributions and tax relief from the government, your employer will also pay in on your behalf too.

However, unlike defined benefit schemes, there is no guarantee how big your retirement fund will be, or what income it will be able to generate. Instead its eventual value is determined by how much the contributions made by you, the government and your employer, grow.

In order to grow your savings, they will be invested in the stockmarket. Default funds exist for those savers who don't want to make any investment choices, but enthusiastic investors who are able to research their options and willing to monitor their pension's performance regularly, may get a better return choosing their own funds.

Auto-enrolment

Prior to October 2012 you would have been given the choice as to whether or not you joined your company pension scheme.  However because uptake rates were so low and the government was concerned about the number of older people retiring in poverty it has gradually rolled out new rules that oblige employers to not only offer a workplace pension but to sign up all eligible employees and make contributions on their behalf.

This is known as auto-enrolment and affects all employees aged between 22 and the state pension age, working in the UK earning more than £10,000 a year. While many employers already paid into their staff's pensions, they are now being forced to do so by law.

Under the current rules the minimum contribution is 8% of qualifying or pensionable earnings (earnings between £6,240 and £50,000). This is made up of 4% from you, 3% from your employer and 1% from the government in the form of tax relief. 

However these are just minimum requirements and your employer may well pay in more than this. Patrick Connolly, IFA at Chase De Vere says: "Most employers are paying in more than this because they are using it as a benefit to recruit and retain the right staff."

It also makes sense for employees to top up their contributions if they can afford to do so, to ensure a more comfortable retirement.

Will your pension get you the retirement income you want? The ultimate guide to auto-enrolment

What if I don't want to pay in?

Nobody can force you to save into a pension, so if you don't want to pay into your employer's scheme you can leave it by filling in an opt-out form.

If you have only made one month's worth of contributions this money will be refunded to you. However if you've been in the scheme for longer than a month, your money will stay invested in the pension and you will not be able to access it until age 55. By law your employer will re-enroll you every three years.

However, you should think carefully before opting out says Connolly. "The only people who should be opting out are those who are really hard up and with high levels of debt. Everyone else should stay put. With auto-enrolment you will know you are in a good quality scheme with competitive charges and employer contributions. If you give this up you are effectively turning down a pay rise."

And, even though your own contributions means your income will reduce, there could be some hidden tax benefits of having less take home pay. Connolly adds: "A reduced income could mean you fall into a lower tax bracket or it could increase your eligibility for child benefit and other state benefits."

Accessing your money

You can access your pension from age 55 and as with all pensions you'll be able to take 25% of your pot as  a tax-free lump sum. Unlike defined benefit pensions it is down to you to decide how you will turn your pension into  retirement income.

You can buy an annuity to guarantee an income for life, leave it invested in your pension and drawdown the required income or cash it in and spend or invest it as you please. However appealing the latter might sound, it wouldn't be tax efficient. Income tax would be payable on the whole lump sum boosting your income for that year and quite possibly pushing you into a higher tax bracket.

Get the best pension income for you

Defined benefit or final salary pensions

Often described as 'gold plated,' final salary schemes are the most generous company pensions, in so much as they guarantee to pay you a defined benefit in retirement - irrespective of how much you or your employer pay in. Hence, they are often referred to as defined benefit pensions.

Some schemes - such as the Armed Forces pension scheme - are non-contributory meaning your pension is entirely paid for by your employer. However in the majority of cases, employees can expect to pay around the 8% mark. According to Hargreaves Lansdown it costs roughly 25% of your salary to fund your pension. You need to meet approximately a third of the cost, your employer picks up the remaining two-thirds.

Exactly how much you will have in retirement will depend on your length of service, your salary and your accrual rate. This is typically 1/60th or 1/80th of your salary for every year you work.

Guaranteed income for life

Your income will be paid direct to you in retirement, you won't have to cash in your fund or buy an annuity and it will be index-linked to ensure it keeps up with inflation.

Other benefits include death payments to spouses and dependent children if you die before pensionable age (usually a lump sum multiple of income) or, if you die once you've retired, a spouse's pension of between half and two-thirds of your income continues to be paid.

Alternatively, if you need to retire early due to ill health you will still get your full pension. Those who simply decide to retire early can do so but with a reduced income, to reflect the longer period over which it will need to be paid.

As with other schemes you can still take 25% of the fund as tax-free cash if you choose. But as you have a guaranteed income rather than finite pot, working out how much cash you can take requires a complex calculation which will be based on your scheme's commutation factor. You will have to contact your employer for details of the rate on your scheme.

Should you cash in your gold-plated pension?

With such guarantees, these schemes are incredibly expensive to maintain and are becoming more so as life expectancy increases. As a result many employers are scaling back these pensions to reduce their own liabilities and most schemes are now closed to new members. Many schemes have been scrapped altogether. Traditionally benefits have been based on workers' final salaries, but many surviving schemes are now moving towards a career average.

It's no surprise then that this type of pension is becoming increasingly rare in the private sector. Although public sector workers still have defined benefit schemes the terms offered continue to change as the government desperately tries to save cash.

What if my employer goes bust?

While these pensions are supposedly the best available for staff, many workers may naturally be concerned that their employer won't be able to meet their pension commitments - particularly as life expectancy continues to increase. Indeed many company schemes are in deficit, meaning they don't have enough money to meet all of their pension commitments.

The Pensions Regulator does oblige employers to address these deficits, however in the event that your employer cannot meets its obligations, protection for employees exists in the form of The Pension Protection Fund. This was set up in 2005 to protect members from failing schemes. If you were already beyond your employer's retirement age when the scheme went bust, 100% of your income would be protected. If you retired early or are still working 90% of your income would be covered.

Following the introduction of the pension freedoms in April 2015 more people are transferring out of final salary pensions.This gives final salary scheme members a lump sum to spend as they wish - however as it involves sacrificing an income that is guaranteed for life, it would only be recommended in a minority of cases. In recognition of the risks, the Financial Conduct Authority requires any members with a transfer value over £30,000 to get independent financial advice first.

Number of savers doing risky transfers on the rise

 

 

This article was originally published in our sister magazine Moneywise, which ceased publication in August 2020.

These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

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