What types of personal pension are there?
Pensions encompass a diverse range of plans, but the majority fall into one of two categories, either Defined Contribution (DC) or Defined Benefit (DB).
Understanding the fundamentals of these pension structures is valuable, as depending on the type(s) of pensions you have, this will impact:
- How you can access your pension in retirement;
- How much income you will receive,
- The tax you will pay.
There are lots of decisions that you need to make, all of which will influence your retirement planning strategy.
Defined contribution retirement plan: what it means.
A defined contribution pension scheme is often also referred to as a workplace pension, money purchase pension or personal pension so it’s easy to get confused about what these are.
A Defined Contribution (DC) retirement plan is a type of pension pot which is personal to you. They can be created by an employer on your behalf, in to which both you and your employer could contribute, or they can be something you create yourself if for example you want to increase your pension provisions but prefer to keep this separate from other pension arrangements.
With a defined contribution pension you build up a pot of money that you can use to provide an income in retirement. Unlike defined benefit schemes, which promise a specific income, the income you might get from a defined contribution scheme depends on factors including the amount you pay in, the fund’s investment performance and the choices you make at retirement.
Key features of Defined Contribution plans include:
Individual Accounts: Each participant has a separate account, and contributions are made to that account on a regular basis.
Contributions: Contributions can be made by the employer, the employee, or both. There may be specific rules regarding the amount or percentage that each party contributes.
Investment Choices: Participants typically have some control over how their contributions are invested. Common investment options include stocks, bonds, mutual funds, or other investment vehicles. Many scheme’s will also offer life styling. The goal of life styling is to automatically adjust the investment strategy within a pension portfolio over time to match changing risk tolerance and investment horizon as you approach retirement. For example for those who have 40years until retirement the life styling strategy might apply a greater level of risk, where as someone who has 5 years until retirement will potentially have a lower risk strategy, as they have less time until they will need to access the plan to make up any losses.
Market Fluctuations: The value of the retirement benefit is subject to market fluctuations. The account balance will depend on the performance of the chosen investments.
Who has defined contribution pensions?
The pension sector has seen many changes over recent years and defined contribution pensions are now the most common pensions. In October 2012, the UK Government introduced automatic enrolment for employees aged between 22 and state pension age who earn above a certain limit. Simply put employers were required to set up a defined contribution pension for those aged between 22 and state pension age to support individuals in building up additional pension provisions for when they reach retirement.
You might have a defined contribution pension if you’re employed, self-employed or if you have set up a pension to make additional contributions towards your retirement.
How much will I receive from my defined contribution pension?
Unlike Defined Benefit plans, there is no guaranteed payout at retirement. The retirement benefit depends on how much you and your employer have contributed and investment returns as mentioned above.
The value of your pot at retirement will depend upon:
- How much has been paid into it;
- The length of time that each contribution has been invested;
- Fund selection and Investment performance over the period it has been invested;
- The charges deducted by the scheme;
Individuals with Defined Contribution plans need to actively manage their investments and make informed decisions about contributions and asset allocation to ensure a sufficient retirement nest egg. As there is no guaranteed pay out, careful planning and regular review is vital to understanding what your pension will provide in retirement and whether this meets with what you need.
Seeking financial advice can aid with your understanding and we use cash flow modelling to help you visualise your retirement. You can find out more about cash flow modelling and how this can help you here.
How many defined contribution pensions can I have?
There is no limit to the number you can have and you can contribute to more than one each year. Although there is a limit to the overall amount you can add to a pension in any one year. If you are thinking about adding a large contribution to a pension it is a sensible idea to seek advice as there can be significant tax consequences if you accidentally add to much.
Can I take a lump sum with my defined contribution pension?
Typically, you have the option to withdraw up to 25% of your pension savings as a tax-free lump sum. The remaining portion remains invested, providing the opportunity for potential growth. Subsequently, you can choose between receiving a regular income or withdrawing amounts as needed.
Defined contribution pensions offer the flexibility to take a greater lump sum than 25% although this can have significant tax consequences dependent upon your tax position when you access the pot.
It’s crucial to thoroughly understand the terms and options available within your specific DC pension plan. Seeking financial advice will enable you to evaluate the potential tax implications, assess your overall financial situation, and make informed decisions based on your retirement goals.
When can I access my pension?
At present you can access pensions from 55years although this will rise to 57years from April 2028.
What are my options at retirement?
When you have a Defined Contribution (DC) pension, you typically have several options at retirement. Here are common options for individuals with a DC pension at retirement:
Lump Sum Withdrawal – You may have the option to take a portion or the entirety of your pension savings as a lump sum. A certain percentage (often up to 25%) is usually available tax-free, with the remaining portion subject to income tax.
Purchasing an Annuity – You can use your pension savings to buy an annuity, which provides a regular income for a specified period or for the rest of your life. Annuities offer financial security but may provide less flexibility compared to other options. For more information on annuities visit our financial guide what is a pension annuity here .
Flexi-Access Drawdown – With this option, you keep your pension savings invested and withdraw money as needed. There is typically a limit on the amount you can withdraw each year, and the remaining funds stay invested, potentially providing growth.
Leave it Invested – You can choose to leave your pension savings invested and access them gradually over time. This allows your investments to potentially continue growing.
Mixing Options – You may have the flexibility to combine different options. For example, you could take a lump sum for immediate needs and use the remainder to purchase an annuity or enter a drawdown arrangement
Working with a financial adviser to understand the options above and what is right for you is essential. Pensions can be complex, confusing and regulations have a habit of changing regularly. Seeking financial advice from a professional means they will carefully consider your financial goals, lifestyle, and any tax implications associated with each option above.
`Income drawdown' will reduce the size of your pension fund and the investment growth may not be sufficient to maintain the level of income you wish to draw. If you withdraw money at a rate greater than the growth achieved by your investments, your remaining fund will reduce in value. The level of income you take will need to be reviewed if the fund becomes too small - this is more likely the higher the level of income you take.
The income you receive may be lower than the amount you could receive from an annuity, depending on the performance of your investments. As annuity rates can change substantially and rapidly, there is no guarantee that when you do purchase an annuity the rates will be favourable. This could mean that your pension thereafter may be less than you hoped for. The rules governing how much income you can take directly from your pension fund may change. This could mean that the income you can take from the investment no longer meets your requirements.
Defined benefit retirement plan: what it means.
A defined benefit pension scheme is often also referred to as a final salary pension or a career average pension so it’s easy to get confused about what these are.
To keep it simple think of defined benefit as the type of pension where you know up front what your benefits will likely be in retirement. This is different to defined contribution pensions where all you know is what you are putting in as opposed to what you will get out.
Because it’s a fixed sum of money that is paid out when you retire, you know it will give you a guaranteed income for the rest of your life, however long you live. This is a valuable benefit to have and is the reason why so many people feel fortunate to have this type of pension.
Who has defined benefit pensions?
You might have a defined benefit pension if you’ve worked for a large employer or in the public sector. Your employer contributes to the scheme and is responsible for ensuring there’s enough money at the time you retire to pay your pension income. You can contribute to the scheme too, and, depending on the scheme, this may be a requirement.
These schemes are expensive to run for the employer so many companies have closed their schemes or have changed the level of benefits received so they are now less common than they once were.
There are two types of defined benefit pension – final salary schemes and career average schemes.
What is a final salary pension?
The retirement income that you receive is based on how much you’re paid at the point you leave the scheme or when you retire assuming you’re still working for the employer.
These schemes can be very generous especially if your salary increases over the years, but you could lose out if you decide to reduce your hours or maybe take a step back as you wind down to retirement.
Every scheme is different so its important to understand the rules that apply to you.
What does career average pension mean?
This is different to a final salary as the amount that you receive in retirement is based on an average of your salary throughout a specific period.
This may give less income in retirement than a final salary if you had a period where your income was lower, for instance whilst starting out in your career. However, the impact of reducing hours or winding down closer to retirement is likely to be less in this case. This assumes every year of your employment is considered.
Again, it’s important to understand the rules of your own scheme.
How much will I receive from my defined benefit pension?
A defined benefit (DB) pension scheme is an employer-based pension scheme which is based on the number of years you have worked for the company and the salary you’ve earned at the time you left the company or retired.
Schemes have a predetermined formula which typically considers factors such as:
- Salary – Either your final salary or your average salary over a specific period. This may be your entire period of service, or some newer versions looked purely at the last 5 years of your employment.
- Years of Service – The number of years you’ve worked for your employer.
- Accrual Rate – This represents how much of your salary is multiplied by your years of service to calculate your annual pension benefit. You may hear terms like a 60th scheme or an 80th In the example of a 60th final salary scheme, you’ll accrue 1/60th of your
salary for every year that you work. If you work for 40 years, you’ll retire with a pension income which is around two thirds of your final salary.
Whether yours is a final salary pension or a career average pension, once you reach retirement you will receive a secure income for life. It is quite common for this type of pension to rise each year in line with inflation or a specific percentage amount dependent upon the scheme rules.
Scheme rules
It’s important to check the specific details of your pension plan, as different plans have different formulas and rules. Additionally, there may be provisions for early retirement, cost-of-living adjustments, and survivor benefits that can affect the amount you receive at retirement.
To determine the exact amount of your pension, you should refer to the plan documents provided by your employer or pension administrator. They should be able to provide you with personalised information about your expected pension payout based on your specific circumstances.
Can I take a lump sum with my defined benefit pension?
Whether you can receive a lump sum from your pension depends on the specific rules and options offered by your pension plan. Typically, a defined benefit pension will provide a guaranteed income for life. However, some plans may offer the option to take a lump sum in addition to the regular pension income but in exchange for this the income will be reduced.
Some defined benefit pensions will offer a lump sum as part of their initial pension quotation. It is common for you to also have the ability to “commute” or take a larger lump sum and a lower annual income or vice versa a smaller lump sum and a larger annual pension.
Are defined benefit pensions taxable?
The amount you receive as a lump sum is tax free whereas the income you receive has the potential to be taxable dependant upon your total overall income and circumstances.
Can I access my pension early?
Defined benefit schemes typically have a normal retirement age of 60, 65 or your State Pension age. Each scheme has different rules so it will depend upon your individual scheme.
Whilst many will have a normal retirement age it may be possible to access your pension early. At present you can access pensions from 55years although this will rise to 57years from April 2028.
Should you to wish access your pension early, you may find that your pension provider will reduce your pension. By accessing your pension earlier, it is assumed that your pension provider will need to pay you a pension for longer. They therefore reduce the amount of pension you receive because you are accessing it earlier than your normal retirement age. Should you wish to consider this option your pension administrators will be able to provide a personalised quotation.
If you are looking at your early retirement options, it’s wise to get quotes to access the pension at the current time and on each birthday up to the normal retirement age so you can see in pounds and pence the impact of delaying.
A financial adviser can also explore your long-term income sustainability need to ensure that however long you live, you understand what income you will have available to you and whether this is sufficient to meet what you need.
Achieving your pension goals
Pensions and understand your options can be complex and daunting. Whatever your retirement plans, planning early and not sleepwalking into retirement will help you work towards the retirement you dream. Seeking financial advice, understanding your current position and planning for the future will provide peace of mind.
For more help and advice or to receive a complimentary guide covering wealth management, retirement planning or Inheritance Tax planning, contact Yorkshire Financial Planning on 01482 275540 or complete our contact form here.
The value of an investment with St. James’s Place will be directly linked to the performance of the funds selected and may fall as well as rise. You may get back less than the amount invested.
The levels and bases of taxation and reliefs from taxation can change at any time and are dependent on individual circumstances.
The levels and bases of taxation, and reliefs from taxation, can change at any time. The value of any tax relief is dependent on individual circumstances.
