From 5 April 2015 the pension situation in the UK is straightforward.
Pensions are in essence a way of saving for your retirement in regular manner and in general they are given a more tax efficient treatment which makes them attractive than saving in deposit accounts. Contributions (sometimes called premiums) are paid over a long period of time during which some sort of return is added (perhaps interest or capital growth that is generally tax free) so that at a point in the future there is a fund of assets available to finance retirement.
There are essentially two type of pension scheme and the only difference is in what benefits are guaranteed.† The first is known as a Defined Benefits (DB) scheme which is where there are specific benefits guaranteed to be paid on retirement. Such schemes are normally set up by larger employers and are quite common in the Public Sector but are not that popular in the Private Sector since they are quite expensive to finance.
It is a complicated calculation to work out how much needs to be put into a DB scheme to ensure that there is enough money in the fund to provide the guaranteed benefits in the future. The maths is done by actuaries who use the membersí details (age, benefits entitled to, length of service left etc.) along with assumptions (rate of return etc.) to come up with an amount that needs to go into the scheme each year.
The more common type of scheme in the Private Sector and for Personal Schemes is the Defined Contributions (DC) scheme which is where there are no benefits guaranteed. The fund available at retirement in this case is simply the product of all the amounts contributed plus what return has been generated. There are no limits on how much can be contributed into such scheme but there are limits on how much of the contributions will attract tax relief.
From the age of 55, benefits can be taken from the fund and there are essentially two options. The first is to buy an annuity which is simply a regular amount (annually or monthly) that someone is prepared to pay you for the rest of your life in exchange for the capital in the fund. Clearly the younger you are when you buy this annuity, the longer you are expected to live and hence the regular amount will be lower each time.
The advantage to this that you have are sure of what income you will get for the rest of your life regardless of how long you live or changing financial environments. The downside is that it stops when you die and you take the risk that you wonít get back all of what the fund was worth. Clearly the older you are when you start to take the annuity the more likely it is that you may not recoup the full amount of what the fund was worth.
On retirement there is the option to take 25% of the entire fund taxĖfree and only use the balance to buy the annuity. The funds you get are therefor part of your estate and itís only the other 75% that you may not live to recoup but the regular amount that you would receive clearly drops by 25% each time as well.
You can also build in options to the regular payments such as a guaranteed payment period (say 3 or 5 years) which will ensure that you get paid for at least that period even if you die in the interim. You can also choose to take a spouse pension which will be paid to him/her after you die for the rest of their lives (normally at ⅔ of the regular amount you would have got). You can also opt to have the pension increase each year either by a set percentage or by reference to a quoted index which will ensure that some account of inflation is built in. However all these option come at a cost so the regular amount that you get decreases with each additional option you buy.
There are many providers of annuities in the marketplace and it is important that you shop around to get the best deal for you.
The second alternative is not to buy and annuity but to take withdrawals from the fund as and when you want. The first 25% of the fund is still tax free. The advantage to this option is that the undrawn part of the fund will still be generating income and you can change the amounts you draw down each year to suit your circumstances. It will also remain as part of your estate on your death. On the other hand there is no guarantee that there will be sufficient funds for the remainder of your life and the fund could run out before your death.
It is possible to take the entire pension fund in one lump sum with the first 25% being tax free and the remainder subject to income tax at your highest rate.
In the event of your death any undrawn funds in your pension fund can generally be drawn either as a lump sum or as regular income. If you were over 75 at the date of death the amounts will be subject to tax.
Annuities are subject to income tax (but not to national insurance) which will be deducted at source by the provider after allowing for any unused part of your annual tax allowance. Depending on your overall income in the year there could be a higher rate tax liability (see Income Tax).
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