Planning for retirement is not a straightforward process, and when it comes to choosing a pension there are lots of different things to take into account. You may not be aware, but there are actually three different types of pensions. Let’s explain a little about them…
- The State Pension: Everyone who has paid (or been credited for) National Insurance Contributions for at least 30 years will receive this in full. Those who have 10-29 years will receive a reduced state pension. A full state pension is currently £113.10 per week (rising to £115.95 in April 2015) and you may also receive an additional earnings related state pension. This is due to change for those who reach state pension age after April 2016. The new state pension will be at least £148.40 per week but with no additional earnings related pension. Also, the number of years to qualify for the full amount will rise to 35 years.
- Final Salary or Career Average Salary based (Private Pension): Some employers provide their employees with a final salary pension or career average pension. This is a proportion of your salary – either your final salary or your average salary over your career – for the number of years you have worked. For example, if the scheme is a “60ths” scheme and you have worked for them for 15 years, you will receive a quarter of your salary (15/60th is a quarter) at your normal retirement age.
- Personal Pensions (Fund Based, Private Pension): These types of pension are now much more common than final salary and career average pensions. What’s more they are available to all UK residents under the age of 75. You do not have to be working to take out a personal pension plan. Your employer may offer to pay in percentage of your salary or wages into your pension. If they do it’s a no brainer to join! Contributions from you or an employer will be invested in a fund or funds of you choosing and grow virtually tax free, just like a Cash ISA or Investment ISA. When you are at retirement age (55 or earlier if forced into retirement) you can then spend the “pot” you have built up over the years. As a rule of thumb, we would recommend that you do not take out more than 5% per year of the fund value so that it is sustainable over a longer period of time. You will however have the choice to withdraw as much or as little as required.
Taking Your State Pension
The state pension (currently £113.10 per week or £5,881.20 per year) will go some way towards providing for you in retirement, although by itself it is unlikely to be enough to live on comfortably. It does need to be taken into account in retirement planning though. As we discussed in a previous blog, when you plan for retirement the first thing you need to work out is how much money you will need to live on per year. Deduct the state pension from this and you are left with a yearly figure for how much extra you will need to find from pensions, investments or savings.
The state pension is inflexible. Unlike private pensions, you cannot exchange some of your state pension for a lump sum or take it early. Your only options are to take it at state pension age as normal or defer it and take it later, either for a higher state pension (an extra 10.4% per year) or the a lump sum equal to the deferred payments plus interest.
Taking Your Final Salary/Career Average based pensions
Most schemes have a “normal” retirement age (e.g. 60 or 65) with an option to take your pension earlier than this, providing you are at the legal minimum age for taking your private pension (55 or earlier if forced). Some schemes will allow you to take your pension early, however the amount you receive will reduce by a percentage (known as actuarial reduction). For example, if the normal retirement age is 60 and you take your pension at age 58, the reduction may be, say, 10%.
Another option you have is to take a lower pension in exchange for a tax-free cash lump sum. This option is available at normal retirement age or earlier.
Taking your Personal Pension
As with the above, you can take your personal pensions at any age after the legal minimum age. Personal pensions are the most flexible type of pensions, especially when the new rules come into force in April. You will be able to use it “like a bank account”, taking as little or as much out as you want. You don’t have to draw your whole pension in one go or even retire. For example, if you have a pension pot worth £100,000 and you need a one-off lump sum £20,000, you could “vest” £20,000 of it and leave the £80,000 remaining to continue to grow for later. A quarter of the £20,000 would be tax free and the other £15,000 would be taxable as income in the normal way.
This means two things. Firstly, you can use your pension pot for any one-off purpose, perhaps to pay off your mortgage, put it towards a wedding, a gift to your family or a holiday. Secondly, you may wish to pay into a personal pension rather than paying into an ISA or as well as paying into an ISA (assuming you can afford to leave it set aside for the longer term and to age 55 at least) then withdraw it later when retired.
Article by Daniel Cook, Adviser Support for Charles James Financial Planning Ltd which is authorised and regulated by the Financial Conduct Authority