Pensions For Beginners: Part Three
The third and final part of our Pensions For Beginners series, Serena Cowdy explains what personal pensions are really all about.
This is the final article in our `Pensions For Beginners' series.
In Part One, I explained what a pension is and had a look at the pros and cons - and the alternatives.
Part Two covered the basics of the State Pension and salary-related pension schemes.
Now, on to the third and final pension category:
These are also known as defined contribution or personal pensions.
This is the pension type you'll have the most control over.
If you're not part of a salary-related scheme, the chances are you'll need to invest in a money-purchase pension to ensure you have a comfortable retirement.
Under the `money-purchase' umbrella, there are four main sub-groups: personal pensions, stakeholder pensions, group personal pensions and self-invested personal pensions or SIPPs.
1) Personal pension
What is it? It's a type of pension scheme into which holders pay a regular amount (usually every month) or a lump sum.
How does it work? The payments go into an investment fund, usually run by a financial organisation such as a bank, building society or insurance company.
This pension provider will then invest the money on your behalf. The final value of your pension fund will depend on how much you've contributed, and how well the fund's investments have done.
The pension provider will charge you for setting up and running your pension.
How much can I invest? You can have as many personal pension schemes, and contribute as much money, as you want. However, as I explained in Part One, there are certain limits above which your money will be taxed.
Should I get one? A personal pension may work well for you if you're employed but not already part of a salary-related scheme (see Part Two).
It can also a good option if you're self-employed - or if you're not working, but can afford to put aside money for retirement.
What happens when I retire? At this point the following two options are available to you:
a.) You can buy an annuity from an insurance company. This is a regular income, payable for life.
You don't have to buy the annuity from your pension provider - and it's important to shop around, as other providers may offer better rates.
On the plus side, an annuity can provide peace of mind and financial stability, as the level of income you receive is set.
However, many offer relatively poor value for money. Find out more about annuities here.
b.) An unsecured pension: You can choose to take an annual income from your fund while the rest continues to be invested. This is known as an unsecured pension if you're under 75, and an alternatively secured pension if you're 75 or over.
This is quite a risky option, because the amount in your pension pot is still dependent on the stocks and shares it's invested in.
However, if the investments perform well, your pension could grow substantially even though you've retired.
Lump sum: In both cases, when you retire you can take up to 25% of the final amount saved as a tax-free lump sum, providing it is no more than 25% of the government-defined `lifetime allowance'.
Remember - if you want a lump sum, you need to organise it at the same time you're choosing how to receive your pension.
And whether you get an annuity or go down the unsecured pension route, you'll have to pay income tax on any money you receive which isn't part of this lump sum.
Find out more about personal pensions here.
2.) Stakeholder pension
What is it? A stakeholder pension is a type of personal pension which has to meet certain government criteria.
It works in much the same way as a standard personal pension (see above). However, it also has to offer certain set levels of flexibility, security and value for money:
a.) Flexibility: You can switch pension providers, stop, start, and change your payments whenever you want - with no penalty fees.
b.) Security: It must be run by trustees or by an authorised stakeholder manager - who is responsible for the scheme meeting the criteria set.
c.) Value for money: Managers can only charge fees of up to 1.5% of your pension fund each year for the first ten years. After that, the fee drops to, at most, 1%.
Should I get one? Because of the flexibility offered, a stakeholder pension may be the right choice for you if your future financial circumstances are unpredictable.
Although it won't necessarily the cheapest pension product on the market, it should also offer reasonable value.
Find out more about stakeholder pensions here.
3.) Group personal pension:
What is it? This is a type of personal pension organised via your employer.
Employees contribute to individual personal pensions which are then grouped together and managed by a pension provider of the employer's choice.
Am I eligible? If there are five or more employees where you work, your employer is normally required to offer you the chance to join a pension scheme.
They must provide access to a group stakeholder pension (see above), unless they offer either a salary-related scheme (see Part Two) or an alternative group personal pension scheme.
If you're offered a stakeholder scheme, your employer doesn't have to pay anything into it themselves.
However - If your employer offers you an alternative group personal pension, they must also contribute the equivalent of at least 3% of your salary.
Should I get one? There are certain benefits to being part of a group personal pension:
- Many employers choose to contribute to their employees' pensions (even if they are not obliged to).
Some match your contributions pound for pound (usually up to a set limit). In this case it usually makes financial sense to get involved.
- Your employer might be able to negotiate better terms than you would on your own - such as reduced administration costs.
What happens if I change jobs? You normally won't lose the money your employer has already contributed.
You may be able to continue making contributions to your pension if you change employers, but you're likely to lose the group benefits (like lower administration costs).
Find out more about group personal pensions here.
4.) Self-invested personal pension (SIPP):
What is it? A SIPP is a yet another type of personal pension - but you have more control over it because you pick the investments yourself.
In some ways it's a bit like an Individual Savings Account (ISA), because it's a `vessel' into which you put your chosen investments. And like an ISA, you don't have to pay Capital Gains Tax on any profit you make.
How does it work? Contribution limits and retirement payout restrictions are the same as those for standard personal pensions (see above).
However, as the plan holder you have the freedom to decide how much to put in, which fund(s) to invest in, and whether or not to increase your level of investment.
Should I get one? You need to have some confidence in your abilities as in investor, because you'll be responsible for protecting your retirement fund.
Find out more about SIPPs here.
If you're still with me, give yourself a pat on the back and have a nice cup of tea - pensions can be a hugely confusing topic!
You may not plan to retire for decades - so it's very tempting to put sorting out your pension at the bottom of the `to-do' list.
However, when you do decide to save for your retirement, I hope you'll now be in a position to make the right choices.