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The Features and Benefits of Different Types of Pension

Richard Beardsworth Pension Expert

By Richard Beardsworth.

Independent Financial Advisor

More Reading on Pensions...

We generally accept the fact that pensions are an important part of retirement. Unfortunately, UK workers are notorious for failing to save for the future. This is one of the primary reasons the government came up with auto-enrolment a few years back. It is a good idea to know and understand the different types of pension investing in light of new auto-enrolment mandates, given that you will probably be invited to participate in a pension very soon if you are not already doing so.

In this guide, we will discuss a long list of pension options. The types of pension investments you have the opportunity to participate in will depend on your individual circumstances. Whatever you do, don't be afraid to ask whatever questions you might have. There are plenty of answers available by way of financial advisors, charities, and government guidance.

Two Pension Structures

Pensions in the UK are divided into multiple categories and subcategories. At the top of the category tree are the two primary pension structures almost every pension scheme falls under. Those two structures are known as 'defined contribution' and 'defined benefit'. These two structures do not apply to the state pension system – we will explain why later.

A defined contribution (DC) pension scheme is one that relies solely on investments to determine how much you will receive in retirement. The main features of the DC pension are as follows:

  • Contributions are received from worker, employer, and government tax relief
  • Pension operators invest contributions on behalf of members
  • Pension pots rise or fall based on investment performance
  • Members are given limited choices regarding how money is invested
  • Pensions are eligible under freedoms introduced in 2015.

Participating in a DC pension allows you to put money away for the future with the understanding that the pension operator will grow your money by investing it in the vehicles of your choice. You receive benefits and retirement commensurate with how well those investments perform. A scheme that enjoys substantial growth should pay you quite well in retirement while one that does not perform as well will pay less.

A defined benefit (DB) pension scheme is one that may or may not be invested on the behalf of members. Those that are invested are known as funded schemes, those that are not are considered unfunded. In either case, the main features of the DB pension are as follows:

  • Contributions are received from worker, employer, and government tax relief
  • Pension operators may or may not invest contributions
  • Pension pots do not rise or fall based on the performance of any investments
  • Members are not given any choices regarding how money might be invested
  • Pensions are not eligible for most of the freedoms introduced in 2015.

Participating in the DB scheme allows you to put money away for the future with the understanding that your payments and other benefits are guaranteed based on the pension contract. Any investments made by the pension operator have absolutely no bearing on benefits received. The amount a worker receives in retirement is calculated using a mathematical formula that accounts for pensionable years, pensionable earnings, and accrual rates.

Multiple Types of Pension Schemes

Underneath the two primary pension structures are numerous types of pension schemes that you might participate in. We will start with the state pension, which is neither a DC nor DB scheme. The state pension collects contributions from workers through National Insurance contributions throughout their working careers. As you may know, the state pension system from 2016 will not look anything like the system most of us are familiar with. It is a flat rate system that eliminates the second state pension as well as some of the additional credits that were available in the past.

In order to be eligible to receive the state pension, a worker must put in a minimum of 10 years of National Insurance contributions. Those years do not have to be consecutive. However, to be eligible to receive the maximum basic pension payment requires 30 years of contributions for those who reach retirement age prior to 6th April 2016, and 35 years for those who retire on or after that date.

Beyond the state pension, there are quite a few additional options:

  • Occupational Pension – An occupational pension is one that is provided by an employer. It can be either a DB or DC scheme although fewer and fewer employers are offering their workers DB pensions. Those that still have them tend to be looking for ways to wind them up and transfer new workers into DC schemes.
  • AVC Pension – The Additional Voluntary Contribution pension is a supplemental pension offered through an employer that allows a worker to receive additional pension benefits in lieu of salary. Paying into an AVC pension allows an employer the benefit of still paying workers while reducing tax liabilities for themselves. Employers that offer occupational pensions must also offer this additional option.
  • Stakeholder Pension – The stakeholder pension is a personal pension established between an individual and the pension operator. Such pensions can be set up through an employer willing to offer the option, or they can be purchased separately through an insurance company or specialist provider. Employers can legally contribute to the stakeholder pension on behalf of an employee.
  • Self-Invested Personal Pension – Also known as a SIPP, this is another kind of personal pension established between an investor and a pension operator. Employers may choose to contribute this sort of pension as well, but they are not allowed to establish SIPPs and then turn around and offer them to workers.
  • QROPS – The qualified recognised overseas pension is a scheme located in another country into which you might transfer should you decide to retire overseas. The government maintains a list of schemes that qualify for such transfers. But be careful: transferring into a scheme that is later dropped from the government list could result in significant tax penalties.
  • SSAS – The Small Self-Administered Scheme is designed for small businesses operated primarily by a handful of directors. It is an excellent option for self-employed individuals who may operate their businesses with the help of family members. The downside to this scheme is that you can enrol no more than 12 people in it. One of the major benefits is that an SASS can loan out money to the business for the purposes of buying property or otherwise expanding.

One last pension we have not mentioned is the second state pension. We did not include it in our list because it is being phased out as of April 2016. If you have previously contributed to it, such contributions will be reflected in your state pension payments when you retire.

As you can see, there are multiple types of pension schemes you can invest in. We recommend you take the time to learn what your options are in order to make the best use of potential retirement income. A good place to start is to speak with your employer. Auto-enrolment rules require most employers to offer something by the end of 2018. You need to know what that offering is and whether or not you qualify for participation under auto-enrolment. If not, consider one of the other types of pension schemes. A stakeholder pension or SIPP might be just what you're looking for.

Are you already participating in and occupational or personal pension scheme? If so, you are on the right track. Now you need to pay attention to your scheme to make sure it is performing up to expectations. Any pension that is not doing well is one you do not have to stick with. You can always transfer to one the other types of pension scheme you qualify for. As always, a certified financial advisor can provide the guidance you need to create and maintain a sound financial plan for retirement. Take advantage of that advice, for your own good and for that of your family.

One last pension we have not mentioned is the second state pension. We did not include it in our list because it is being phased out as of April 2016. If you have previously contributed to it, such contributions will be reflected in your state pension payments when you retire.

 

As you can see, there are multiple types of pension schemes you can invest in. We recommend you take the time to learn what your options are in order to make the best use of potential retirement income. A good place to start is to speak with your employer. Auto-enrolment rules require most employers to offer something by the end of 2018. You need to know what that offering is and whether or not you qualify for participation under auto-enrolment. If not, consider one of the other types of pension schemes. A stakeholder pension or SIPP might be just what you're looking for.

 

Are you already participating in and occupational or personal pension scheme? If so, you are on the right track. Now you need to pay attention to your scheme to make sure it is performing up to expectations. Any pension that is not doing well is one you do not have to stick with. You can always transfer to one the other types of pension scheme you qualify for. As always, a certified financial advisor can provide the guidance you need to create and maintain a sound financial plan for retirement. Take advantage of that advice, for your own good and for that of your family.

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