‘Private pensions’ means any pension schemes you have apart from a State Pension. They may be schemes you join through your workplace, or schemes that you arrange for yourself.
How much you can save
Private pension schemes are one of the most tax-efficient ways to save, because you get tax relief on the money you pay in, your savings build up tax-free and you can take out a quarter of those savings tax-free (the rest counts as taxable income). In fact, the tax reliefs on pension schemes cost the government nearly £52 billion a year. To contain that cost, there are limits on the amount that you can save through pension schemes. These work in several ways.
First, tax relief on contributions is given only on contributions up to a maximum of £3,600 a year or an amount equal to 100 per cent of your UK earnings for the year, whichever is higher. This tax relief is given in one of two ways: at source or through the net pay method. With the at-source method, you deduct tax relief at the basic rate (2023/24: 20 per cent) from your contribution before handing it over to your pension provider. The provider then claims the same amount from HM Revenue & Customs (HMRC) and adds it direct to your pension savings. For example, suppose you want to pay £3,600 into your pension scheme: 20 per cent of £3,600 is £720. You deduct this from the £3,600 and hand over just £2,880 to your pension provider. The provider claims £720 from HMRC and adds it to your savings. The upshot is that £3,600 in total has gone into your scheme at a cost to you of £2,880. Under the at-source method – used for many workplace schemes and all schemes you arrange for yourself – you get this tax relief even if you are a non-taxpayer. If your top rate of tax is higher than the basic rate, you can claim extra tax relief by filling in a tax return (see Chapter 4 for how to do this).
The net-pay method is used by some workplace schemes. Your employer subtracts your pension contributions from your pay before working out how much income tax to deduct from your pay packet. This method is convenient because it automatically gives you all the tax relief you are due, without the need to complete a tax return. But, tax-wise, this method is not great if your earnings are too low to have to pay tax, because currently you don’t get any tax relief at all, unlike the at-source method. However, from 2024/25, the government is due to correct this by allowing low-income pension savers to claim top-up payments equal to basic-rate tax relief. Bear in mind that, even without tax relief, you do still benefit from contributions paid in for you by your employer, so for most people it will usually still be worth saving through a net-pay scheme.
The second way that the government limits the amount you save through pension schemes is to set an Annual Allowance, which is the maximum amount by which your savings can increase each year. You can ask each pension scheme you have to tell you how much of your Annual Allowance it has used. In 2023/24, the standard Annual Allowance is £60,000 (up from £40,000 in recent years). If you want to make a bigger increase to your savings, you can carry forward any unused allowance from the previous three years. But the standard allowance is reduced in some circumstances to £10,000 in 2023/24 (up from £4,000 in previous years). This applies if you draw your savings before retirement or flexibly once you have retired or you are a high earner (broadly speaking earning £260,000 or more including pension contributions from your employer). This reduction applies only to the type of pensions where you build up your own savings pot (see Defined-contributions schemes below). If your savings increase by more than yourAnnual Allowance, you have to pay a tax charge that, in effect, claws back the tax relief you’ve had on the ‘excess’ savings.
The government also used to limit the amount you can save through pension schemes over your whole lifetime by setting a Lifetime Allowance. However, this allowance (which stood at £1,073,100 in 2022/23) has in effect been abolished from 6 April 2023 onwards. Before the abolition you had to pay substantial extra tax when you withdrew the ‘excess’ savings. Now you can save however much you like and whatever you draw as pension is simply taxed up to your marginal rate in the normal way that applies to any income (see Chapter 4). There is still a limit on the amount you can take out of your pensions as a tax-free lump sum and this is set at a total of £268,275 in 2023/24. But, if you want to take a bigger lump sum, the ‘excess’ is now simply taxed as income in the normal way.
The standard Annual Allowance (and the old Lifetime Allowance) is high compared with the amount most people can afford to save for retirement, so you might not need to worry about them. However, it’s important to be aware that, if you do draw out some or all of your pension savings early, your Annual Allowance can fall sharply, making it harder to rebuild your savings – for more about this, see Drawing your savings early later in this chapter.
Workplace pension schemes
Under a system of automatic enrolment, nearly every employee will find themselves by default belonging to a pension scheme at work. Although you can opt out if you want to, it’s usually a good idea to stay in the scheme as not only does your employer contribute, but you often get other benefits as well as a pension and tax-free lump sum when you retire. These could include life insurance, which pays a lump sum and/or a pension to your dependants if you die. It could also include a pension if you have to retire early because of ill health.
There are several different types of workplace scheme. You might find yourself in a company scheme set up by your employer, or in some type of group personal pension plan arranged by your employer but provided by another organization, usually an insurance company. You could be enrolled into a multi-employer scheme, which is like a company scheme but has members from many different firms, or you might be in NEST (the National Employment Savings Trust), a multi-employer scheme set up by govern-ment. The key difference when thinking about your retirement is whether the scheme promises you a certain level of pension (a defined-benefit scheme) or you are simply building up a personal pot of savings (a defined-contribu-tion scheme).
DEFINED-BENEFIT SCHEMES
These are the Rolls-Royce of pension schemes because they promise a known proportion of your pay when you retire. They are always company schemes set up by your employer. Defined-benefit schemes used to be quite common, and are still the norm if you work in the public sector, but are becoming rare in the private sector. How much you get is worked out from how many years you’re in the scheme and your annual salary while working. You build up a pension at a certain rate – 1/60th or 1/80th is quite common – so for each year you’ve been a scheme member, you receive, say, 1/60th of your annual pay. For example, if you were in the scheme for 10 years and your salary was £30,000, you’d receive a £5,000 a year pension – that is, 10/60ths of £30,000.
How your salary is defined depends on the scheme rules. In the past, it typically meant your pay shortly before retiring (or at the time you left the scheme if earlier) and these are known as final salary schemes. These days it is more common for ‘salary’ to mean your average pay during all the years you’ve been a member of the scheme. Pay in the earlier years will have been lower because the cost of living was lower, so usually your pay from previ-ous years is revalued in line with price inflation before the average is worked out. For this reason, such schemes are often called career average revalued earnings (CARE) schemes.
Once you start to draw a defined-benefit pension, typically it is increased in line with inflation but only up to a maximum amount, such as 3 or 5 per cent a year.
Defined-benefit schemes are costly for employers to run. A combination of people living longer, statutory improvements to benefits and increased regulation have made these schemes safer and more generous over time for employees, but have pushed up the costs and uncertainties for employers, to the point at which many have pulled back from this type of scheme. Typical changes are to switch from a final salary to a CARE basis, close the defined-benefit scheme to new members, stop existing members building up future defined-benefit pensions and offer some form of defined-contribution scheme to employees instead. These changes are not usually backdated, so when you reach retirement you may find you have a pension with several parts, for example a bit that’s worked out on a final-salary basis, another bit on a CARE basis and some on a defined-contribution basis.
Another way that some employers have been trying to cut the costs of defined-benefit schemes is to buy out your pension rights. You may be offered an eye-watering sum that you can transfer into a defined-contribu-tion scheme (and then perhaps cash it in – see below). However, just because an offer is big, that doesn’t mean it’s good value. For example, if you gave up a pension of £20,000 a year that would have increased with inflation up to a maximum of 5 per cent a year, in mid-2023 you would need around £425,000 to replace that income using an annuity. So, if the amount you’re offered to give up the pension is less than £425,000, it’s not a good deal.
DEFINED-CONTRIBUTION SCHEMES
All other workplace pension schemes are defined-contribution schemes. These can be company schemes set up by your employer, but are often some type of personal pension scheme – see Pensions you arrange for yourself later in this chapter – or multi-employer schemes, such as NEST. The money paid in by you and your employer is invested and builds up a fund that provides your income when you retire. Since April 2019, the minimum amount paid in must be 8 per cent of your salary between a lower and upper limit, with at least 3 per cent of that coming from your employer. You typi-cally pay 4 per cent, and tax relief adds the final 1 per cent. With defined-contribution schemes, you don’t know the amount of pension you’ll get at retirement. This will depend on how much you and your employer pay into the fund, how well your invested contributions perform, the charges taken out of your fund by your pension provider, how much you take out as a tax-free lump sum at retirement (or cash in before then), and the terms on which you eventually convert your savings into pension (including your decisions about whether to inflation-proof your income – see Chapter 5 Investment).
It helps to think of defined-contribution pensions as having two stages:
- Accumulation. The fund is invested, usually in stocks and shares and other investments, with the aim of growing it over the years before you retire. Most schemes offer a choice of investment funds, but have a default fund that you are invested in if you don’t make an active choice. You can find information about choosing investments in Chapter 5, but broadly speaking, for savings that you will not be cashing in within the next 10 years, it usually makes sense to invest mainly in shares. For savings you do intend to cash in or use to buy an annuity, it is common to gradually shift your savings towards safer investments such as cash and bonds (a process sometimes called ‘lifestyling’).
Decumulation. When you retire, you can take a tax-free lump sum from your fund and use the rest to provide an income – either in the form of a lifetime annuity or through drawdown (leaving your savings invested and just cashing in amounts as you need them).
ANNUITIES
A lifetime annuity is an income you buy with part or all of your pension fund. It provides a secure income for the rest of your life, however long you live, so is best thought of as insurance against living longer than your savings would otherwise last. While the average 66-year-old today can expect to survive to age 85 (man) or 87 (woman), you’d be unwise to plan your retirement on an average, since you might well be in the half of the population that lives longer – often much longer. According to the Office for National Statistics, a man aged 66 has a one in four chance of reaching age 92, and a one in 34 chance of surviving to age 100. For women, there’s a one in four chance of reaching age 94 and one woman in 20 can expect to survive to 100.
On the other hand, many people worry that, having handed over a large chunk of their savings for an annuity, they might die within a few years and not get value from the annuity. But some types of annuity can help you guard against this. You’ll find information about different types of annuity in Chapter 5.
If you are buying an annuity, it’s important to shop around for the type that’s most suitable for you and the best deals on the market. MoneyHelper has a free tool to help you do this (Directory, p 32).
DRAWDOWN
Don’t confuse drawdown with taking cash out of your pension savings before retirement (discussed below). Drawdown lets you choose the point at which you want to start drawing some kind of retirement income. First, you take any tax-free lump sum, and what remains goes into your drawdown fund. These savings are invested, usually with quite a high proportion still in shares because your fund may have to support you for several decades. This means the value of your drawdown fund will go up and down with the stock market.
Drawdown is very flexible. You don’t have to draw out anything and, if you do, you choose how much to draw out and when. You might opt to draw out sums regularly to create an income. You might draw out lump sums to cover one-off expenses. You can even cash in the whole lot! Whatever you do draw out, the whole sum counts as income for that year and is taxed in the normal way (as explained in Chapter 4). Any unused amount left in your fund on death can be left as a pension or lump sum to anyone you choose – there is more information about this in Chapter 15.
A challenge with drawdown is that you do not know how long your savings will have to last. You might want to draw out a steady income each year, rising just enough to keep pace with inflation, but there is a risk that your savings will run dry part way through retirement. To guard against this, some advisers suggest you draw off a set percentage of your savings each year, say 4 per cent. The drawback with doing that is that in years when the value of your investments falls, your income will also fall. On the other hand, if you doggedly carry on drawing the same income in pounds each year, when the market dips, you will have to sell investments at a loss and you will lose the future growth they might have produced, so your pension pot may run out sooner. The big stock market falls seen during the 2020 pandemic highlighted this dilemma and many advisers now suggest that you keep enough in cash to cover two years’ spending so you don’t have to cash in any of your drawdown funds when the stock market is low.
Opting for drawdown affects your Annual Allowance (described in How much you can save earlier in this chapter). The limit on the amount you cansave in future each year through defined-contribution pension schemes is capped at £10,000.
STRIKING A BALANCE
Annuities and drawdown each have advantages and disadvantages, and many experts suggest you use both.
One strategy is to work out the minimum income you would be prepared to live on. Check whether your State Pension plus any defined-benefit pensions from work provide that minimum. If not, consider buying an annuity to top up your income to the minimum. This ensures you have secure sources of income up to that level. You could then use any remaining pension savings for drawdown.
Another strategy is to rely on drawdown during the early part of your retirement, but use part or all of the remaining drawdown fund to buy an annuity once you reach, say, age 85. The annuity then covers the remaining risk that you might continue to need an income until a very old age. This strategy is helped by the fact that annuities get cheaper as you get older (because the income they provide is expected to be paid out for a shorter period than buying the same income when you are younger).