This guide is based on UK law as at 1 August 2015, unless otherwise stated. It is part of a series of guides on pensions. Pensions are often overlooked. They are just too complicated,... 

This guide is based on UK law as at 1 August 2015, unless otherwise stated. It is part of a series of guides on Pensions.

Pensions are often overlooked in companies. They are just too complicated, there are too many decisions to make and the jargon is off-putting. But pensions are crucially important: they can be the single biggest expense of a company and one of the most valuable elements of remuneration. You ignore them at your peril.

Main types of pension scheme

A defined benefit or final salary scheme promises a set level of pension once you reach retirement age – no matter what happens to the stock market and the value of investments. The benefit is usually calculated as a proportion of your final salary for each year of service. For example, if you are promised 1/60th of final salary for each year you work for the company and you work for 40 years, you will be paid 40/60ths (ie two-thirds) of your final salary. On top of that, the law requires an element of inflation-proofing to be built in.

In effect, as long as you keep your side of the bargain and make the required level of contributions (typically about five or six per cent of pay), the employer takes all the risk.

There’s a downside, though. The employer’s contributions may not be enough to guarantee the pension promise in all circumstances. If the scheme winds up, the huge cost of paying everyone’s pension may well be beyond its means. What’s more, members don’t own a share of the fund: where a scheme winds up in deficit, monies are divvied up in accordance with a statutory priority order.

The Pension Protection Fund (PPF) offers compensation when employers go out of business, but this is subject to limits: your entitlement from the PPF won’t necessarily match your entitlement under the pension scheme.

The funding problems associated with defined benefit/final salary schemes mean they’re rapidly going out of fashion. As our guide, Pensions: Liabilities for underfunding, makes clear, organisations that have them are closing them to new members.

A defined contribution or money purchase scheme makes no promise about what you will get when you retire. You simply contribute to the pension scheme. The money is then invested in the way you have asked. At retirement, you buy a pension (an annuity) with whatever funds are available, or you simply draw down funds as you need them. The amount you get depends on how well the investments have done and how much it costs to buy an annuity, as well as other factors such as whether you want any dependant to get a pension on your death and whether you want inflation-proofing built in. So, in defined contribution schemes, it’s the pension scheme member who takes all the risk. He or she does have a legal right to a share of the funds, but there is no certainty about what it will be.

Defined contribution pension schemes can either be run by a board of trustees (as an occupational pension scheme) or take the form of a contract with a provider, usually an insurance company (as a personal pension scheme).

Employer’s duty to provide a pension

Since October 2012 employers have started automatically enrolling their staff in a pension scheme which meets minimum requirements. The statutory requirement to auto-enrol staff is being rolled out for employers according to number of workers. Once it applies, employers must contribute to a pension scheme for those of their workers aged between 22 and state pension age who earn above a minimum amount (£10,000 a year for 2015/16). Both employers and employees are required to contribute. Employees join the scheme automatically but are able to opt out.

Employers are required to provide certain information to their staff about auto-enrolment, and penalties apply to employers who fail to comply. The Pensions Regulator has published a number of guides to help employers and pensions professionals.

Tax breaks

To encourage contributions to schemes, the government offers tax breaks. Annual tax relief will be given on the higher of £3,600 (the threshold for total yearly contributions to pension schemes) and your UK earnings (although there are restrictions on tax relief for high earners – see Rules and restrictions, below.) Investment returns within the scheme are also tax free. Employers get corporation tax relief on what they contribute. Pension payments are generally taxed at the pensioner's marginal income tax rate, although you can usually cash in a quarter of your pension fund tax free.

Rules and restrictions

To discourage abuse of the system, there are restrictions on the amount of pension that can be built up each year.

Annual allowance

The annual allowance is the amount of pension you will be allowed to build up each year without incurring tax.

For defined contribution schemes, this limit applies to the contributions that you or your employer make. Increases in investments within the scheme are ignored.

For defined benefit schemes, the annual allowance is the annual increase in the capital value of your benefit. The capital value is basically how much more your pension is worth. The government has set down in legislation how this will be calculated.

The annual allowance was reduced to £40,000 in April 2014.

The £10,000 money purchase annual allowance is an allowance which, once triggered for a particular person, limits the annual level of contributions in respect of that person to any defined contribution arrangements going forward. It is generally triggered when an individual receives pension benefits from defined contribution savings other than through an annuity (for example, by drawing down money directly from the savings).

Lifetime allowance

There’s also a limit on the amount of pension that can be built up during your life. This was £1.5m for 2012/13, but has been reduced to £1.25m for 2014/15. It will fall again to £1m for 2016/17.

The amount of pension that you build up in a defined contribution scheme is simply the value of your pension account. If you have a final salary benefit, the capital value is the annual pension you are entitled to receive multiplied by 20, plus the value of any additional lump sum benefit.

Pension funds are tested against the lifetime limit each time a new benefit is paid, on death and if you transfer to an overseas scheme. If you take your benefits in stages – for example, if you reduce your working hours and therefore only take part of your pension entitlement – some of your lifetime limit will be used up each time.

Compliance and tax collection

The onus is on individuals to ensure that they are within the limits or pay the necessary tax. Pension schemes are also responsible for the payment of the lifetime charge.

The annual allowance tax is calculated through the self-assessment system. Tax will be charged at 40 per cent on any contributions above the annual allowance.

If you incur tax charges above £2,000, you will be able to elect to pay it from your pension benefits. You may offset excess pension savings against any unused annual allowance in the previous three years. This will help some members who might otherwise be caught because of a spike in their pension savings (such as a pension augmentation or redundancy or a one-off pensionable bonus).

The lifetime allowance tax charge is only payable on pension benefits above the lifetime limit. If you decide to take the excess as a lump sum there will be a one-off tax charge of 55 per cent. If you opt for an additional pension, you will incur a tax charge of 25 per cent on the excess capital value. On top of this, you will be liable for income tax on the additional pension.

Protection of non-standard lifetime allowances

Some individuals benefit from non-standard lifetime allowances. On the introduction of the lifetime allowance in 6 April 2006, individuals were able to apply for an increased lifetime allowance based on their then pension savings (primary protection) or they could take themselves outside the lifetime allowance regime (enhanced protection). Similarly, individuals were able to retain a lifetime allowance of £1.8 million after 6 April 2012, and of £1.5m after 6 April 2014, by applying for fixed protection. And similar protection will be introduced on the reduction of the lifetime allowance from 6 April 2016 to £1 million. The important point to remember is that both fixed protection and enhanced protection are lost if the individual builds up any additional pension savings.

The investment regime

Investment rules for a pension scheme include:

  • a ban on loans to sponsoring employers; and
  • a five per cent restriction on shares of the sponsoring employer.

Normal minimum pension age

The earliest age at which most people can draw their pension is 55 (the previous minimum was 50).

You can only get benefits before you reach 55 if:

  • You are eligible for an ill-health or incapacity pension. (The rules for this are fairly prescriptive and will be set out in the pension scheme booklet.)
  • The law gives you a protected right to retire earlier.

The requirements for meeting the second criterion are detailed and depend (among other things) on whether there was an unqualified right to retire under the rules of your pension scheme at 10 December 2003. (If you exercise this right, you will need to take all of your benefits at the same time and leave employment completely.) The lifetime allowance will be reduced by 2.5 per cent for each year you take the pension before the age of 55.

Taking your DC pension

The majority of members of a defined contribution scheme have in the past bought an annuity with their pension funds on retirement.

An annuity is a product, usually sold by insurance companies, that promises a certain income until death. What you get therefore depends on how expensive annuities are at the time you retire. Whether they are good value depends on how long you live. 

Annuities have been unpopular with some retirees. From April 2015, individuals have instead been able to choose to draw down funds directly from their savings from age normal minimum pension age (usually age 55) without restrictions. Different schemes may restrict how drawdown operates – for example, it may be possible to drawdown only a certain number of payments each year.

Retirees need to think carefully about their retirement options. Pension Wise is a free guidance service that the government has set up to help.

Other forms of pension

Small self-administered schemes (SSASs)

SSASs used to be very attractive to controlling directors. They offered a tax-efficient vehicle that allowed directors to be trustees and members of their occupational pension scheme.

Trustee members had control over how the assets were invested, and the restrictions were few.

The relative attractions of SSASs have diminished since 6 April, 2006, when all pension schemes became subject to one investment regime. 

Self-invested personal pension plans (SIPPs)

SIPPs are personal pension plans that allow individuals to select their own investments. You must use an external provider to hold the money for you.

SIPPs offer members more control in managing investments and are therefore attractive to people with a good understanding of personal finance and the capital markets. There are, however, tax penalties for investments in residential property, paintings, antiques, etc.

Unfunded schemes

An unfunded scheme is, as its name implies, not pre-funded. It’s little more than a paper promise. The employer promises to pay a certain pension at retirement, but does not put aside any money to do so. This is all very well if your employer is the government, but risky if you work in the private sector. (Unlike the government, private companies can go bust.) A financial promise is only as good as the organisation behind it.