GUIDES

What are private pensions and how do they work?

Paul Hepplestone
Pension Adviser

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IN THIS GUIDE:

  • How do private pensions work?
  • Workplace pensions
  • What's auto-enrolment?
  • Personal pensions
  • Stakeholder pensions
  • Self-invested personal pensions

“Private pension” is a broad definition which covers both workplace pensions arranged by your employer and personal pensions which you set up yourself. Private pensions provide a way for you to save for retirement, so that you’ll have an income to supplement the amount you’ll receive from the state pension. What are they and how do they work?


How do private pensions work?

Private pensions are defined contributions (DC) plans, where any payments you make are invested. The amount you end up with at retirement depends not only on how much you’ve paid in, but also on how your investments have performed and the level of charges you have been paying. A defined contribution pension is one of the most common types of private pension around. Here's a comprehensive list.

Workplace pensions

Workplace private pensions are usually DC schemes arranged by your employer. They can vary in format, to a certain degree. Many will be defined contribution pensions, though some may offer a salary sacrifice scheme.They work by both you and your employer making contributions regularly, usually based on your salary. Your employer’s chosen pension provider will then use those contributions to invest into the stock market and other assets through funds.

What's auto-enrolment?

Since 2012, employers are legally required to automatically enrol their employees on a pension scheme, unless the employee opts out of it. This requirement is for those over the age of 22 and earning more than £10,000. 

The law also requires employers to pay 3% of a person’s salary into the pension scheme, with the employee asked to pay a further 5% from their wages.

However, 1% of that is tax relief that would have otherwise gone to the Government in a form of tax. Being put on a workplace pension scheme is therefore like a 3% pay rise and individuals should carefully consider their choice before opting out of one. Plus, some generous employers will pay more than the required 3%. In these instances, you can therefore choose to pay less than 5% to bring the total added to your pension pot each year to 8%. Or you can, of course, choose to pay more.

Auto enrolment also works on the basis of qualifying earnings. So your employer and your contributions are calculated on wages between £6,240 and £50,000. 

Bearing qualifying earnings in mind, consider a person who earns £20,000 a year at Company X. The Company’s minimum required contribution to that employee’s pension is £412.80 a year. The employee’s contribution should be 5%, which is £688. However, included in that contribution is £137.60 of tax relief. That tax relief would have otherwise gone to the Government in tax, but goes towards the employee’s pension instead.

A real-life example

Imagine earning £20,000 and you decide to contribute 5% to your pension each year. This equates to £1,000 each year and is taken from your gross pay - meaning you will lower your income tax taken from your salary. Your employer may have a scheme in place where they agree to match your contribution. In this example it means they also pay £1,000 into your pension which is also free from tax deductions. The result is that £2,000 is paid into your pension pot each year - with fees charged according to your pension providers fee structure.

Another choice you will have is how much of your pension pot you will take and when. Pensions and tax implications have a big bearing on how people draw their pension. It is possible to take the whole pot as a lump sum. A quarter of your pension pot withdrawal will be totally tax-free. The rest will be taxed at the relevant income tax bracket the withdrawal puts you into. 

Alternatively, you can take lump sums whenever you need. The taxation on withdrawing from your pension like this is similar to taking one entire lump sum. The first 25% is tax-free and then the rest is taxed at the relevant income tax bracket.

If neither of these options suits your needs, instead you can take your 25% tax-free lump sum and then leave the rest of your pension fund to provide you with a regular income. Some individuals choose to do this by buying an annuity

Over time, it could be that you amass many defined contribution pensions. This is increasingly more common as moving jobs regularly over the lifespan of a career is the norm these days. For that reason, it is good practice to keep a record of all your defined pension schemes so that you can stay on top of your pension planning. 

Personal pensions

A personal pension is a defined contribution pension scheme too. The difference is that you find the provider and you make the contributions. Compared to previous decades, there's way more flexibility choosing or switching a personal pension. You can control how much you're paying in. You balance the level of risk and security, for growth. And now, after the age of 55, (57 if born after 1971) you get to decide how you want to take the money. They are a good option if you do not have a workplace pension. 

Personal pensions offer two main benefits. Firstly and obviously, they allow you to save more money for your retirement and be a bit more optimistic about your financial plans. Secondly, you gain some tax relief in doing so.

The pension provider you choose will claim back that tax relief and simply direct it back into your pension pot. They do this at the basic rate of tax to begin with, though if you are a higher rate taxpayer, you then need to claim the higher amount back on your tax return to the HMRC. Secondly, it is you who chooses where your money is invested in terms of funds that are offered by your pension provider - and not your employer. 

Once you have chosen your pension provider, they work like a defined contribution pension - you decide how much you put in so that you build your pension pot up by adding to it, as well as growth from investments made.

You can also have a personal pension in addition to a workplace pension. Or, if you start working at a company where they have a workplace pension, you can contribute to that so as to make the most of employer contributions too. However, the money you leave in your personal pension pot may be subject to some charges so do check with your provider. 

Stakeholder pensions

Stakeholder pensions date back to 2001. Back then companies with more than five employees had to offer some sort of pension scheme. Employers didn’t have to pay into them, but a group stakeholder pension was easy to set up so became a popular choice. However, in the recent pension shake-up, auto-enrolment schemes replaced stakeholder pensions schemes from 2012 because employers have to pay into them.

The main things about these pensions were the minimum standards set by the government. They were:

  1. Low minimum contributions. If you were setting up a personal pension from scratch you were often asked to contribute £200 or more. A stakeholder pension would take small contributions from £20 a month. This made them ideal for low and middle-income earners. These contributions could also be flexible.

  2. Charge free transfers. You can move your pension to another stakeholder pension without being charged a penalty withdrawal fee or transfer fee. 

  3. Set management charges. The management fees for a stakeholder pension are set at 1% -1.5% per annum for the first 10 years.

Interestingly, 1% -1.15% sounds low. However, those fees can be lowered through other pension types. Keeping fees as low as possible is critical for optimising how much money actually makes it into your pension pot. 

Withdrawing from a stakeholder pension is the same as withdrawing from a defined contribution pension. And how your pension pot will build up is the same as the example given above - if you contribute the same amount each month. However, one of the biggest advantages to stakeholder pensions are that they are flexible in terms of how much you can pay in on a monthly basis. 

Self-invested personal pensions

Self-invested personal pensions or SIPPs are a form of personal pension that are highly flexible in where money can be invested. Traditional pensions limit the funds your provider can invest in. But with a SIPP you can invest in pretty much anything e.g. overseas properties, car parks, but mainly FCA unregulated products. These investments typically grow (or fall) at higher rates than traditional pension funds. So, investors are hoping for a higher rate of return. But of course, with that higher rate of return, usually comes higher risk. 

So what does this mean in practice? A SIPP can be seen as a do it yourself pension where you are not limited by just the funds that a traditional pension scheme from a pension provider may offer. To start a SIPP, you need to find a provider, but from there, you simply direct them on how to invest your cash. 

There are low-cost SIPPs and full SIPPs. A low-cost SIPP means you can invest an amount as low as just a few thousand pounds. While low-cost SIPPs may not provide many added extras like mobile trading apps to run your investments, they will usually have lower charges too. A full SIPP will usually provide you with a large range of investments that can even include real estate. If your investments are more complex, having a full SIPP should mean you have a team at your provider to help you implement them. However, that obviously comes at a charge. 

The range of assets that a SIPP can hold are:

  • Unit trusts

  • Shares

  • Investment trusts

  • Gilts/bonds

  • Cash

  • ETFs (Exchange Traded Funds)

  • Property

You may want to start a SIPP with your own savings or with money from other pensions. If it’s from your own savings you can do so by making monthly contributions or simply by opening it with one large lump sum. For transfers from other pension plans, you will be starting a SIPP with a large lump sum. However, before doing so, ensure that you are aware of the charges surrounding the transfer. Many pension plans have substantial withdrawal fees that act as a penalty. Moving your pensions into one place may not be financially the best decision, therefore. 

A SIPP, owing to the huge flexibility of the product, can vary in large amounts. An example would be investing £1,000 a year into your SIPP which is purely invested in funds. You can invest that through your provider in a wealth of ways. You can ask for your portfolio to be spread equally across bonds and stocks. Or you can invest entirely in ETFs. Most portfolio managers would recommend spreading investments across different asset classes to help diversify away some investment risk. 

Having a private pension - key takeaways

Perhaps the most crucial idea to remember - regardless of the type of private pension you have - is that you at least have one. Starting early when it comes to pension planning is the number one piece of advice that any financial adviser will tell you. However, it is never too late to start saving for your pension and there are so many types of private pensions out there that there will be one that works best for your circumstances. Making use of a pension calculator can be prudent, but also seeking pension advice can be one of the best things you can do to help you plan for your future. 

The world of pensions can be a complicated place. Yet, pensions are something that affects us all, so it is necessary to understand your pension wealth as best as possible. If you are ever in any doubt about what to do about your pension and retirement, seek pension advice from a professional. It has been shown that people who seek pension advice are better off in retirement than those that do not, so it really does pay to talk through your finances with an expert. 

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