Understanding Pensions
Understanding Pension Types
Pension provision in the UK is made up of the State Pension and ‘private’ provision by an individual and/or an employer.
‘Private’ pensions can be classed as either a Defined Benefit (also known as Final Salary), or Defined Contribution (also known as Money Purchase).
We believe that before you can make decisions about a possible divorce settlement it is important to have background understanding of the different types of pension arrangements.
What follows is a ‘guide’ and does not cover all eventualities and should not be considered as financial advice.
Defined Benefit
A defined benefit scheme provides a secure income for lifetime. The amount of benefit is based upon an accrual rate, how many years of service with the employer and the salary earned.
They are often referred to as Final Salary schemes.
They are usually provided to employees of large employers or in the public sector such as the NHS and Police.
No, unlike defined contribution arrangements the benefits are not linked to how much you pay.
Individuals may be required to contribute to such schemes with contributions between 2% and 5% being most common, however the employer contributes significantly more as they have a responsibility for ensuring that there is enough money at the time an individual retires to pay their pension income.
The pension is based upon an accrual rate which is the rate at which the pension builds as a fraction of the earnings that are taken into account for each year of pensionable service, (the most common accrual rates are 1/60th or 1/80th).
Example
Mitchell’s employers pension scheme provides 1/60th of salary for each year of service.
Mitchell retires at age 65 after 20 years of service on a salary of £30,000.
The pension is calculated as
20 (years) multiplied by £30,000 (salary) divided by 60 (accrual rate) = £10,000
Defined benefit schemes usually have a normal retirement age when the benefits would become payable. This is usually between age 60 and 65, but increasingly it is becoming the individual’s state pension age.
The income payable is known as a ‘Scheme Pension’
This depends on the scheme rules – some do not allow early retirement whilst others may allow you to take pension from after age 55, but if so the pension payable is usually reduced to take account of early payment, with the reduction commonly between 3% – 6% for each year you go early.
It may be possible to take benefits without retiring.
Once your pension starts it will be payable for lifetime, and will usually increase each year that it is in payment.
In the event of the failure of the sponsoring employer there is a Pension Protection Fund that provides compensation.
If you were to die a pension may continue to be paid to a spouse, civil partner of a dependents.
There may also be a lump sum payable but this usually the balance of the first 5 years of retirement income if death occurs within this period.
Some schemes provide a tax-free cash in addition to a pension – particularly in the public sector.
Other schemes allow a portion of the pension (usually up to 25%) to be exchanged for a tax-free cash sum. For example, £1 of pension given up provides a tax-free cash sum of £12. This is called commutation.
The scheme will have a scheme booklet which is the member’s guide to the operation of the scheme and should be able to provide answers to a lot of questions about the scheme.
The scheme is usually governed by the Scheme Trust Deed and Rules. These are lengthy legal documents and would not normally be referred to by scheme members except in the event of a dispute.
You should be out to obtain a member’s statement that will show the benefits you personally have accrued to date.
If you cannot find the details of an old defined benefit scheme you can use the Pension Tracing Service www.gov.uk/find-lost-pension to help locate who is now responsible for the administration of the scheme.
Because of changes in legislation over several decades, the benefits payable under defined benefit arrangements can be quite complex with different benefits payable for different periods of service. What we have shown above is a very simplistic outline. In the event of getting divorced it is necessary to obtain a lot of detailed information on a specific scheme(s).
You may require the services of a shadow expert to help structure the questions to be answered within an expert witness report.
The cash equivalent value from a defined benefit scheme on divorce is unlikely to reflect a ‘fair value’ of the cost of providing an alternative pension income by way of an annuity or for offsetting purposes.
Therefore, if the cash equivalent is £200,000 in the family home is also worth £200,000 then one person keeping the house and the other keeping their pension is unlikely to be ‘fair’!
The availability of defined benefits to either party is likely to require the preparation of a pensions report.
Defined Contribution
Defined contribution schemes build up a pension fund tax efficiently using contributions from either the employer and / or the individual plus investment growth and tax relief to provide an income for lifetime and or cash lump sum(s) – part of which may be tax-free.
They are often referred to as ‘money purchase’ arrangements.
There are many types of products that are considered as a defined contribution arrangement and these include
Personal Pensions
Stakeholder pension
Retirement Annuity contracts
Section 32 Buyout Plan (S32)
Additional Voluntary Contributions (AVC)
Free Standing AVCs (FSAVC)
Executive pension plan (EPP)
Group Personal Plan (GPP)
Self Invested Personal Pension (SIPP)
Small Self-Administered Scheme (SSAS)
The amount of benefit on retirement depends on a number of factors
The size of your pension pot which depends on how long you save for, how much you and/or your employer pay into your fund and how well your investments grow
The choices you make when you retire on the type of income you want and how often it is paid
How much you take a tax-free cash sum
Annuity rates at the time you retire, if applicable
What charges are taken out of your pension fund by your pension provider
The following contributions can be made to a personal pension
You and/or your employer can make monthly or yearly contributions.
You can make single contributions any time.
If you are to receive a pension sharing order then the pension credit benefit is most likely to have to be transferred to a personal pension if shadow membership is not an option.
If you have another pension plan you may wish to transfer into a new arrangement, but we would recommend that you take independent financial advice before proceeding with this.
Contributions are invested in a variety of funds to take account of your personal circumstances and requirements.
These depend on how long the monies will be invested for, the amount of investment risk you are prepared to take and your capacity for financial loss.
These should be regularly reviewed, and it is recommended that an IFA is consulted.
If the pension arrangements is an employer-sponsored scheme, such as a workplace pension, then it is probably a default fund unless you make a personal selection.
You can generally access and use your pension fund from age 55.
No, you don’t need to give up working to take your retirement benefits, but you may wish to carefully consider the income tax that may be payable.
You can continue to contribute to a pension plan once you start income release, however you may be subject to the Money Purchase Annual Allowance which restricts the amount that will receive tax relief to £4,000 per annum.
You will normally be able access to your retirement savings any time after age 55.
The options available include
Take your whole pension pot as a lump sum in one go. A quarter (25%) is available tax-free and the balance will be subject income tax and taxed in the usual way. Remember that a large lump sum could tip you into a higher income tax bracket for the year
Take lump sums as and when you need them. A quarter of each lump sum is tax free and the balance will be subject to income tax and taxed in the usual way. Remember that a large lump sum could tip you into a higher income tax bracket for the year
Take a quarter of your pension pot (or of the amount you allocate for drawdown) as a tax-free cash sum and then use the rest to provide a regular taxable income taken from the remaining fund that stays invested.
Take a quarter of your pension pot as a tax-free lump sum and then convert some of the rest of it into a taxable retirement income by way of an annuity
An annuity is a financial product that provides you with an income for the rest of your life using the proceeds of a defined contribution pension scheme.
If you are member of a defined contribution pension scheme the product will provide you with a ‘lifetime annuity’.
In planning it is important to consider how long a pension will be payable.
Most people underestimate their anticipated life expectancy.
If you believe your life expectancy will be 84, then in fact you have as much probability to survive to age 97!
Lifetime annuity can only be purchased with the proceeds of a defined contribution pension scheme
The amount of your annuity will depend on a number of things, for example
The amount of your pension fund used to buy your annuity
Your residential postcode
Whether you smoke
Whether you have certain health conditions
Your age when you buy the annuity
The pension options you choose
How often the pension is paid
Annuity rates when you take your pension
Alternatively, some individuals when they start taking benefits don’t, for a variety of reasons, want to commit immediately to an annuity therefore you may have the option of income release, or income drawdown as it is sometimes known.
Once an annuity has been purchase it cannot be changed. You will have various options to choose from and careful consideration is important before making a final decision.
You have several options you can choose from – each option has an effect on the actual income payable. The options include
Frequency
You can choose how regularly you wish to receive your pension payments to be. This is normally monthly but less frequently may be an option.
Increase in payment
You can choose to have your pension stay the same year after year or increase automatically each year by a fixed percentage or increase (and decrease) in line with the Retail Prices Index
Death benefits
You can choose to have a pension payable to your spouse or civil partner and/or dependents when you die in return for a small pension for yourself from outset.
You could include a guaranteed period which means that you if you die during that period the pension will continue to continue to be paid to your spouse or civil partner of a dependents or to your estate until the end of the guarantee period.
However, once you start to take your lifetime annuity pension you cannot cash it in, change it to another provider or temporarily stop receiving payments.
Income release allows benefits to be taken directly from the pension fund, whilst the remainder of the fund is still invested for your future benefit.
No, you do not need to use your entire plan for income release, you decide how much to use, based on your own income requirements.
You can use your retirement savings to receive benefits in a number of ways such as
Regular tax-free cash payments within limits
Lump sum tax-free cash payments within limits
Regular taxable income payments
One-off taxable income payments
or a combination of tax-free cash and taxable income payments.
Since April 2015 drawdown has been more flexible and an unlimited amount can be taken anytime, i.e. the whole fund could be encashed if required, however it is important to remember that any income taken above the tax-free cash entitlement, if appropriate, will be taxed at your highest marginal rate of income tax. Prior to this limits on the income applied to ensure that the fund did not run out over your lifetime.
Once you’ve used up all your tax-free savings, any future payments you receive will be treated as taxable income payments.
Regular tax-free cash and combined regular tax-free cash taxable income payments can be stopped or started any point on your plan.
But income release may not be suitable for all parties because if you withdraw too much income there is a risk that you all run out of money and you should seek independent financial advice.
You can use income release at any age after the minimum pension age, which is currently 55, (but this may increase in the future). Also, some pension products do not provide for income release so therefore it may be necessary for you to transfer your pension fund to an alternative provider to take advantage of this flexibility.
Normally the value of your plan is paid as a lump sum or in instalments to the individuals you have nominated as your beneficiaries such as your spouse, civil partner or dependents on your death.
If you die before age 75
The remaining value of your plan will be paid to the individuals you have nominated such as your spouse, civil partner or dependence on your death subject to the pension providers agreement.
The beneficiaries will have 3 options
- leave the fund invested and take an income as they require, which is payable tax-free
- purchase an annuity
- take the remaining fund as a tax-free lump sum
If you die after age 75
If you are using income release the remaining value of your plan will be paid to the individuals you have nominated such as your spouse, civil partner or any dependents on your death subject to the pension providers agreement.
The beneficiaries will again have 3 options
- keeping the fund invested and take an income as they require, which will be taxed as income
- purchase an annuity, which will be taxed as income
- take the remaining value of the plan as a cash lump sum, this will be added to the individual’s taxable income and taxed accordingly
If after choosing to take an income through Income Release you decide you prefer a guaranteed income you can purchase an annuity at any time, but once you have secured an annuity you cannot switch back to income release.
Your pension will be treated as Pay As You Earn (PAYE) income and may be taxable.
HM Revenue and Customs will advise the annuity provider as to how much tax should be deducted from your annuity. This will depend on your individual circumstances.
If you’re a taxpayer, the pension will be paid after the tax has been deducted. You’ll be taxed at the basic, higher or additional rate depending on your personal circumstances.
If you decide to fully encash your pension fund as a one-off payment you should be aware that you will probably initially pay a greater amount of tax.
This is because the pension provider will not hold a valid tax code for you and therefore HM revenue and Customs requires tax to be deducted at an emergency rate.
As result you may need to reclaim tax from HMRC if the pension provider has deducted too much tax, or you may have to pay additional tax if they have not deducted the right amount.
HM Revenue and Customs (HMRC) has a Lifetime Allowance on the total funds in pension plans that an individual can have to be used to provide pension benefits. This is current £1 million.
There are circumstances where an individual may have a personal Lifetime Allowance that is higher, but conditions apply.
If the value of an individual’s pension benefits exceeds the Lifetime Allowance, then any excess is subject to a Lifetime Allowance Charge of 55%.
Any Lifetime Allowance due to HM Revenue and Customs must be deducted from the proceeds of your pension scheme before the annuity purchased.
When benefits are put into payment after 6 April 2006 they must be assessed against the lifetime allowance this is known as crystallisation.
CW Pension Consultants Ltd is not authorised to provide financial advice and the information contained within this website is for information purposes only.
We would be delighted to make a referral to a trusted financial adviser, if required.