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Types of pension

01 February 2018

Pensions can seem complex and daunting, especially if you’re new to them. But there are lots of options available to suit individual needs and circumstances. We take a look at the main types of pension and explain how they work.

The value of investments can fall as well as rise. You may get back less than you invest. Tax rules can change and their effects on you will depend on your individual circumstances.

What you’ll learn:

  • How much you could receive from your State Pension.
  • What the two different types of company scheme are.
  • Why SIPPs normally appeal to more experienced investors.

It’s been well documented that many Britons aren't saving enough in their pension for their retirement. But pensions offer generous tax benefits as an incentive. After all, if you're a basic rate taxpayer, for every £80 you pay in, the taxman will top it up to £100. And if you're a higher or additional rate taxpayer you can claim back up to an additional 20% or 25% through your self-assessment tax return.

There's a limit though on how much you can squirrel away every year, known as the Annual Allowance. Currently for most people this threshold is set at £40,000 or 100% of earnings — whichever is lower, provided that you haven't withdrawn a taxable income from any pensions. However, those whose earnings exceed £110,000 and their combined income and pension contributions exceeds £150,000 will see theirs gradually reduced to a minimum of £10,000 which kicks in when these adjusted earnings reach £210,000. In addition, there's a cap on the total value of all your pensions, called the Lifetime Allowance, which in the 2017–18 tax-year is set at £1m.

Always remember that the value of any personal, and most company pension schemes, will depend on the performance of the investments held in it and these can fall in value as well as rise. You may get back less than you and your employer invest.

The State Pension

The State Pension is provided by the government and is based on National Insurance (NI) contributions. To receive the maximum amount, of £155.65 per week, you'll need to have 35 years of NI contributions. If you’re thinking of relying on the State Pension alone, then it’s important to realise it’s barely going to cover the basics. You won’t get your State Pension until you reach State Pension age. Remember, retirement age isn't the same as State Pension age, which is currently 65 for men and between 62 and 65 for women and is rising to 67 for both by 2028, from which it will gradually rise further.

Company pensions

Company pensions, as you might expect are set up by employers. These are most commonly Defined Contribution (DC) or money purchase plans where the fortunes of the scheme are linked to investment market performance. With these schemes there’s no guarantee of the income you’ll receive when you come to retire. The retirement benefits won’t be known until an employee reaches the stage when the benefits are taken.

With DC company pensions when you pay in, your boss does too. Under legislation introduced in 2012, all companies must eventually offer a workplace pension and automatically enrol eligible workers into it. This rule has been applied to larger employers since October 2012 but will apply to companies of every size by 2018. How much your employer pays in can vary. The minimum amounts are currently 1% of your ‘qualifying earnings’ from your employer, with 0.8% from you and 0.2% tax relief, but both you and your employer can pay in more. Your employer will work out your ‘qualifying earnings’, which are your earnings (before tax and National Insurance are deducted) that fall between a lower and upper earnings limit set by the government.

Very few company schemes are now final salary, or Defined Benefit schemes. Under this type of scheme, the employee’s retirement benefits are set out or ‘defined’ in advance by the pension scheme. This means that the income you’ll receive from your pension is guaranteed depending only on your income during your membership of the scheme.

Personal pensions

A personal pension is another type of money purchase or DC scheme. You, or your financial adviser, choose which pension provider you'd like to administer your pension and where you want your contributions to be invested, from a range of funds offered by the provider. This should cover the full range of investment assets — shares, government bonds, corporate bonds, cash and commercial property. The aim is to grow the fund over the years before you retire. The amount of income your pension will pay you when you retire will chiefly depend on how much you save into it and the performance of your chosen funds over time, after taking account of the charges. Like DC company schemes, the value of your pension fund will depend on the performance of the investments held in it and these can fall in value as well as rise. You may get back less than you and your employer invest.

Stakeholder pensions

Stakeholder pensions are often viewed as the low-cost option in the world of pensions as they're typically cheaper than other schemes and have very low and flexible minimum contributions. But compared to other plans they typically offer a narrow range of investment options. However, should you require wider choice at some point you can transfer stakeholder pensions to another type of pension plan, or to another stakeholder pension provider — and you won’t be hit with a charge for doing so. Like a personal pension, the success of your stakeholder pension will be down to how much you save and how markets perform.

Self-Invested Personal Pensions (SIPPs)

A Self-Invested Personal Pension or SIPP is a type of personal pension but with added bells and whistles. Like all pensions, it's a tax-efficient savings wrapper but you can invest in a much broader range of investments — including individual shares, in some schemes individual commercial properties and you won’t be restricted to pension funds offered by any single pension provider. SIPPs may appeal more to experienced investors who are happy to monitor and manage their pension themselves and want to take advantage of the wider range of assets available. Some plans offer investment management, with a specialist making investment decisions for you, but there'll be additional charges for this type of service. If you're considering investing in a SIPP, you need to be prepared to take a risk as you could lose the money you've invested and you could end up with insufficient savings in retirement.

Remember too that the favourable tax treatment associated with all pensions may change in the future and that the value of this tax treatment to you will depend on your individual circumstances, which can also change.

Again always bear in mind that the value of any personal or defined contribution (DC) pension scheme will depend on the performance of the investments held in it and these can fall in value as well as rise. You may get back less than you and your employer invest.

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