A beginner’s guide to pensions

Don’t think you need a pension?  Unsure what happens to your contributions?  Andrew Colyer-Worsell guides you through the basics.

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What is a pension?

A pension is a savings plan with special tax benefits designed to build a fund at retirement. Employees, employers, self employed and unemployed all may pay into a pension plan.

“Why open a pension? For starters, every £8 you contribute into your pension plan you will get £10 deposited”

Why save into a pension?

For starters, you get tax relief on pension contributions.  This means that if you are a basic 20 per cent tax payer for every £8 you contribute into your pension plan you will get £10 deposited.

The £8 deposit is called the net contribution, the £10 deposit is called the gross contribution and the difference between the two is called the tax relief.

If you are a nil rate tax payer and you contribute £3,600 or less per annum you will still obtain 20 per cent tax relief.  This means the maximum net figure you would be able to contribute to get tax relief is £2,880.

If you are a higher rate tax payer you will be eligible for 40 per cent tax relief meaning for every £6 you contribute £10 will be deposited.

The tax relief therefore makes this type of saving for retirement extremely attractive.

What happens to the contributions?

Clearly your contributions have to be saved somewhere and that somewhere is called a pension fund.  Pension funds are many and varied and this aspect can become very confusing.  The fund choice largely depends on your attitude to risk and your age. Typically, but not always, the younger you are and the longer the time period until you retire, the higher the risk you can take and, hopefully, the higher the rewards you will obtain.  This is where specialist advice is required to ensure you are investing in a fund or group of funds aligned to your attitude to risk.

Therefore, you should be looking for a pension with a wide range of funds and fund types to give you maximum investment flexibility.

What’s a Sipp?

A Sipp stands for self-invested personal pension. Like all pensions, a SIPP offers up to 45 per cent tax relief on contributions and there is no capital gains tax or further income tax to pay. The tax benefits will depend on your circumstances and tax rules are subject to change by the government.

However, whereas traditional pensions typically limit investment choice to a shorter list of funds, normally run by the pension company’s own fund managers, a SIPP lets you invest almost anywhere you like and choose your own investments.

What are the charges?

A financial adviser’s fees will vary from adviser to adviser.  It may be a flat fee, an hourly rate or a percentage of contribution.

Pension companies may take a percentage of the contribution as an initial fee.  The pension companies will typically take a percentage of the fund value every year as their fees.  This will include the administration and the fund management. The fees will vary from company to company, pension to pension and fund to fund.

The total pension company’s fees are expressed as a reduction in yield and nowadays will typically be between 0.3 per cent and 1 per cent. This means that the total cost to run your pension will be between 0.3 per cent of the total fund per annum to 1 per cent of the total fund per annum.

Should I increase contributions?

If your income is increasing it makes sense to increase your pension contributions in line with income so that your pension income keeps pace with your earnings.

What happens at retirement?

At retirement the pension fund is used to provide a pension income, either by purchasing an annuity or by drawing down an income from the pension fund. The drawdown route is normally reserved for pension funds larger than £100,000.

Retirement income can be joint life, single life, level or increasing.  There can also be a guarantee, which means if the annuitant dies within the guarantee period (typically five or ten years) the balance of the income payments are paid out as a lump sum.

Taxation at retirement

Pension income is taxable but you are normally entitled to a tax free lump sum of 25 per cent of the fund value.

How else can you save tax? Use our Tax Calculator to work out how else to save money.