What are Personal Pensions?

Saving for Retirement

All UK citizens are eligible for a state pension at the statutory retirement age. But just listening to pensioners who have only this benefit to rely on in old age makes one realise how inadequate this is for the majority of people.

There are various ways to prepare financially for retirement, including saving by way of Cash ISA’s and investing in stocks and shares. Many people will; already have access to a company pension scheme. However, a personal pension is often overlooked as a way to plan for retirement.

The Basics

A personal pension is a long term commitment to saving for your years in retirement. Once invested, your money cannot be accessed until you retire.

Your contributions can be by way of lump sum or regular monthly payments into the scheme, and will be available for tax relief.

The amount you get back in retirement will depend upon the performance of the investments within your pension policy. Under current legislation you can take a tax free lump sum, and then use the remainder of the fund to purchase an annuity to provide income. The income you receive from the annuity will be classed as taxable income.

Your investments within your policy

A personal pension policy is an investment into a defined contribution plan, also referred to as a money purchase scheme. This means that the amount you get back depends upon the investment performance of your plan, and there is no guaranteed amount. This is unlike a defined benefit plan (now rare, and only available within company pension schemes), where you will receive a set amount through retirement.

Because the amount you receive depends upon investment performance, it is very important to carefully select the investments within the plan. This means understanding investment risk, and also taking account of the time until plan maturity. Many pension plan investors take larger risks with their pension investments at the outset, and then decrease investment risk as retirement age draws near. This reduces the risk to the final amount that a shock to the financial system may cause.

Not just benefits in retirement

Some pension schemes offer benefits over and above a sum at retirement to invest in an annuity.

The most common is a life assurance, with a guaranteed sum payable should you die before hitting retirement. Another form of ‘death before retirement’ payment is the return of all payments into the scheme, including any investment growth achieved.

After taking the pension benefits, different types of annuity can be purchased, including those that give a partner’s pension should you die first.

The tax benefits

The government want to encourage people to make their own pension provisions, rather than rely on state funding in retirement. In fact, it is common knowledge that state pension funding is coming under increasing pressure: one reason that the state pension age is being increased.

In order to promote pension investment, there are tax breaks upon the invested amounts. Money saved into pension schemes attracts relief at 20%, and this is claimed back by your pension scheme provider. In practice this means that for every £80 you pay into your scheme, you will have £100 invested.

Those that pay tax at higher rates can claim back the difference between the basic rate relief and the marginal rate through the tax return.

The amount you receive by way of tax relief on your contributions will depend upon your individual tax status, and the amount you pay into your scheme.

Investment growth and tax

The difference between what you pay into your scheme and the amount available to you at the end will be a capital gain. You will have a capital gains tax allowance each year which you can use to offset against any capital gain you make by way of investment.

The growth in your pension fund is not subject to these capital gains tax rules. It is entirely capital gains tax free, and is not added to annual capital gains tax to calculate liability. However, when benefits are taken there may be a tax charge if they exceed the lifetime allowance.

Also, growth within your pension funds could be made tax free, dependent upon the fund type.

If you select to receive the lump sum of up to 25% of your pension fund, then this will be paid tax free.

How much can you save in a pension scheme?

There are different rules for tax payers and non-taxpayers. Non-taxpayers are only allowed to pay in a limited amount with tax relief. Currently this is £2880, which will be topped up to £3600 by the tax relief.

Contributions into a personal pension plan can only be made up to the age of 75, and tax relief is only available up to the lifetime allowance. The annual allowance for pension contributions is reviewed in each year’s budget, and is set at a maximum of your annual salary, or £3600, whichever is the greater. This amount is then limited by the annual cap, which for 2012/ 23 was £50,000. You can put more in than this cap, but any excess contributions will be taxable at your marginal rate of tax.

The advantages and disadvantages of pension savings

The advantages of saving into a pension scheme are very clear. Firstly, for every £80 you pay in, the government will pay in an extra £20. That is, effectively, investment growth from the outset. Higher rate taxpayers, get an even bigger tax advantage.

Secondly, when you retire, should you elect to take the lump sum available, then you will receive this tax free. This could be the financial boost that you need to be able to retire when you want, allowing you to pay off a mortgage or other debts, or take a once in a lifetime holiday, for example.

Paying into a pension scheme is a disciplined way of saving for the long term, but this is seen as a double edged sword. For some, putting that money away and not being able to gain access to it is seen as a definite benefit, whilst others would see this rigidity as a disadvantage.

Perhaps the biggest disadvantage is the potential tax treatment at the end of the policy term and when income is generated through the purchase of an annuity. Tax rules change, and there is no guarantee that you will not be paying more tax on the income than saved through the term of investment.

So, should you save in a personal pension scheme?

A personal pension scheme can be taken wherever you go as a worker. Many allow payment breaks, and have valuable extra benefits. You can also invest in as many schemes as you wish, providing you do not break through lifetime allowance limits.

Savings made into personal pensions attract tax relief, and so the investment made upon your behalf is 25% more than paid in. This investment itself may also attract tax relief within the pension scheme, and a cash lump sum at retirement date is a definite plus point.

Whilst pension saving requires discipline and a long term outlook, the immediate tax advantages and the advantages of increasing income in retirement are the benefits gained by giving up access to money saved.

The sooner you begin saving into a pension scheme, the less you will have to pay for the same benefits at retirement. For example, a man aged 35 wanting an income of £100 per month in retirement will need to save £34 per month. At 45, the amount needed to save to achieve the same benefit rises to £58.

As far as personal pensions go, the sooner you act the better.