How Personal Pensions work

If you are considering setting up a personal or stakeholder pension you will want to know the basic principles as well as implications for your tax, and to begin to work out how much you should be investing. The aim of a personal pension is as simple as investing in a savings account with the purpose of adding to the value of your money. When you retire this fund can then be taken as a regular - usually monthly - income to compensate for your loss of salary.

How to make payments in
Investing in a pension is generally done through either:

  • Regular instalments
    • These are usually made by monthly direct debit. This helps with budgeting as, once the direct debit is set up, you'll soon become used to the discipline of regular debits straight from your account.
  • Single premium payments
    • There are advantages for some people, especially if you're self-employed, in investing one-off contributions when it's convenient to them instead of fixed monthly payments. It can also benefit higher rate tax payers who can claim tax relief at the highest rate on the contribution amount. However, it is on down to you to make sure that the necessary payments are made and pension providers will usually have minimum contribution amounts on lump sums.
You can of course do both. This means you'll have the advantages of committing to automatic, regular payments but can make one-off contributions when you are able to. These lump sum payments also mean you can maximise the tax relief available.

What are the tax implications?

Tax relief
The Government will give you tax relief on your pension contributions at 20 per cent for the basic rate and 40 per cent for higher rate tax payers, going up to 45 per cent for the additional rate. This means that if you're paying into a personal pension or stakeholder plan, for every £80 you put in, £96 goes into your pension pot to be invested. Your pension provider will add the remaining £20 and claim this back from the tax office.

If you pay higher rate tax, you will get the 20 per cent automatically in the same way, but will have to claim back the extra 20 per cent, or 25 per cent at the additional rate, from the tax office yourself through a tax return self-assessment.

If you're self-employed the process for claiming back tax relief is more complicated as it takes into account not only what you've already paid but also makes assumptions about future payments.

You will need to take particular caution when making large single premium payments or if you decided to stop regular payments.

Do remember that the way tax relief is managed depends on your own circumstances and is subject to change.

Tax relief restrictions
You can receive tax relief on contributions to your pension as long as they don't go over the maximum yearly annual allowance, which was set at £40,000 for 2017/18. This figure includes both employee and employer contributions. You can carry forward any annual allowance not used in the previous three tax years.

If you aren't working or don't earn enough to pay income tax, you can still invest up to £3,600 gross per year in a personal pension and claim 20 per cent tax relief. You can also pay this amount into a personal pension belonging to someone else who isn't paying tax. They then claim the 20 per cent tax relief. This can be of benefit to non-working partners, as well as children or grandchildren as part of inheritance tax arrangements.

Investments
You will need to choose which type of fund to invest in. Pension providers will have a large range to choose from - sometimes hundreds - but they largely fall into one of two types:

  • Unit linked funds
    • This is a fund which pools money from a number of people which is then invested in a range of schemes, such as stocks and shares, and looked after by a fund manager. The advantage is that you can spread your money across a wide range of investments under professional management. However, the value of the fund varies according to the investments so if there is a fall in the market the unit price also goes down. This can a positive though for long-term investors who can buy more units at the lower price and make a profit in the event that the market recovers. But for anyone about to retire a fall in the market is not such good news. Those getting close to retirement often transfer their money into more stable funds to avoid this happening. Either way, be aware that unit value can go down as well as up, and you may not get back all your investment.
  • With profit funds
    • With profit funds are lower risk than unit linked investments. They are managed in such a way that the highs and lows of the market are smoothed out. The fund manager will invest in assets like stocks and shares but will keep some of the fund profit in reserve so that investments grow more smoothly.

    When you cash your pension a market value adjustment could apply and the policy's value will depend on how much profit is made by the fund makes and how it's distributed.

    Projections

    Growth assumptions
    When predicting pension fund values the most accurate, and usual, method of predicting how a pension will grow is to base it on current increases in value and inflation rates. For example, if inflation has been at 2% and a pension has grown by 4.5% the growth assumption will be the difference of the two, which is 2.5%

    Pension providers still make assumptions about what the future pension growth rates are, however. The current growth assumptions are currently 0.5%, 2.4% and 5.5% for low, medium and high growth respectively. But the real growth against inflation rate calculation is now the norm.

    Pension options
    Pensions freedom legislation passed in 2015 means you now have a range of new options when it comes to how you take your pension. You can find more details in your retirement options and pensions freedom .

    How much should I invest in a pension?
    The amount you invest in a pension is highly dependent on your individual circumstances. This includes not only your salary but takes into account all your financial commitments and your family circumstances. Put in as much as you can comfortably afford and start as soon as possible, being sure not to overstretch yourself. Remember that this monthly commitment is meant to be maintained over the long term.

    When you've calculated the right investment amount you can then continue to invest it as a percentage of how much you earn over future years. For example, if you've fixed on a contribution of £125 a month and your salary is £25,000, continue to pay 5% of whatever your salary is at any given time.

    You can also look at what income you would like to retire on, and when you want to retire and calculate back to how much you'd need to invest to accomplish that goal. Make sure however to reassess this calculation regularly to reflect market conditions, how your investments are doing and any changes in your ambitions.

    What about the state pension?
    Even if you have a personal pension, whether through your employer or one you've set up yourself, you can still get a state pension.

    The state pension under new rules applies to those who reach retirement age on or after 6 April 2016. You can claim this payment from the Government, which for the 2017/18 tax year is £159.55 a week, if you're eligible and you're:

    • a man born on or after 6 April 1951
    • a woman born on or after 6 April 1953
    How much you're entitled to, and whether you can get additional state pension, will depend on your National Insurance contributions. You normally need to have paid National Insurance for 10 years (not in a row) to get any new state pension. And, you may need around 35 years to qualify for the full State Pension.

    If you reached state pension age before 6 April 2016, you'll get be eligible for the state pension under the previous rules. What about other savings? You may want to look at other forms of savings as part of your provision for retirement. You don't need to necessarily focus solely on personal pensions but they should be a key element of your overall retirement planning.

    Summary
    When thinking about setting up a pension the key questions you need to consider are:

    • Will the amount you want to invest leave you enough to live on comfortably now?
    • Would you prefer the monthly commitment of regular premiums of one off payments, or both?
    • How much income, in addition to your state pension, would you need to live on in today's money?
    • How much would you need save now to reach that goal and how does that break down over the years you have left?
    Please keep in mind that a pension is a long-term investment and the value can go down as well as up. Your final income will be determined by the size of the fund, interest rates and tax legislation.

    Related Articles

    Income Drawdown | Pensions & Divorce | The value of retirement planning | What is a Personal Pension? | Your Retirement Options and Pensions Freedom

    This article (How Personal Pensions work) is intended to provide a general appreciation of the topic and it is not advice. For more information please contact Nurture Financial Planning Ltd on 01603 673502 or email ask@nurturefp.co.uk and we will be happy to assist you. Article expiry: 05 Apr 2018