Everything You Need To Know About Pensions But Were Embarrassed To Ask
So, you have heard about pensions and suspect you should probably have one, but you have never done anything about it because you didn’t want to ask stupid questions.
This article will give you the opportunity to find out the basic facts so you can start funding your retirement lifestyle.
What is a pension?
A pension is a tax efficient means to invest your money for the long term so that it can provide you with an income when you retire.
By tax efficient I mean that contributions you make receive tax relief of 20% . Tax relief is a supplement paid by HMRC to the pension provider on your behalf and is intended to act as an incentive for people to save for their retirement.
If you pay higher rate tax you can get further tax relief by notifying HMRC of the pension contributions you make. This can either be done via your annual self assessment or by having them adjust your tax code.
Once your money is invested any investment growth is free from capital gains tax and income tax (with the exception of dividend payments received from UK shares you own within the pension fund).
Other people can also invest in your pension on your behalf. This may be your employer but could also be a parent who wants to gift you money or your spouse or civil partner; anyone in fact.
How does that provide me with any income in retirement?
When you decide you want to stop working or reduce the work you do you will need to replace your earnings with other income. You can do this a number of ways with your pension fund.
Most people purchase an annuity with the value of the fund. An annuity is simply a guaranteed income for life, the income you receive will depend upon your age, gender, health and also gilt yields. With the exception of the latter the annuity rate you will receive (the income as a percentage of the pension fund you have) will be linked to your life expectancy; the shorter your life expectancy the greater the annuity rate.
Another popular option people take to produce an income is known as Income Drawdown or unsecured pension. With this method your pension fund remains invested (so there is a chance that it can lose value) and the income you receive can be altered. The maximum income is similar to that of an annuity but you have not committed to a single rate for the remainder of your life.
Any income you receive is taxed as income at normal income tax rates. The good news is though that you don’t have to use the whole fund to purchase an income; 25% of the value of the fund can be taken as lump sum tax free.
How does it grow?
The extent to which your pension fund grows will depend upon the degree of investment risk you are exposed to. The rule of thumb is that, over the long term, the more investment risk you are exposed to the greater the return you can expect to receive.
You can read more about investing your pension fund in this article.
How much can I invest into one?
There are limits on how much you can contribute to a pension in a tax year. This limit is known as the Annual Allowance and is the lower of £50,000 and 100% of your earnings.
If you have contributed more than £50,000 in the current tax year it may be possible to contribute more if you did not use your full allowance in either of the previous three tax years (this is a simplified explanation so you should get advice before you contribute any more than £50,000).
Over the lifetime of your pension fund there is a limit on the total pension pot that you can accrue and maintain the tax efficiency. This is known as the Lifetime Allowance and from 6th April 2012 it will reduce from £1.8m to £1.5m.
How much do they cost?
Pension funds used to be expensive but since 2001 they have become more competitively priced. For a basic pension you should expect to pay a single annual management charge (amc)which will vary between 0.15% and 2% of the value of your fund. The large variance is because the higher charges will bundle three separate costs; the cost of administration, the cost of the fund management and the cost of the advice.
Other administrative costs may apply depending upon the type of pension you have. SIPPs (Self Invested Personal Pensions) may have annual admin charges and transaction charges on top of the amcs so, if you have a SIPP, you should check you are not paying charges for services you are not using.
All I hear about are people striking over pensions. Surely this means they are no good?
People are striking because their work pensions are being closed or the benefits are being reduced. Typically these are Final Salary schemes that provide a retirement income based on the time you have been working for the company multiplied by a factor linked to your final salary.
They are closing because they are costly for companies to run; they are obliged to pay workers the pension for the entirety of their retirement, often increasing in line with inflation and providing an income for the ex-employees spouse when the employee dies.
Anyone who has a Final Salary scheme pension is very fortunate and today they are as rare as hen’s teeth with companies regularly announcing the closure of their schemes.
This does not mean pensions are bad. They are a very tax efficient means of investing and if we wish to enjoy a particular standard of living when we retire we will need to generate an income somehow. Pensions enable us to do this.
Are there any disadvantages?
Pensions do have their disadvantages. The major one is that it is not possible to access the fund until age 55 at the earliest and even then only the 25% tax free lump can be accessed as capital, the balance has to been taken as a taxable income.
Additionally, the income that is available via annuities and income drawdown is on a downward trend. This is because, as a population, we are living longer and also the gilt yields that back the annuity rates are currently at historically low levels.
However, as highlighted above pensions are an important means of providing an income in retirement.
Can I get advice about them?
While this is intended to give a summary of what pensions are they can be complicated investments, particularly if you have accrued a number of pension funds over time. It is therefore sensible to get advice from an independent pension expert before taking any action. Fortunately, you can do so here: http://www.icl-legal.co.uk/contact-us/.
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