If you are part of a company pension scheme, the chances are that it is a type of defined-contribution or money-purchase scheme.
This is as opposed to a defined-benefit or final-salary pension – these were more common in the past and generally more generous, but they have been largely phased out over the past few decades.
In a defined-contribution scheme, workers know how much money they are putting into their funds, but there are no guarantees about how much income they will get in retirement. (Final-salary pensions, on the other hand, do offer such a guarantee, which is backed by the company that provides the scheme.)
The size of a defined-contribution pension fund at retirement depends predominantly on how much money goes into it and how the investments it holds perform. This type of pension is sometimes called a money-purchase scheme, because the money in the fund has traditionally been used to buy a retirement income through an annuity, although changes introduced in 2015 have opened up more options.
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How company pensions work
A typical company pension arrangement involves employees putting a certain proportion of their monthly earnings into their pension, and the employer adding its own contributions as well.
This money is then invested in some form of stock-market-linked fund, often run by a major pension provider. The aim is for the savings to grow over the years until retirement to a size that, when added to any state pension entitlement, can generate sufficient income to live on.
Tax relief on pension contributions
To give workers an incentive to save for retirement, the government applies tax relief to any contributions made to a pension. This means that for every £80 you save into a pension, the government tops it up to £100, reflecting the basic rate of income tax at 20%.
For higher-rate (40%) and top-rate (45%) taxpayers, further rebates can be claimed through the self-assessment system.
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The auto enrolment scheme
Until recently it was up to individual employers whether or not to offer a pension, between 2021 and 2019 a new auto-enrolment scheme was rolled out across the country, with all employers with at least one employee has a duty to enrol eligible staff into a pension scheme.
An eligible employee is any paid worker who is at least 22 years old but under state pension age. They must work in the UK and earn more than £10,000 a year. They don't need to be enrolled if they are already paying into a workplace pension scheme.
Under auto enrolment, workers are free to opt out of their company’s pension – they may wish to do this because making regular contributions will reduce their take-home pay.
But once the scheme is fully up and running, workers will pay in 4% of salary, with a further 3% from their employer and tax relief contributing a further 1%.
As your contribution is taken automatically out of your gross pay, hopefully you’ll hardly notice the small dip in your take-home wage. You should also reap the benefit when you retire.
Can you opt out of auto enrolment?
For most people, auto enrolment is a sensible idea and should be welcomed. But if you’re in debt, it may be better to clear what you owe before you think about saving in a pension.
You can opt out of auto enrolment at any time. If you do this within a month of being enrolled, any payments you’ve made will be refunded. After a month your payments are not refundable, and will stay invested in your pension until you retire. It’s worth noting that if you do opt out – perhaps to sort out your personal finances – you can re-enrol at any time.
Do note that your employer will be legally required to re-enrol you in their workplace pension scheme every three years, providing you still meet the eligibility requirements.
In some company pensions – usually those run by outside providers – you will have a choice over how your money is invested. Many pension firms offer a default stock-market fund for workers, but a number of alternatives as well.
You may have the option, therefore, to manage the level of risk in your pension. For example, you could opt for a high-risk fund which invests in emerging markets or smaller companies – with the potential to benefit from a higher growth rate.
If your company’s pension scheme is run by trustees, on the other hand, you may not have a choice over how your money is invested.
Many experts recommend taking a higher level of risk when you are younger, but gradually reducing this risk as retirement approaches – this helps avoid any sudden falls in the value of your pension just before you take it. Some pension funds will make this kind of risk adjustment automatically.
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How big will my pension fund be?
The size of your fund when you reach retirement depend on the following factors:
- How long you pay in for. The earlier you start saving and the later you retire, the bigger your fund should be.
- How much is paid in. Under auto-enrolment rules, workers should see contributions worth at least 8% of their salaries paid into their pensions. But many experts say that significantly more should be saved in order to guarantee a comfortable retirement. Some companies’ pensions do offer more generous contribution rates, however.
- How your investments perform.
- What the charges are on your investments.
Although defined-contribution pensions do not guarantee a particular level of income, you can use an online pension calculator to get an idea of what kind of income your fund might be able to generate.
Such calculators use factors such as your current age, your planned retirement date, the size of your existing pension fund and your current rate of saving, to provide an annual figure. This will be based on certain assumptions about future investment growth and inflation, and is likely to show what level of income you might be able to obtain by buying an annuity – although this is no longer the only option, as explained below.
You can take money from your pension at any point after you have turned 55, and a quarter of your fund can be withdrawn as a tax-free lump sum. The most common way to turn the remaining savings into a regular income has been by buying an annuity, which provides a guaranteed regular income for life.
Since the introduction of reforms in April 2015, however, other options have become more widely available. For example, it is now easier to leave money invested in the stock market – giving it the chance to keep growing – while taking a regular income, a process known as drawdown.
And the tax rates on withdrawing the whole fund have been relaxed, so it is now an option to take out all the money from the pension for use in other investments such as buy-to-let property.
Any money you take out of your pension aside from the tax-free lump sum is liable to income tax at 0%, 20%, 40% or 45%.
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