Workplace pensions: a guide
In addition to tax relief on your contributions, you also get the benefit of contributions from your employer so, irrespective of the type of scheme offered, the quality of the funds it invests in, or its charges, it usually makes sense to sign up. Ignoring it is equivalent to turning down a pay rise.
Find out more about the type of scheme your workplace offers, how it works and how much your employer will be paying in with our guide.
If you don't know what type of pension your employer offers talk to your HR department straight away.
Final salary pensions
Often described as 'gold plated,' final salary schemes are the most generous company pensions, in so much as they guarantee to pay you a defined benefit in retirement - irrespective of how much you or your employer pay in. Hence, they are often referred to as defined benefit pensions.
Some schemes - such as the Armed Forces pension scheme - are non-contributory meaning your pension is entirely paid for by your employer. However in the majority of cases, employees can expect to pay around the 8% mark. According to Hargreaves Lansdown it costs roughly 25% of your salary to fund your pension. You need to meet approximately a third of the cost, your employer picks up the remaining two-thirds.
Exactly how much you will have in retirement will depend on your length of service, your salary and your accrual rate. This is typically 1/60th or 1/80th of your salary for every year you work.
Other benefits include death payments to spouses and dependent children if you die before pensionable age (usually a lump sum multiple of income) or, if you die once you've retired, a spouse's pension of between half and two-thirds of your income continues to be paid.
Alternatively, if you need to retire early due to ill health you will still get your full pension. Those who simply decide to retire early can do so but with a reduced income, to reflect the longer period over which it will need to be paid.
As with other schemes you can still take 25% of the fund as tax-free cash if you choose. But as you have a guaranteed income rather than finite pot, working out how much cash you can take requires a complex calculation which will be based on your scheme's commutation factor. You will have to contact your employer for details of the rate on your scheme.
With such guarantees, these schemes are incredibly expensive to maintain and are becoming more so as life expectancy increases. As a result many employers are scaling back these pensions to reduce their own liabilities and most schemes are now closed to new members. Many schemes have been scrapped altogether. Traditionally benefits have been based on workers' final salaries, but many surviving schemes are now moving towards a career average.
It's no surprise then that this type of pension is becoming increasingly rare in the private sector. Although public sector workers still have defined benefit schemes the terms offered continue to change as the government desperately tries to save cash and major changes have been scheduled for April 2015 (2014 for members of the Local Government Pension Scheme).
Do you work in the public sector? Find out how YOUR scheme has changed
While these pensions are supposedly the best available for staff, many workers may naturally be concerned that their employer won't be able to meet their pension commitments - particularly as life expectancy continues to increase. Indeed many company schemes are in deficit, meaning they don't have enough money to meet all of their pension commitments.
The Pensions Regulator does oblige employers to address these deficits, however in the event that your employer cannot meets its obligations, protection for employees exists in the form of The Pension Protection Fund. This was set up in 2005 to protect members from failing schemes. If you were already beyond your employer's retirement age when the scheme went bust, 100% of your income would be protected. If you retired early or are still working 90% of your income would be covered.
Money purchase schemes
Also known as defined contribution schemes, these pensions are the norm in the private sector. In most cases the schemes are essentially personal pensions into which you pay in every month, the only difference being that they are set up by your employer and contributions are taken direct from your salary (this is why they are also known as group personal pensions). Some people may be offered a trust-based scheme, in these cases the pension fund is managed by a board of trustees.
Your employer may make contributions on your behalf too – 6% of your wages is typical according to Hargreaves Lansdown. If this is the case it's better to pay into your work scheme rather than going it alone with a personal pension.
Unlike defined benefit schemes, there is no guarantee how big your retirement fund will be, or what income it will be able to generate. Instead its eventual value is determined by how much the contributions made by you, the government and your employer, grow.
In order to grow your savings, they will be invested in the stockmarket. Default funds exist for those savers who don't want to make any investment choices, but to really make the most of your money it's recommended you take an active interest and choose which funds to invest in yourself and monitor their performance regularly.
As with all pensions, you'll be able to take 25% of your final pension pot as a tax-free lump sum. There are currently lots of rules stipulating what you do with the remainder, however from April 2015, savers will have open access to their pension savings.
You can buy an annuity to guarantee an income for life, leave it invested in your pension and drawdown the required income or cash it in and spend or invest it as you please. However appealing the latter might sound, it wouldn't be tax efficient. Income tax would be payable on the whole lump sum boosting your income for that year and quite possibly pushing you into a higher tax bracket.
Prior to October 2012 you would have been given the choice as to whether or not you joined your company pension scheme. However because uptake rates have been so low (according to ONS, just 35% of us are signed up to an occupational pension scheme, the lowest level since 1953) and the government is concerned more people are going to be retiring into poverty and relying on the state, it is now in the process of forcing employers to sign employees on to their pension schemes automatically.
This is known as auto-enrolment and affects all employees aged between 22 and the state pension age, working in the UK earning more than £10,000 a year. While many employers already do make contributions on employees' behalf they are now being forced to do so by law.
Under the new rules workers need to pay a minimum of 0.8% of their qualifying earnings, your employer pays in 1% and the government pays 0.2%. However this will increase to 4%, 3% and 1% respectively by 2018. This will mean if Anne pays in £40, her employer pays in £30 and the government pays another £10, Anne will have a total of £80 going into her pension.
However these are just minimum requirements and your employer may well pay in more than this. Patrick Connolly, IFA at Chase De Vere says: "Most employers are paying in more than this because they are using it as a benefit to recruit and retain the right staff."
The process of auto-enrolment started back in 2012 among the UK's largest employers and is gradually being rolled out to medium- and small sized businesses. By 2018 all employers will have to automatically enroll qualifying employees onto a workplace pension.
What if I don't want to pay in?
Unlike in Australia, nobody can force you to save into a pension, so if you aren't happy to pay into your employer's scheme you can leave it by filling in an opt-out form.
If you have only made one month's worth of contributions this money will be refunded to you. However if you've been in the scheme for longer than a month, your money will stay invested in the pension and you will not be able to access it until age 55. By law your employer will re-enroll you every three years.
However you should think carefully before opting out says Connolly. "The only people who should be opting out are those who are really hard up and with high levels of debt. Everyone else should stay put. With auto-enrolment you will know you are in a good quality scheme with competitive charges and employer contributions. If you give this up you are effectively turning down a pay rise."
And, even though your own contributions means your income will reduce, there could be some hidden tax benefits of having less take home pay. Connolly adds: "A reduced income could mean you fall into a lower tax bracket or it could increase your eligibility for child benefit and other state benefits."
Thankfully, despite pressures on household incomes the pensions message does appear to be hitting home. One year after auto-enrolment, not-for-profit pension provider, NEST (National Employment Savings Trust) reported that less than 10% of employees had opted out.
Tax-free lump sum
An inelegant phrase that is nonetheless accurate in what it describes: a one-off payment to a beneficiary that is free of any form of taxation. Usually received when using a pension fund to purchase an annuity, as 25% of the overall fund can be taken as a tax-free lump sum.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
In exchange for any lump sum – usually your pension fund – an annuity is “bought” from an insurance company and provides an income for life. When you die, the income stops. Annuity rates fluctuate daily and depend on your sex (although from 21 December 2012 insurers will no longer be able to use gender as a factor when calculating annuities), age, health and a number of other factors, so you have to pick the right one and, once bought, its terms cannot be altered, so seek financial advice.
A financial adviser who is not tied to any financial services company (such as a bank or insurance company) and is authorised by the Financial Services Authority (FSA). They can advise on financial products to suit your circumstances. All IFAs have to give consumers the choice of paying by fees or commission and have to explain which would best suit the customer in that particular instance. Also, if commission is paid either by the client or the financial service provider recommended by the IFA, the IFA must disclose what that commission is.