Do you know your defined contribution pension from your money purchase pension? Wait - aren't they the same thing? Welcome to our pension primer with a difference, as we tell you what all those confusing terms really mean... Article by Nick Green.
Reading about pensions is enough to make your head spin. What is an annuity? What's the difference between a scheme and a fund? What on earth is 'decumulation' - a kind of rain cloud? But these are all vital terms to understand if you want to take control of your retirement savings. So here's a fun glossary to ensure you never get baffled again.
Accrual rate
What it sounds like: The speed at which a Disney villainess acquires Dalmatians.
What it actually means: If you have a defined benefit pension, the accrual rate is the proportion of your salary you receive as pension for each year of service. For example, if this rate is 1/80, and you spend 20 years in the scheme, then your pension will pay you 20/80 (i.e. a quarter) of your final salary.
Annuity
What it sounds like: ‘Good night’ in Esperanto.
What it actually means: An annuity is an insurance product that pays you a guaranteed income for a set period of time (usually the rest of your life, unless you arrange otherwise). Traditionally the standard pension option for the majority of people at retirement. It’s vital to shop around to get the best value annuity, so don’t just take the first one offered by your existing pension provider.
Compound interest
What it sounds like: The hobby of a chemistry professor.
What it actually means: Interest on investments (e.g. in a pension pot) that goes on to earn interest itself. All right, you knew that – but it’s one of the best reasons to start a pension as early as you can, as the effects of compound interest on your money can be astonishing over time.
Decumulation
What it sounds like: Is the weather clearing up?
What it actually means: 'Decumulation' is the opposite of 'accumulation'. It's the word financial advisers use to describe the way your pension pot gets smaller over time once you start making withdrawals from it - via the process of drawdown. The trick, of course, is to do this in way that ensures you don't run out of money too soon.
Default fund
What it sounds like: Your eldest child's piggy bank, when you need spare change
What it actually means: The default fund is the set of investments in which your workplace pension is invested initially - and where it will stay unless you ask for it to be changed. The default fund is unlikely to be ideal for you (it's merely the best compromise to suit all scheme members equally) so ask your financial adviser if you should consider switching to a more suitable fund.
Defined benefit
What it sounds like: An attractive former colleague you still see occasionally when you’re bored.
What it actually means: A workplace pension that pays you a guaranteed income for life (similar to an annuity) at a level based on your pensionable service, pensionable earnings and the scheme’s accrual rate. Often called a final salary pension, though may be based on your average salary over the course of your employment. Mostly found in public sector jobs, rare in the private sector. This kind of pension is excluded from pension freedom unless you undertake a pension transfer.
Defined contribution
What it sounds like: The minimum you can pay for a poppy and walk away with dignity.
What it actually means: The most common kind of pension scheme. You choose (‘define’) how much you want to contribute to the scheme, and so build up a pot of money during your membership. Your contributions receive tax relief at your marginal rate (20 per cent for basic rate taxpayers) and (if it is a workplace pension) your employer’s contributions will be boosted in the same way. The pot is invested for long-term growth and benefits from compound interest. You can access the money from the age of 55 onwards under the rules of pension freedom.
Drawdown
What it sounds like: A showdown between two rival graphic artists.
What it actually means: Drawdown is a way to draw an income in retirement. The money from your pension pot is invested to generate income, so you can draw out as much as you need/want each year. This is a more flexible option than an annuity, but comes with much higher risk. If the stock market performs badly then the growth alone may not meet your income needs, forcing you to draw more on the original sum of money. As this sum gets smaller, the growth will shrink too, in what can become a vicious circle. This is why it’s vital to seek financial advice if you’re considering a drawdown scheme.
Final salary
What it sounds like: The leftovers in the salad bowl.
What it actually means: See defined benefit (above). Note that the term may be misleading: some ‘final salary’ pensions are actually based on your average salary over your pensionable service.
Money purchase
What it sounds like: I have forgotten my credit card.
What it actually means: See defined contribution. The term ‘money purchase’ reflects the fact that you will eventually ‘purchase’ pension benefits using the money built up in your pot.
Pension freedom
What it sounds like: Could be a Jack Nicholson film?
What it actually means: In place since April 2015, this is a set of reforms enabling people with defined contribution pensions to access their pension pots from the age of 55 onwards in many more ways than were previously allowed. It is prudent to seek advice on the best way to use pension freedom, as there are still many factors to take into account (such as tax on withdrawals and the inherent risks of certain options such as drawdown).
Pension transfer
What it sounds like: A washable alternative to the pension tattoo.
What it actually means: If you have a defined benefit pension, then you can’t access it flexibly as you can with a defined contribution pension – you will just be paid an annual income (and possibly a one-off lump sum). If you want the kind of flexible access available under pension freedom, you will need to transfer your current pension into a defined contribution pension. However, this option is usually not recommended, as you are unlikely to obtain the same level of value. For this reason it is a legal requirement to seek financial advice if your pension has a transfer value of £30,000 or over (and highly recommended in all cases).
Pensionable earnings
What it sounds like: Making some extra cash in retirement by gardening or similar.
What it actually means: If you have a defined benefit pension, this is one of the factors used to calculate how much you will receive. Depending on the scheme, your pensionable earnings are either your salary at retirement, or your average salary over the period of your membership.
Pensionable service
What it sounds like: Being in the Home Guard under Captain Mainwaring.
What it actually means: Another factor in working out your defined benefit pension. This is simply how long you’ve been a member of the scheme (which may or may not be the same as the length of your employment with that employer).
SIPP
What it sounds like: The start of a large DRINK.
What it actually means: A SIPP is a self-invested personal pension. This defined contribution arrangement lets you decide how your pension contributions are invested, choosing from a range of investments including stocks and shares, investment trusts, commercial properties and national savings products. A SIPP is generally higher risk, but has the potential to generate greater growth. Ask your financial adviser about whether a SIPP is the best choice for you.
Stakeholder pension
What it sounds like: Income received by Van Helsing after he gave up chasing Dracula.
What it actually means: A kind of personal pension arrangement, a defined contribution arrangement simpler than a SIPP and with lower management costs. Management charges cannot be more than 1.5 per cent of the fund’s value for the first 10 years, and 1 per cent after that. Stakeholder pensions are a popular choice for people who don’t have access to a workplace pension scheme (e.g. the self-employed or those not in work).
State pension
What it sounds like: The government will look after me.
What it actually means: The state pension is a small guaranteed pension provided by the government. Though it can be useful to top up the income from your private pension, it’s unlikely to be sufficient. The new state pension is just £168.60 per week for those reaching state pension age today, which alone isn't enough for most people to live on.
Tax relief
What it sounds like: Phew! I’ve finished my self-assessment.
What it actually means: When you pay into a pension, the government pays back the money you would have paid on it in income tax. This means that if you pay income tax at 20 per cent, a contribution of £80 into your pension will turn instantly into £100, because that 20 per cent tax has been added back on. Higher and additional-rate taxpayers are currently able to claim 40 per cent and 45 per cent tax relief – however, many advisers believe that the government will slash these figures in the near future, so now is the time to take advantage of the more generous rates.
Tax relief remains the most attractive benefit of saving into a pension, setting pensions apart from all other types of investment.
Unfunded scheme
What it sounds like: Bad news!
What it actually means: Good news! An unfunded scheme is a type of defined benefit pension provided for public sector workers and funded directly by the taxpayer (unlike a funded scheme, which depends on a central fund). This kind of pension is often the most generous of all. The only (arguable) downside is that you can’t do a pension transfer out of an unfunded scheme, as you can with a funded scheme. However, with the guaranteed benefits of a defined benefit pension, most people shouldn’t want to leave it.
Pension calculator
What it sounds like: A calculator from your school days that amazingly still works.
What it actually means: A free tool from Unbiased that lets you estimate how much income you can expect in retirement from your private pension - and more importantly, tells you how much you'd need to save now in order to enjoy the retirement you want. Try the pension calculator today!
