Pension guide

Pension information: guide to the basic facts.

You might have one or more different types of pension. Understanding which you have is important because it affects the decisions you need to make as you approach retirement.

• What type of pension do I have?

• Your State Pension choices

• Your pension choices if you have a defined benefit pension

• Your pension choices if you have a defined contribution pension

What type of pension do I have?

What is a pension pot?

‘Pension pot’ refers to the savings you build up in a certain type of pension known as a ‘defined contribution’ pension scheme. You and your employer (if you are employed) pay into the scheme and this builds up a ‘pot’ of money over time, which you can use to give yourself an income when you want to cut down on how much you work, or stop working altogether. It includes workplace, personal and stakeholder pension schemes.

There are three main types of pension:

• the State Pension

• defined benefit pensions, and

• defined contribution pensions

State Pension

Most people get some State Pension. It’s paid by the government and is a secure income for life which increases by at least the rate of inflation each year.

You build up your entitlement to the State Pension by making National Insurance contributions during your working life.

In some cases, you can do this even when you’re not working, such as when you’re bringing up children or claiming certain benefits.

From April 2016 a new flat-rate State Pension was introduced. For the current tax year 2019-20 the full new State Pension is only £168.60 per week.

However, you might be entitled to more than this if you have built up entitlement to ‘additional state pension’ under the old pre-April 2016 system – or less than this if you were ‘contracted out’ of the additional state pension.

To be eligible for the full State Pension you will need 35 years NI record. You’ll usually need at least 10 qualifying years on your National Insurance record to qualify.

Defined benefit pension

You’re most likely to have a defined benefit (DB) pension if you work in the public sector or for a large company. This is a salary-related pension which pays out a secure income for life and increases each year. The pension you get is based on how long you’ve been a part of the scheme and how much you earn.

You might have a final salary scheme where your pension is based on your pay when you retire or leave the scheme, or alternatively a career-average scheme where your pension is based on the average of your pay while you were a member of the scheme.

Defined contribution pension

With this type of scheme, you build up a pension pot which you can draw an income from when you cut down or stop working. But you must be aged at least 55 before you can start to take money out. With this type of pension scheme, you can usually withdraw at least 25 per cent (a quarter) of your pot tax-free.

The amount that builds up depends on:

• the level of charges you pay

• how well your investment performs, and

• how much you and your employer (if you are employed) pay into the scheme

Defined contribution (DC) pensions include workplace, personal and stakeholder pension schemes.

Your State Pension choices

You won’t get your State Pension automatically – you have to claim it. You should get a letter no later than two months before you reach State Pension age, telling you what to do.

You can also defer taking it. If you want to wait to claim your pension, you don’t need to do anything. Your pension will automatically be deferred until you claim it and will increase by 1% for every nine weeks you defer. This works out at just under 5.8% for every full year.

The extra amount is paid with your regular State Pension payment when you finally take it.

Find out your State Pension age at GOV.UK

Your pension choices if you have a defined benefit pension

Most defined benefit pension schemes have a normal retirement age of 65.

If your scheme allows, you might be able to take your pension earlier but this will reduce the pension you get quite considerably. (Typically 5% per annum)

When you take your pension you usually have the option of taking some of it as a tax-free cash sum.

How much you can take will vary depending on your scheme rules, but often you can take roughly up to a quarter of the value of your pension benefits like this.

Reducing the amount of tax-free cash you take might increase the amount of income you receive.

It is possible to transfer your defined benefit pension to a defined contribution pension which would then allow you to access your pension more flexibly.

However, consider this option very carefully as you might be giving up very valuable benefits.

Before going ahead with a transfer from this type of scheme speak to a regulated financial adviser.

Your pension choices if you have a defined contribution pension

Once you reach 55 you have complete freedom over what to do with your pension pot.

However, the longer you leave your pot to continue building up, the more money you will have to live on in retirement.

To understand the choices for using your pension pot, use could use Pension Wise – the free and impartial service backed by government or if you are still unsure of the best option for you, consider taking regulated financial advice.

Source: pensions advisory service

WINN-BROWN & CO.NOVEMBER 2, 2015

Taper allowance

Tapered annual allowance – threshold and adjusted income

So what is the tapered annual allowance?

Pension annual allowance (AA) is the annual limit on the amount of contributions paid to, or benefits accrued in, a pension scheme before the member has to pay tax.

Tapered annual allowance is lower than the standard annual allowance. This lower limit may apply to any member, based on their level of taxable income within the tax year.

Key points

• The tapered annual allowance was introduced from 6th April 2016.

• For the taper to apply, the limits on threshold income and adjusted income must both be exceeded.

• For every £2 of adjusted income over £150,000, an individual’s annual allowance is reduced by £1.

Why was the tapered annual allowance introduced

The government, in an attempt to control the cost of pensions tax relief and help make sure pensions tax relief is fair and affordable. So from tax year 2016/17, a reduced annual allowance may apply to all pension savings by or on behalf of a member, depending on their level of taxable income within the tax year.

On 6 April 2016 the government introduced the Tapered Annual Allowance for individuals with “threshold income” of over £110,000 AND "adjusted income" of over £150,000.

So what is threshold income?

Threshold income is one of two measures used to determine if a member has a tapered annual allowance limit.

Where an individual has a "threshold income" of £110,000 or less they cannot be subject to the tapered annual allowance and there is no requirement to calculate adjusted income.  If threshold income exceeds £110,000 there must be a calculation on the adjusted income to work out the amount of any tapered annual allowance.

For individuals with lower salaries who may have one off spikes in their employer pension contributions the threshold income measure helps to provide certainty . If the individual’s taxable net income is no more than £110,000 they will not normally be subject to the tapered annual allowance. Anti-avoidance rules will apply so that any salary sacrifice for pension savings set up on or after 9 July 2015 will be included in the threshold income calculation.

"Threshold Income" is broadly defined as ‘the individual’s net income for the year’. This will include all taxable income such as salary, bonus, pension income (including state pension), taxable element of redundancy payments, taxable social security payments, trading profits, income from property (rental income), dividend income, onshore and offshore bond gains, taxable payment from a Purchased Life Annuity, interest from savings accounts held with banks, building societies, NS&I and Credit Unions, interest distributions from authorised unit trusts and open-ended investment companies, profit on government or company bonds which are issued at a discount or repayable at a premium and income from certain alternative finance arrangements etc, less the amount of any taxable lump sum pension death benefits paid to the individual during the tax year that can be deducted from the threshold income.

What is adjusted income?

Adjusted income is the other of alternative measure used to determine if a member has a tapered annual allowance limit.

The ‘adjusted income’ definition adds in all employer pension contributions, to prevent individuals from avoiding the restriction by exchanging salary for employer contributions. For those in defined benefit or cash balance arrangements, the value of the employer contribution will be calculated using the annual allowance methodology. That is, the employer contribution will be the total pension input amount for the arrangement, less the monetary amount of any contributions made. 

How does the taper work

Where both the adjusted income and threshold income have been exceeded then the rate of reduction in the annual allowance is by £1 for every £2 that the adjusted income exceeds £150,000, up to a maximum reduction of £30,000, down to a minimum tapered annual allowance of £10,000.

This results in an Annual Allowance of £40,000 for those with an adjusted income of less than £150,000; a reducing Annual Allowance for those with adjusted incomes between £150,000 and £210,000 and an Annual Allowance of £10,000 for those with an adjusted income over £210,000.

The Tapered Annual Allowance limits apply to both Defined Contribution and Defined Benefit pension input amounts. Although the value of "contributions" is easily identifiable within Defined Contribution type schemes, it is not as straightforward with Defined Benefit schemes. When assessing against the above limits it is the combined total of all pension "contributions" that need to be considered. In some circumstances deferred pensions may also count towards the calculation of "contributions".

Those subject to a Tapered Annual Allowance will still be able to carry forward unused allowance from previous tax years.

Source: Prudential

Money purchase annual allowance (MPAA)

The MPAA trap

This little known tax rules mean that pension savers could see their ability to save into a pension slashed by up to 90% if they draw money from the ‘wrong’ pension pot, according to new analysis by mutual insurer Royal London. 

Since the introduction of ‘pension freedoms’ in April 2015, savers aged 55 or above have been able to take money out of their pensions in ‘chunks’ rather than turn the whole pension pot into an income for life by buying an annuity. To prevent people from repeatedly taking money out, benefiting from tax free cash, and putting money back in again with the benefit of tax relief, HMRC introduced a limit on the amount people could put back in to pensions once they had started drawing taxable cash. 

This limit is known as the Money Purchase Annual Allowance (MPAA) and was originally set at £10,000 per year, but has since been cut to £4,000 per year. This compares with the standard annual allowance of £40,000. 

In general, someone taking money out of a ‘pot of money’ or ‘Defined Contribution’ pension is affected by the MPAA if they draw money out beyond the 25% tax-free lump sum. 

But there is a little known exception to this rule. Those who take everything out of a ‘trivially’ small pension pot under £10,000 do *not* trigger the MPAA. 

If an individual has two pensions and wants to withdraw less than £10,000, they should think seriously about cashing in a small pot in full rather than taking a partial withdrawal from a larger pot, as this avoids triggering the MPAA. As a result, they retain the ability to put up to £40,000 into a pension each year in future, rather than having it slashed to £4,000. 

Consider, for example, someone with two pension pots, one worth £4,000 and one worth £20,000. Suppose that they want to withdraw £9,000 (before tax). If they cash in the £4,000 pot in full and take just the 25% tax free lump sum out of the larger pot, they will not trigger the MPAA. But if they take the full £9,000 from the larger pot they will trigger the MPAA which will reduce by 90% their annual allowance going forward. 

Commenting, Steve Webb, Director of Policy at Royal London said: 

“Last year, over half a million people aged 55 or over made flexible withdrawals from their pension, and many of these withdrawals will have been for amounts under £10,000. If they emptied out a small pot then this will have had no impact on their future ability to save into a pension. But if, by mistake, they took the same amount as a partial withdrawal from a bigger pot, they risk triggering stringent HMRC limits on future pension saving. Those with more than one pension pot should consider very carefully the order in which they access these funds, especially if they may want to contribute into a pension in future”. 

Source: Royal London

Pension options at retirement

At retirement when we take our pension from a defined contribution scheme we have a number of options available to us.

• The open market option

• Tax free cash lump sum

• The frequency of payment

• Escalation in payments

• Spouses provisions

• Guarantee periods

Each of these options can be taken in conjunction with any other. However, some of the benefits will defray the initial amount of pension benefit that you would receive should you take a single life pension with no other provisions.

The Open Market Option

The Open Market Option (or OMO) was introduced as part of the 1975 United Kingdom Finance Act and allows someone approaching retirement to ‘shop around’ for a number of options to convert their pension pot into an annuity, rather than simply taking the default rate offered by their pension provider.

 The term OMO is now generally used to support a campaign, often led by the pensions industry and the media, to make sure people know the benefits of shopping around. The majority of people still don’t use the Open Market Option in large part because they don’t know they can or don’t realise the benefits of doing so. Retirees who don’t use the OMO and settle for the default deal offered by their pension provider, may be missing out on up to 20% more income from an annuity. This is especially important as retirees cannot change their annuity once it has been purchased.

 One of the main reasons that people can get more from an annuity if they shop around is that they may qualify for what is known as an Enhanced Annuity (sometimes known as an Impaired Life Annuity) which pays a higher income to people who suffer from a range of health conditions – anything from asthma to a serious heart condition. There are also other products available that may suit peoples retirement needs better than the default deal offered by a pension provider. One suggestion to make the most of the Open Market Option is to speak to an independent financial adviser who will explain the different options available at retirement.

Tax Free Cash Lump Sum

At retirement you are permitted to take 25% (a quarter) of your pension fund in as a Tax-Free Cash Lump Sum. In certain circumstances it could be more than this. The Tax-Free cash can be paid by the ceding scheme or the new scheme should you take advantage of your Open Market Option. The remainder will be considered as earned income by HMRC. The amount of tax you pay will depend on your prevailing tax status at the time that you take the pension.

Frequency of Payments

Most pension providers will allow you to take your pension at different Frequencies of Payments, such as annually, quarterly and monthly, sometimes in advance or arrears. Once you have made your decision that is generally how you will continue to receive your income for the rest of your pension annuity.

Escalation in Payment

You can elect to have your pension paid to you at a flat rate for the rest of your life or have it increase in different ways, through Escalation in Payment, typically by 5%, 7.5% etc. Should you choose this option then the initial pension you receive will be significantly reduced but at least you can ensure that your pension retains some degree of inflation proofing. 

Spouse’s Provisions

Typically people will purchase a single life annuity but you can elect to provide a pension for your spouse, through a Spouse's Provision should you wish to do so. This at least ensures that should you die in the short term your spouse will continue to benefit from your pension. Spouses pensions can generally be provided at different rates as a percentage of your own, for example 33%, 50% or even 100%. As with all other pension options its best to check what the pension provider is able to offer.

Again this particular option does reduce the amount of initial pension annuity because you are effectively buying two pensions from the same amount of money.

Guarantee Periods

At outset, as with all these options you can elect to take a guarantee period against the pension. 

A Guarantee Period can be of different duration, again typically 3, 5 or 10 years. This means that the pension will be paid out to your spouse (or in the event of your spouse predeceasing  you, your estate) for the remainder of the term should you die within the guarantee period. For example if you were to take a 10 year guarantee period and then die in year 6 your spouse (or estate) would continue to receive the pension for the remaining 4 year term, after which time, (unless you had provided for a spouses pension) the pension would cease and no other payments would be made.

These options are not offered at the outset of your pension plan as you have no indication at that time what your marital status may be at the time of vesting, the prevailing rates of inflation and your need for tax free cash. Nevertheless the decisions that you make in relation to these options are of great importance both to you and your family should you have one. Moreover once you have made your decisions they cannot be unwound, there are no “U turns”. It is therefore essential that you give consideration to taking professional financial advice at this pivotal and critical time in your financial planning.

Lifetime allowances

Breach may impact on more than a million workers

An estimated 1.25 million people are set to breach the current lifetime allowance (LTA) limit of £1.055 million for pension tax relief over the course of their working life, according to new research published.

The LTA is a limit on the amount of pension benefit that can be drawn from pension schemes – whether lump sums or retirement income – and can be paid without triggering an extra tax charge. It has been cut three times since 2010, and this research estimates that around 290,000 workers already have pension rights above the limit, and well over a million more people are at risk of breaching it by the time they retire.

Facing a tax charge of up to 55% on pension savings

Those who exceed the LTA could face a tax charge of up to 55% of their pension savings above this level at the time of testing. Around 290,000 non-retired people have already built up pension rights in excess of the LTA. Fewer than half of these are thought to have applied for ‘protection’ against past reductions in the LTA and so could face significant tax bills when they draw their pension. Worryingly, many may be unaware of this. Almost half of these people who are already over the LTA are continuing to add to their pension wealth, thereby storing up an even bigger tax charge with every passing year. Amongst non-retired people who are not currently over the LTA, an estimated 1.25 million can expect to breach the LTA by the time they retire.

Groups likely to breach the lifetime allowance

The two main groups likely to breach the LTA are relatively senior public sector workers with long service, whose Defined Benefit pension rights will exceed the LTA, especially as they now have to work to 65 or beyond rather than 60 as in the past, and relatively well-paid workers in a Defined Contribution pension arrangement where their employer makes a generous contribution into their pension pot.

Highest earners may be less affected by the lifetime cap

Typical salary levels of those affected are in the range of £60,000–£90,000 per year. But ironically, the very highest earners may be less affected by the Lifetime Cap because they are now heavily limited by the amount they can put into a pension each year. The data suggests that only a couple of thousand people exceeded the LTA in the latest year for which figures are available (2016/17). The number likely to face a tax charge could therefore increase more than a hundredfold, purely based on those who have yet to retire but who have already exceeded the LTA.

Workers who would not regard themselves as ‘rich’

The research finds that one of the reasons why so many people will exceed the LTA is that current policy is simply to increase it each year in line with price inflation (as measured by the CPI). By contrast, wages will tend to grow faster than inflation, and the money invested in pension pots should grow faster than inflation over the long term. This means that the LTA will ‘bite’ progressively more severely over time and will affect hundreds of thousands of workers who would not regard themselves as ‘rich.’ 

Source data:

Research conducted for Royal London is based on detailed analysis of data on more than 7,700 workers from Wave 1 and Wave 5 of the ‘Wealth and Assets Survey’ March 2019.