Pensions 101

Sometimes your pension can seem like a distant relative: you met them a long time ago when you were younger but now you can’t really remember where they are or what they do.

As you near retirement though, you’ll be wanting to get up close and personal with those long-lost savings, especially as the state pension is so meagre. Currently the most you’ll get is just over £9,100 a year – not exactly a dream retirement.

There’s never a wrong time to reacquaint yourself with your pension so gather your paperwork and follow our easy steps to get back in touch. For this article we have focused on workplace pensions.

Where’s my pension?

Employers must automatically enrol all eligible staff into a pension scheme. This is either run in-house or by external managers. Your first port of call to find out more is the HR department. If you’ve left a pension pot behind in a former job, make sure you have up-to-date details.

What type of pension is it?

Workplace pensions generally fall into two categories. The most common is called a ‘defined contribution’ scheme. Your final pot depends on how much you saved and what the underlying investments are worth when you take it.

Alternatively, you may be in a ‘defined benefit’ plan. These are typically held by public sector workers. The eventual payout is based on your salary and the number of years worked, not on investment values. They are not called ‘gold-plated’ pensions for nothing!

How much is going in?

The minimum yearly contribution is 8% in total of your salary. Depending on your employer, that may be before or after any bonus payments.

Of the 8%, your employer must contribute at least 3%, leaving you to stump up 5%. Help with this is at hand though because the government refunds tax on money saved into a pension: 20% for a basic-rate taxpayer, 40% for a higher-rate taxpayer and so on.

As an example, let’s look at Ms X who has qualifying earnings of £60,000 a year. The handy calculator from the Money Advice Service says she will pay £250 per month (including £50 of tax relief) and her employer will pay £150, making a total contribution of £400.

Limits do apply – the government isn’t that generous. You can’t put more than your annual earnings or £40,000, whichever is highest, into the pension. There is a lifetime cap too.

Where’s the money going?

Your pension savings are usually invested in a mix of investment funds. Sometimes you can choose those funds from a small selection. Make sure the funds are appropriate to your needs: for example, high risk technology or overseas shares are best for younger investors, not those approaching retirement. The reason for this is that the prices of higher risk assets tend to move more significantly during short periods of time. If you are close to retirement and relying on a certain level of income, it is sensible to stay away from those kind of assets as they can meaningfully change the value of your retirement pot in a short period of time.

Note that there are fees for administration and investment costs as well.

When do I get the cash?

The earliest you can get your pension is normally age 55. At this stage, you can either use the whole pot to buy an annuity (an income for life) or put the pot into ‘drawdown’. This keeps the money invested, allowing you to live off the income and draw down capital when required.

A mixture of both options is possible, while some schemes allow a cash lump sum to be withdrawn too. Whichever way, you’ll get 25% of the pot tax-free. The rest will be taxed as income when you take it.

Ideally, these steps will bring you closer to understanding your pension. If not, getting financial advice is essential. One way or another, you’re going to be in a relationship with your pension for a lifetime: it’s worth more effort than just a card at Christmas.

Date of publication: 11th June 2020