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The one thing all personal pensions have in common is that they are money purchase arrangements (see Guide to occupational pensions).
This means your contributions are invested across a range of funds. The amount of pension you receive when you retire will depend on how much you’ve put in and the investment performance of the funds. On retirement your pension is provided by an annuity purchased from an insurance company, although you can take a tax-free lump sum (see When and how can you take the benefits, below, and Guide to annuities and drawdown)
Conventional wisdom is that the younger you are when you start to save in a pension the better, as you’ll have longer to build up your fund, meaning you can save in smaller amounts. To estimate how much you need to save in a personal pension at a particular age in order to give you an income of a certain amount when you retire visit http://www.pensioncalculator.org.uk/
There are several different types of personal pension, including Stakeholder, SIPPs (Self-invested personal pensions), GPPs (group personal pensions), Freestanding AVC schemes, SSASs (Small self-administered schemes), EPPs (Executive pension plans) and, to add to the confusion, schemes that are simply called Personal pensions.
Why would you want one?
If you are self-employed, or you are an employee but for some reason unable to join an occupational scheme, or would like to supplement the benefits you are in line for in such a scheme, you could take a personal pension.
Personal pensions are also an option for those who are not working at all, but who would like to save towards retirement; or you can pay into a personal pension on behalf of someone else, a non working spouse or even a child, for example, and obtain tax relief at your marginal rate (the highest rate at which you pay tax).
Employees who decide they would like to opt out of the second state pension (as opposed those who belong to an occupational scheme that is contracted out) also need an Appropriate Personal Pension (APP) in which to invest their ‘contracted out’ rebate (see APPs, below).
How much can you invest tax-free?
Since April 2006 (known as ‘A Day’), when the rules on pensions were simplified and standardised, all pensions are treated the same for tax purposes and you can have both a personal and an occupational pension, provided you remain within the overall limits for tax-free investment. In 2008-09 the annual limit is £235,000 or 100% of an employee’s earnings, whichever is lower.
In the year before retirement you can contribute as much as you like, provided you remain within the overall lifetime limit, which is £1,650,000 in 2008-9. You can invest a lump sum if you can afford to, but most people make monthly or annual contributions.
If you do not work in paid employment you can still invest in a personal pension, up to £3,600 a year in a Stakeholder plan, or someone else can invest this amount on your behalf (see Stakeholder pensions, below).
Where are my contributions invested?
You can generally spread your contributions across a selection of investments, including cash deposits and collective managed funds such as unit trusts. The type of personal pension you have, and the pension provider you select, will determine how wide a choice of investments you have.
It is important to review your selection of funds on a regular basis to ensure they still meet your objectives and are still performing satisfactorily, taking professional advice if you feel you need to.
When and how can you take the benefits?
You can normally draw your pension from age 50 (rising to 55 in April 2010). You can take a tax-free lump sum of 25% on retirement and the rest is used to buy an annuity (see Guide to Annuities and Drawdown).
However, if you have only a small pension ‘pot’, worth less than £15,000, you can take the whole amount as a cash lump sum, 25% of which will be tax-free.
If you have more than one pension the cumulative total must be less than £15,000 for this option to be valid.
What are the different types of personal pension?
Stakeholder pensions
Stakeholder pensions were introduced in 2001 and are designed as low cost, simple pensions aimed at encouraging more people to save towards their own retirement.
Generally provided by insurance companies, Stakeholder pensions must conform to certain criteria. These are:
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Charges are ‘capped’ at no more than 1.5% per annum for the first ten years and 1 per cent thereafter.*
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Minimum contributions must be no higher than £20 and you must be given the flexibility to pay as and when you choose.
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You must be given the right to transfer the pension to another provider without penalty
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There must be a ‘default’ fund into which contributions are invested for anyone who does not want to make their own fund selection. Moreover, this so-called ‘lifestyle fund’ must become more conservative as you get older, so that as retirement approaches your money is in safer investments.
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Stakeholder pension schemes must be run in the interest of their members, and will either have trustees or they will be run by a scheme manager.
(*The annual charge for anyone who purchased their stakeholder pension scheme before 6 April 2005 is 1% and will remain at that level for as long as they remain in the scheme. However, if they switch to another plan this new charging structure will apply).
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If you are employed then your firm may offer a Stakeholder scheme that you can take advantage of, where the charges may be even lower and your employer may boost your own contributions by paying into the scheme on your behalf.
Self-invested personal pensions (SIPPs)
Traditionally SIPPs have been the preserve of the wealthy, often people in business for themselves. They are personal pensions where, instead of allowing an insurance company to invest contributions on your behalf, you retain total control.
A SIPP is basically a ‘wrapper’ which ring-fences your investments so that the funds inside are given all the tax advantages of a pension. You choose what those investments are. They can include stocks and shares, cash, commercial or industrial property (but not residential), and collective investments such as unit trusts.
The cost of SIPPs could be high, with separate charges made for each element, for example administration and dealing charges, which meant they were only suitable for those on high incomes.
However, more recently providers have sought to broaden the appeal of SIPPs by offering low-cost options, with a single set of charges covering everything. Basically, there are now three types of SIPP:
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Low cost SIPPs – your choice of investments is likely to be limited and will generally comprise collective investments and direct equities (stocks and shares) through an investment manager;
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SIPPs from insurance companies – generally you will have to invest at least some of your money in the company’s own pension funds, but most also allow direct investments in equities and some allow property investment as well; and
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SIPPs from specialist providers. A ‘bespoke’ or ‘discretionary’ service that allows most types of investments, including equities and property. Either you allow the provider to take investment decisions on your behalf or you can be completely ‘hands on’ and instruct them what to do, taking advice from their specialists if you wish.
Group personal pensions plans (GPPs)
As their name suggests, GPPs are personal pensions that are offered to a group of employees who work together. Other than that they are the same as any other personal pension plan.
The advantage of a GPP, if your employer offers one, is that the charges may be lower than with an equivalent ordinary personal pension. The provider, because they are dealing with bulk business, may be able to offer a reduction in their normal charges.
This is an important consideration, as the less you pay in charges the more money goes into your pension, giving you a larger fund at retirement.
However, the potential disadvantage when compared to a Stakeholder scheme is that, if at some future date you want to transfer your money to another scheme or provider - if you change jobs for example - many GPP providers charge a one-off penalty. Such penalties are not permitted under Stakeholder scheme rules.
Small self-administered schemes (SSASs)
SSASs are technically money purchase occupational pension schemes, generally used by family firms. They are complex arrangements, and to qualify there must be fewer than 12 members currently building up pension benefits, at least one of whom must be a controlling director, or have been in the last 10 years.
Since the changes to pension legislation introduced on 6 April 2006 (‘A Day’) many of the special features of SSASs have been removed.
For detailed information go to
www.pensionsadvisoryservice.org.uk/Specialist_Pension_Arrangements/SSAS/
Freestanding AVC schemes (FSAVCs)
Prior to ‘A Day’, FSAVC schemes were a useful way for employees who were already in an occupational pension scheme to ‘top up’ their pension by contributing to a personal pension offered by an insurance company.
Charges tended to be relatively high and FSAVC schemes were not hugely popular. Since ‘A Day’ employees can top up their occupational pensions using a low-cost Stakeholder scheme which has made new FSAVC schemes virtually redundant.
Executive Pension Plans (EPPs)
This is another type of scheme that has little relevance since ‘A Day’. EPPs are also for employees. They were attractive to high income earners because contribution levels were more generous than other types of pension, enabling them to build up a large pension in a relatively short space of time. Now that all pension schemes are treated the same, and there is an overall contributions limit that applies across the board, there is no reason to have an EPP.
Section 32 contracts
A Section 32 or ‘Buy-out Policy’ is similar to a personal pension, although you may not contribute a regular monthly or annual premium.
Introduced in 1981, Section 32 contracts only allow single "one-off" transfers, and they are specifically designed to accept preserved pension rights being transferred from an occupational pension scheme and maintain them in their original form (which could be final salary).
Benefits are payable from state pension age.
Appropriate Pension Plans (APPs)
Individual employees are allowed to contract out of the second state pension (known as S2P and prior to April 2002 SERPS) and instead invest the money in an Appropriate Pension Plan.
You and your employer pay national insurance contributions at the full rate, but the NIC office pays over a national insurance rebate, plus tax relief on the employee’s share of this rebate, directly to your personal pension provider. The fund that builds up from this part of your NICs is known as a Protected Rights Fund.
APPs can be taken out by employees who are not already contracted out through an occupational pension scheme.
Any Stakeholder or personal pension scheme is potentially ‘Appropriate’. You need to check with the pension provider.
Schemes that are closed to new business
The following are the forerunners to current personal and Stakeholder pensions. Both have been closed to new business since 1988, but you may still be paying into one:
Retirement annuity policies (RAPs): Similar to personal pensions, these also offer the possibility for commutation to a tax-free lump sum at retirement age.
Section 226 policies: These were designed for the self-employed and people who did not have access to an occupational pension scheme.
In some cases you can draw a larger lump sum (up to 33%) than the 25% maximum allowed with a personal pension. The policies also include a lump sum death benefit, and if you are still paying into one it may well be worthwhile retaining it until you retire.
What if I am still paying in to any of these old pension schemes?
It is impossible to generalise as to whether you should continue paying in to an older style personal pension. However, the improvements to pensions after A Day certainly mean that you are advised to have your pension arrangements reviewed by a qualified pension adviser, who will look at its costs, performance and potential benefits in comparison to today's pension options.
To find an independent financial adviser in your area who specialises in pensions go to http://www.unbiased.co.uk/
What are my options when I retire?
Most people use the proceeds of a personal pension on retirement to buy an annuity to provide a pension for their rest of their life, although they may take a tax-free lump sum.
There are different types of annuity and you can buy your annuity from a different company to the one that provided your personal pension plan. This is known as exercising the open market option.
There are also schemes (known as drawdown) that allow you to defer buying an annuity on retirement and leave your pension fund invested. (see Guide to annuities and drawdown).
CashQuestions Guide to State Pensions
CashQuestions Guide to Occupational Pensions
CashQuestions Guide to Private Pensions
CashQuestions Guide to Pensions for Women
CashQuestions Guide to Annuities
CashQuestions Guide to Drawdown
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