Fancy an easy pay rise? Start a pension and hey presto. The Government will give you extra, and your employer may also HAVE to help.
Here's the 15 things you NEED to know about pensions, including the new rules for those auto-enrolled into a workplace scheme.
Fancy an easy pay rise? Start a pension and you've got one. Not only will the Government top up your pension pot, but if you're employed, your employer may also HAVE to help.
This guide lists the 15 key things you NEED to know about pensions, including the new rules which mean, over time, every employee will be auto-enrolled into a workplace scheme.
In this guide
Note: This guide doesn't apply to final salary schemes where your wage and length of company service determine your retirement income - for basic info go to the Different pension types section. Nor does it cover the humble state pension - always check if you can boost it.
Thanks Dennis Hall, MD of Yellowtail Financial Planning, for fact-checking this guide.
What is a pension?
A pension is not necessarily what people think it is, and it most certainly isn't only for old people.
A private pension is fundamentally a simple product:
It is just a tax-free pot of cash you, your employer (and sometimes the Government) pays into, as a way of saving up for your retirement.
At retirement, you can draw money from your pension pot or sell the cash to an insurance company in return for a regular income until death, called an annuity.
New rules announced in the 2014 Budget mean that once you reach 55, you can start accessing your pension pot, taking as much or as little as you like, whenever you like.
But it's important to understand how a pension affects your income.
- Yippee! I'm getting a pay rise (later). Any employer contribution, plus the tax you get back on your money, means your overall income will rise as extra cash is pumped into your pension pot. You may not get that extra cash in your pay packet to spend immediately, but it's going towards your future.
- Damn! I'm losing disposable income (now). If you contribute to your pension, it means you'll get less in your pay packet, so consider this carefully when budgeting. See our free Budget Planner tool.
For many years, your company may have set up and contributed to a workplace pension. But not all companies offered this - many didn't offer any pension contribution.
New auto-enrolment rules mean that if you're an employee, your employer will be forced to offer you a pension scheme. By 2018 all employers by law will have to contribute to their employees' pensions, but to start with only larger firms will offer this.
Auto-enrolment is designed to address a chronic lack of retirement savings. At the moment, fewer than one in three UK adults are contributing to a pension.
You have the option to say no to auto-enrolment if you don't want to join. But it's an opt-out rather than an opt-in scheme, so if you do nothing, you'll be opted in.
Auto-enrolment key facts
Who will be auto-enrolled?
You'll be automatically enrolled into a workplace pension if you:
- are employed (the self-employed aren't involved in auto-enrolment).
- are aged 22 or over.
- are under the state pension age, which is currently 65 for men and 61 and five months for women, although this is gradually rising to 65 by 2018. (See the Government's State Pension Age Calculator to see when you'll qualify).
- earn more than £10,000 a year (in 2014/15).
When will I be auto-enrolled?
Auto-enrolment started on 1 October 2012, when staff in the largest companies - with 120,000 or more staff - were automatically opted in.
The roll-out will be gradual, with everyone eventually enrolled by the start of 2018.
To give you an idea, firms with (example correct from 1 April 2014):
- 50,000-120,000 staff began on 1 November 2012
- 10,000-19,999 on 1 March 2013
- 2,000-2,999 on 1 August 2013
- 350-499 on 1 January 2014
- 60 on 1 October 2014...
...then it gets complicated until February 2018. Have a look on your last payslip for your employer's PAYE reference. Then put it into this calculator to see exactly when your employer has to enrol.
You should also check with your employer exactly when you'll be enrolled as your firm can bring the date forward.
How much must I and my employer contribute?
All employers must ensure the following minimum contributions go into your pension once it's started. You can put in what you like if you aren't eligible for auto-enrolment yet, or if you pay into a non-workplace pension.
The minimum amount both you and your employer must pay into your pot is worked out as a percentage of your pre-tax qualifying income. See the table below.
What is qualifying income?
This depends on which 'tier' of the scheme your employer has chosen to use:
Tier One - This includes your basic pay only.
Tier Two - This includes your basic pay only. However, your basic pay can be no less than 85% of all your earnings before tax.
Tier Three - This includes your salary, overtime, bonuses and commission, as well as statutory sick, maternity, paternity or adoption pay (your "gross earnings").
Minimum contributions must be paid on all qualifying earnings between £5,772 and £41,865.
So if you earn £30,000 a year, the current (2014/15) minimum employer/employee contribution is 2% of £24,228 (as you discount the first £5,772), which is £485 a year.
|Contributor||Tier One||Tier Two||Tier Three|
|You pay||0.8% of your basic pay now. 4% by 2018.||0.8% of your basic pay now. 4% by 2018.||0.8% of your gross earnings now. 3.2% by 2018.|
|Your employer pays||2% of your basic pay now. 4% by 2018.||1% of your basic pay now. 3% by 2018.||1% of your gross earnings now. 3% by 2018.|
|The Government pays||0.2% of your basic pay now. 1% by 2018.||0.2% of your basic pay now. 1% by 2018.||0.2% of your gross earnings now. 0.8% by 2018.|
If it wants, your employer can cover the entire minimum so you don't have to make your own contribution. You'll also get tax relief on whatever you and your employer pay in.
There is a chance your employer will reduce your pay to cover the contributions it makes. Only time will tell if that actually happens.
I already have a pension, what happens to me?
If your employer already operates a scheme, nothing should change unless your employer contributes less than the minimum, in which case you should get more at the point you become eligible for auto-enrolment. The new law is in place to encourage those without a pension to start saving.
In theory, your employer could reduce the benefits of your pension in line with the minimum standards, but research conducted with employers by the Department for Work and Pensions suggests this is unlikely to happen.
If you already have a non-workplace pension then you will still be enrolled into your employer's scheme at the appropriate time. Remember, your employer will pay into your pension, so it's an effective pay rise, so think carefully before opting out of it. There's nothing to stop you paying into both pensions.
I'm self-employed - why aren't I getting an automatic pension?
Auto-enrolment applies to those who are employed, but if you're self-employed, it doesn't mean you'll be excluded from auto-enrolment, ie for personal service workers (whose job can't be done by someone else due to the expertise). You can always start your own private scheme (see How do I get a pension?).
With auto-enrolment, it forces an employer to contribute, but if you're self-employed you have the right to give yourself whatever you want.
I want to opt out of auto-enrolment, what do I do?
Only you, and not your employer, can decide whether to keep your pension, but seriously consider whether you want to give up the pay rise and whether you are leaving yourself enough to retire on.
However, you may not have the disposable income to give up now. See our free Budget Planner tool to help you decide.
If you decide to opt out, ask your employer for an opt out form. You should fill this out and return it to your employer. You will be automatically re-enrolled every three years, but with the option to opt out again.
Is a pension REALLY worth it?
The killer boost of a pension is the tax relief, which comes in two forms.
You get some tax back on the money you put into a pension, while gains from the investments you make with that cash are largely tax-free.
Tax relief on contributions
You get the tax back you've paid on all contributions, if you're under 75, subject to an annual allowance. This usually goes straight into your pension pot.
What tax relief do I get?
If you pay the money into your pension yourself, or if it is taken by your employer from your pay packet, you automatically get 20% tax back from the Government as an additional deposit into your pension pot.
If you are a higher rate taxpayer you can claim an additional 20%, while top-rate taxpayers can claim an additional 25%. If you are part of a workplace pension, you may not need to reclaim any tax if your employer simply deducts less tax from your pay packet.
However if you don't reclaim, it won't be paid. Therefore it is important to check if you are in a higher tax bracket. For more information on how to reclaim tax see HMRC.
If your employer puts the money straight in from your pre-tax pay then it's never taxed in the first place, so you still win.
How does the tax relief work?
If you get 20% tax relief, it doesn't mean you get 20% back of what you contribute.
Instead, the taxman works out your earnings on your contribution amount before tax was deducted. You then get back the difference between your contribution and your pre-tax earnings.
So when a basic 20% rate taxpayer invests £80 of their take-home pay in a pension, they'd have actually earned £100 before tax to come out with £80 (20% of £100 is £20, leaving £80). In that example, the tax relief is £20.
The graph below illustrates the tax boost.
Is there a limit to tax relief?
There are two limits. You get tax relief on contributions up to your annual earnings. Imagine you earned £20,000 each year, but had £30,000 in savings, and decided one day to put all your savings into a pension. In this situation, you would only earn tax relief on the first £20,000 of your contributions.
The second limit applies to higher earners. You also can also only get tax relief up to your current annual allowance. It's made up of the current year's allowance - which is £40,000 in 2014/15, up until 6 April 2015 - while you can also carry forward unused allowances from the previous three tax years. It's explained below...
Current annual allowance = £40,000. But...
You can carry forward an allowance of up to £50,000 from the previous three tax years, as that was the allowance in those years.
Say you invested £10,000 in a pension in each of the previous three tax years. You'd then have three lots of £40,000 - the unused parts of the previous three years' allowances - you could carry forward. This sum would total £120,000.
Your current allowance would be £160,000 (£120,000 from the previous three years, plus £40,000 from this year).
Money paid by someone else, such as your employer, counts towards those allowances.
You can still save more into a pension but you will only get the tax breaks up to the stated maximums above.
Like when you invest within an NISA, most of the gains are usually tax-free, so there's no savings tax and no capital gains tax.
There are some exceptions, though. See the HMRC website for full info.
What's 'salary sacrifice'?
Paying into a pension gets all taxpayers a tax break. But for an extra and easy bonus, salary sacrifice is worth considering.
Salary sacrifice applies to a number of workplace benefits, not just pensions.
It's where you give up some of your monthly earnings while your employer puts it towards something else - in this case, private pension contributions.
As it comes out of your PRE-TAX salary and straight into your pension, you pay a reduced rate of employees national insurance (NI). Your employer will also pay a reduced rate of employer's NI which gives them incentive to operate the scheme.
- Basic-rate taxpayers: Because your pension contribution comes out of your pre-tax salary, you'll pay less income tax at 20%. You'll also avoid your 12% NI contributions on the amount you sacrifice. This means for every £68 you sacrifice from your pay packet, £100 goes into your pension pot.
- Higher or top-rate taxpayers: If you pay tax at the higher 40% or 45% rates, salary sacrifice means you don't have to claim back the extra tax relief yourself - as you are never taxed on those contributions in the first place - and you don't have the 2% NI deducted on those contributions either. To deposit £100 in your pension pot, you only have to give up £58 from your pay packet, as no tax or NI is deducted as a higher rate payer. For a top-rate payer, you only give up £53.
One thing to take into consideration is that you'll take less money home, albeit to get a great benefit back in the future. However, having a lower upfront salary may hit you — for example, it could reduce your earnings so that you'd no longer qualify for Statutory Maternity Pay. At current rates, this means that if your salary sacrifice takes your salary below £111 per week, £481 per month or £5,772 per year, you'll be affected. Therefore — think twice before sacrificing.
It could also affect mortgage applications, state pensions and benefits, such as Jobseeker's Allowance and Employment and Support Allowance.
How much should I put in a pension?
While this guide has already dealt with the minimum you have to put in under auto-enrolment, often, you really should be contributing more - if you can.
Before starting, it's worth noting those in debt, especially at high rates of interest, should consider whether it'd be better to get rid of that before starting a pension. Plus, a pension's only one form of retirement planning. Combining it with other methods is often a good plan.
If you opt for a pension, the simple answer of how much to put in is as much as possible, as early as possible. There's a very rough rule of thumb for what to contribute for a comfortable retirement...
Take the age you start your pension and halve it. Put this % of your pre-tax salary aside each year until you retire.
Make sure you include your employer's contribution in that percentage.
So someone starting aged 32 requires 16% of their salary for the rest of their working life. This huge sum will scare the pants off anyone, but the rule helps us set some aims:
- Don't delay. The sooner you contribute, the longer your money has to grow. The compounding effect - where the cash your investment earns can, itself, attract additional earnings - makes a massive difference.
- Increase payments. It's important to put away a constant proportion of your earnings. As your pay increases, make sure your contributions increase proportionately, or you'll fall behind.
- Use the 'pay rise trick'. Most people will be unable to contribute enough at the beginning. So start with whatever you can, but each time you get a pay rise, put a quarter of it each month into your pension. Then you'll be basking in the glory of more money, without getting used to spending the cash destined for your pension.
For a more accurate way of calculating how much you need to retire, try using the Money Advice Service's pension calculator. It'll ask for information including when you want to retire, how much you and your employer are contributing, and whether you want your pension to be inflation-proof.
Should I take my employer's pension?
If you're employed, your employer may top up your pension as part of your benefits package, so absolutely consider it.
This is effectively a pay rise, so don't give that away, plus there's no tax to pay on that contribution (subject to annual allowances, above). It may not be going into your pay packet, but it is cash going towards your future.
Of course, you may not have the cash to afford the compulsory contributions, and there's no point getting into costly debt if that's the case. See our free Budget Planner tool to help you decide.
You also need to check if you have primary, enhanced or fixed protection. This is where you will have fixed your lifetime pension allowance (currently it's £1.25 million for anyone without protection). If you have protection you will lose it if you take your employer's pension so weigh up the benefits.
But before you do, check out our Pensions Calculator to work out what's actually going into your pension from your contributions, to show the boost a pension can give, factoring in any employer boost, plus tax relief.
****** Please use a desktop computer to see this calculator ******
Pension Calculator Widget What you're really saving with tax relief and employer cash
- This is a ready reckoner to give you a ROUGH idea of what you'll be saving in a pension. Always double check the figures yourself before acting on them.
- There are a number of assumptions built into the calculator. Click here to see them.
- ✖If you are a higher rate or top rate taxpayer you may need to claim back some of your tax relief via HMRC. The calculator assumes you do this, therefore taking full advantage of available tax relief.
- This calculator assumes you are under 65. Different reliefs apply to those older. If you're over 75 you get no tax relief.
- The calculator assumes you get tax relief on all your contributions. However, there are limits for high earners, though these vary. See the annual allowances section for info.
- It is possible to save even more using a salary sacrifice scheme where you avoid paying National Insurance. This calculator does not have a salary sacrifice option.
- The calculator assumes you fit the standard tax rules and allowances. For some, your circumstances may be different.
Aren't pensions a load of rubbish?
Confused? Ignore whatever you've heard. This all stems from a fundamental misunderstanding of what a private pension is. It's simply a tax-free wrapper to save money for retirement. Their bad rap comes from investments that don't pay off or high charges (see Martin's blog: The one word that caused the pension crisis).
Pension saving is a tax-efficient option that isn't implicitly risky. The risk comes from the investment choice. Safer investments, such as putting your money in cash rather than exposing it to the risks of the stock market, are available.
The different types of pension
Pensions come in all shapes and sizes. The first distinction is whether the pension is a final salary or a private pension.
Final salary pensions
These pensions, sometimes referred to as defined benefit schemes, are largely funded by employers, though staff sometimes have to pay into them. With one, you get a percentage of your final salary before retirement, or when leaving that firm, as an annual income.
What that percentage is depends on how long you worked for that particular firm. There is normally an 'accrual rate' set by your employer as a fraction of your final salary.
Say the rate is 1/60th, you get 1/60th of your final salary as a retirement income for each year you worked for that firm. So if you worked for 30 years, you'd get 30/60ths, or 1/2 your final salary with that firm.
Money purchase pensions
The majority of this guide is all about personal pensions, otherwise known as defined contribution schemes. The way you save under a 'money purchase arrangement', by putting cash in a pension pot, is the same for all personal pensions. How they differ is the way the money is invested and/or the level of charges.
Personal pensions fall into the following categories:
- Workplace pension scheme. This is where you and/or your employer make regular monthly payments, with that money invested by a pension company until you hit retirement. There are two types of workplace pensions: trust-based and contract-based pensions.
- Trust-based pensions - A board of trustees manage investments on your behalf. You and possibly your employer pay into the pot, and it's invested. The trust fund is kept at an arms length principle, separate from the company. What's more it allows benefits to be handed to your partner or other dependant members.
- Group personal pensions - This type of pension is between you and a third party insurance provider. The provider isn't required to act in your best interests. The snag is that your employer chooses the provider, but these arrangements usually offer you a choice of investments.
- Stakeholder pensions. These are similar to workplace pensions, but have low and flexible minimum contributions, capped charges and a default investment choice. You won't have to decide where to put your cash.
- Self-invested personal pensions (Sipps). These work in the same way but are DIY pensions, allowing you to choose your investment. Investors prepared to do the legwork themselves can run a Sipp on the cheap, if they use the right provider. Read a full guide to Sipps.
Don't forget the state pension. This is where you get a small pension from the Government when you hit state retirement age. The basic state pension is currently £113.10 a week. You build up entitlement to the state pension by paying national insurance (NI) throughout your working life (see the State Pensions guide).
The table below shows how the different pensions differ:
|Pension||Can you contribute?||Can your employer contribute?||Do you invest the cash?|
|Trust-based||Yes||Sometimes||On your behalf|
|Group||Yes||Yes||On your behalf|
|State pension||Yes, by paying national insurance||No||No|
Who's holding my money?
If your employer chooses which company manages your investments, you can decide the type of risks you want to take with them.
The Government has set up its own scheme, called the National Employment Savings Trust (Nest), which many employers, who have yet to start a workplace plan, are expected to join.
In a workplace pension (not a final salary scheme), where the money is managed by a third party, the fund manager may choose the particular investments, but you can let it know the type of risk you want.
If you start your own pension, you choose the manager. If you opt for a self-invested personal pension (Sipp), it will also be managed by another firm but you make the investment decisions (see the Cheapest Sipps guide).
While the National Employment Savings Trust (Nest) arrangement by the government is a great scheme to encourage employers to provide employees, some who have not started a pension, with contributions, it isn't necessarily the only option.
For some, sticking to pension contributions could reduce take-home salary, which could affect existing repayment arrangements and squeeze finances.
As of July 2014, a year after the introduction of Nest, it's clocked up 1.3 billion members. But if it's not for you, there are alternatives such as the not-for-profit People's Pension or the for-profit NOW which collaborates with one of the largest pensions funds in Europe.
How do I get a pension?
Under the new rules, many people will end up in a company pension so all they need to do is go ahead with what their employer offers. To pocket any contributions your employer makes, you need to agree to be part of its scheme.
If you opt for your own pension (where only you contribute) then you will need to scour the market for the best deals.
Unless you are financially savvy, it's usually best to get advice from an independent financial adviser (IFA), given there are a whole host of charges to watch out for. Since January 2013, IFAs can no longer be paid in commission, so you'll have to pay a fee for advice.
See our Financial Advice guide for how to pick an IFA, including what getting advice will cost you.
How do I get a cheap pension?
If you don't get a workplace pension, it's time to do your homework.
Claw back the cash (if you know what you're doing)
If your pension is straightforward, or you have the financial savvy to know what you want to invest in, you can head straight to the pension company and set that up.
However be aware that this may not necessarily be the cheapest option as group plans (such as with your employer) can be cheaper.
There are a number of specialist pension discount brokers. Here, you just tell them the pension you want and they arrange it without giving you advice. This means they rebate some or all of the charges back into your fund, effectively reducing the charges compared to going direct.
Even though we're only talking about fractions of a percentage point, the compounding effect means your fund could be £1,000s better off.
Using this route means you get no advice, which may not be a problem. But if you're confused, unsure, or have complex circumstances, it's best to be safe and see an IFA. It's better to pay a few hundred pounds upfront so you don't end up losing thousands over your lifetime, if you've no idea what to do. Unbiased.co.uk lists local advisers.
Important! Even if you pay a low set-up fee and/or get some charges rebated, you may still pay what's called an annual management fee charged by the fund manager that looks after your investments, so there are additional costs to consider.
Some of the cheapest firms
Some companies give you information/brochures on their funds, though this is not technically advice, so you don't pay for it. There's no set-up fee, although there will be other ongoing charges. These are Cavendish Online, BestInvest, Commshare, Close Brothers, Chelsea Financial Services, Fidelity, Hargreaves Lansdown* and TQ Invest.
Note: The firms mentioned above all offer decent deals, though it may be possible to beat them - it's not a definitive list.
What happens when I retire?
Once the money is in a pension, it can't be withdrawn willy-nilly. It must stay there until you're at least 55. (There are some extenuating circumstances where you can withdraw the money before 55). At that point, you can take 25% of it as a tax-free lump sum, with the rest ideally providing an income for the rest of your life...
If you get approached before you're 55 and get told you can take more than 25%, it's a scam known as pension liberation. For full details of how to release money from your pension legitimately and how to avoid scams, read our Release Pension Cash guide.
When your regular income stops... it's decision time. Ideally, start preparing a few years beforehand. Most people buy an annuity with their pension pot (after taking any tax-free cash), which is a product that gives an income for life.
But from April 2015, provided you're over 55, you'll be able to take as much as you like, when you like - though drawdowns above the tax-free 25% will be taxed at your marginal rate - so 20% if you're a basic rate taxpayer, 40% or 45% if you're a higher or additional rate payer, or the amount you've taken from your pension pushes you into that rate.
What if I've got a small pension pot?
You can take up to three small pension pots under £10,000, regardless of your total pension wealth.
If the total of all your funds is less than £30,000, you can also take your fund as a
cash lump sum instead of income, with 25% of it tax-free.
You must be at least 60 but not yet 75, and you have to convert all your pension funds to cash within 12 months.
For the full details on this, read our Pension Loophole guide.
Must I buy an annuity?
No, is the simple answer. It may still be the right option for some people, but you've now more options than ever before about how you use any savings you've made for retirement.
You can still buy an annuity, but there's flexibility on how you can 'drawdown' the cash in your pension pot. There's 'flexible drawdown' or 'capped drawdown', but both are basically drawing cash directly out of your pension.
As getting an annuity wrong can mean you're trapped in a poor investment which can't ever be changed, it's one of the very biggest financial decisions you'll make.
How safe is my pension?
With normal savings accounts, the simple rule is that up to £85,000 per person per institution is fully protected should your bank go bust, under the UK's Financial Services Compensation Scheme (FSCS, see the Savings Safety guide).
If you put money in stocks and shares or funds that invest in them, then you've got a 'risk-based' investment, NOT savings, and a totally different FSCS protection applies. Critically...
FSCS protection for pensions is very complex, and can vary with each product's structure. This is just a general guide, always check with your provider.
The FSCS does not protect performance losses, say if the companies you invest in go bust, that's the investment risk you take. Protection with investments only applies if you lose money due to the product provider of the investment going bust, in this case the fund manager you've bought into through the pension.
What protection do I get?
Usually with pensions, the broker you buy it through doesn't hold any of the cash, it simply acts as a conduit for you to put the money into whatever funds or investments you want. Therefore in the unlikely event it goes bust, your money should be OK, and still held by the fund manager or bank it resides with. The protection applies should any of those go into default.
If protection kicks in, the FSCS will first try to transfer your funds from the failed company to another company. If that's not possible, you get 90% of whatever you have saved in a pension back.
For failed IFAs or brokers that mis-sold or provided dodgy pension advice, there may be a claim against the firm for mis-selling via the FSCS. This would be up to the investment limit of £50,000.
If you've got a defined benefit (final salary) pension, there's a risk of your employer going bust, leaving you with no pension income. However, the Government set up the Pension Protection Fund (PFF) which may pay compension, subject to limits.
A note for high-earners
For the few individuals with a pension that exceeds £1.25 million in the 2014/15 tax year, you may be able to apply for Individual Protection 2014. This is a protected lifetime allowance up to £1.5 million, and you won't lose it it if you make further savings. The deadline for applying is 5 April 2017.
You can also get Fixed Protection for your pension, which is where you can take pension savings worth up to £1.5 million without paying the lifetime allowance charge. To ensure you don't lose out on Fixed Protection, make sure you opt out of automatic enrolment as soon as you can within the one month window. Your protection could be voided if you make further payments.
If you invest using a stakeholder pension, this is usually covered under the 'long-term insurance' FSCS coverage. This means only 90% of everything in the pension (with no upper limit) is covered. For details of previous limits, see the FSCS website.
If you have a Self Invested Personal Pension (Sipp) and decide to hold the money as cash, you are normally covered under the standard £85,000 cover per person per institution, the same as normal savings get.
Ask your Individual Sipp provider which bank the cash is held in (often they spread it around up to five). Then check whether any other savings you may have are in institutions linked to those used for the Sipp cash, as cumulatively you'll only get up to £85,000 protection in each (See What Counts As A Financial Institution?).