Types of Pensions
The different pension options can be confusing. Below is a summary of the most common types of pension, and what they involve.
The State Pension
This is provided by the government, and is based on an individual’s National Insurance (NI) contributions. In order to receive the maximum State Pension, which is currently £155.65 per week, you need to have paid 35 years’ worth of NI contributions.
When thinking about what you will rely on in retirement, it’s important to consider that the State Pension is unlikely to cover much, if anything, more than the basics. In addition, you cannot receive it until you reach the State Pension age – this is not the same as retirement age. Currently, the State Pension age is 65 for men, and 62-65 for women, set to rise for both to 67 by 2028, and even higher into the future.
Unsurprisingly, these are pensions provided by employers, and are usually defined contribution (DC) or money purchase plans, where the value of the pension scheme is determined by the performance of the investment market.
This means that the income you will receive in retirement is not guaranteed, so the true benefits will be unknown until you reach the point at which you are eligible to take them.
With DC company pensions, your employer matches any payments into the pension that you make yourself. The 2012 legislation dictates that all companies are required to offer a workplace pension, and that eligible employees are automatically enrolled. Since October 2012 this has applied to large employers, but from 2018 it will apply to companies of any size. The amount that your employer will pay in on your behalf may vary, but the minimum is currently 1% of your ‘qualifying earnings’ – your earnings (before tax and NI deductions) between a lower and upper limit determined by the government – plus 0.8% from you and 0.2% in tax relief. However, you and your employer can both pay more, if you choose. Your employer will calculate your qualifying earnings.
These days, not many company pension schemes are final salary, or defined benefit (DB) schemes. These are where your retirement benefits as part of your pension scheme are established, ‘defined’, in advance. This guarantees the pension income you will receive in retirement, and depends only on your income whilst you were participating in the scheme.
This is again a type of money purchase, or DC pension scheme, whereby you (or your financial adviser) select the pension provider that you would like to administer your pension, and where you would like your contributions invested – chosen from a variety of funds offered by your provider.
These will typically cover the entire spectrum of investment options: shares, corporate bonds government bonds, commercial property, and cash.
The aim here is clearly to grow the fund over the years preceding your retirement. The value of your pension when you retire is what will determine the income it provides you in retirement, and will be affected by the amount you have paid in, and the performance of the funds you chose to invest in, minus any charges.
Like DC company schemes, the final value of your pension fund will be determined by the performance of the funds it is invested in, which can decrease in value, meaning you may get back less than you and your employer have paid in.
These are a lower-cost pension option, and are typically less costly than the other types of schemes outlined above, and allow much lower and more flexible minimum contributions. However, they also provide a much narrower range of investment options.
Nevertheless, you can always transfer a stakeholder pension to another pension scheme, stakeholder or other type of pension, if you come to require greater choice, with no charge.
As with personal pensions, the value of a stakeholder pension depends on the performance of the markets, and how much you invest.
Self-Invested Personal Pensions (SIPPs)
A SIPP is one form of personal pension, but with a few added extras. Like other pension types, it is a tax-efficient savings product, but there is a much broader range of investment choices available, including individual shares, and, in some schemes, individual commercial properties. In addition, you are not limited to the pension funds offered by any particular pension provider.
As such, SIPPs often appeal to more experienced investors who are prepared to monitor and manage their own pension, and aim to take advantage of the full range of potential assets available.
Some SIPP plans offer investment management, where a specialist makes the investment decisions on your behalf, though this of course incurs additional charges. If you are thinking about considering an SIPP, you need to be comfortable with taking a risk, as there is a chance of losing the money you’ve invested, leaving you with not enough savings in your retirement.
You should also remember that the favourable tax treatment all pensions are associated with may not continue into the future, and that the value of any tax relief, or lack of, to you will vary depending on your personal circumstances, which may also change.
Again, always consider that the value of ANY personal or defined contribution (DC) pension scheme will be dependent on the performance of the investments held within it, and that these can decrease in value as well as increase, meaning you may receive back less than you and your employer have paid in.