All you need to know about pensions
Pensions are some of the least well-understood financial products in the UK.
Most people understand how current accounts, credit cards or loans work. A smaller audience understands the intricacies of mortgages or stock trading.
Pensions, on the other hand, remain a mystery to most.
Part of this is due to the complicated nature of the products and part is an Ostrich mindset towards retirement. Who wants to think about a time generally associated with a decline of physical independence and cognitive function?
“I grabbed a pile of dust, and holding it up, foolishly asked for as many birthdays as the grains of dust.
– Ovid, Metamorphoses
I forgot to ask that they be years of youth. ”
Pensions as a product – as simply as possible
Pensions in the UK can at the highest level be split into two – the State Pension and private pensions.
State Pension
The State Pension provides bare bones retirement income, which is paid into by National Insurance contributions over the course of a person’s working life. As of 2022, this equates to around £9k a year from a full working life of contributions. This is not going to be adequate to fund even a meagre lifestyle.
The government offers extra money for those on very low income, known as Pension Credit. This can also help you become eligible for things like housing benefit, a free TV license, heating costs and so on. It’s truly sad to think about, but this is the reality for some.
Due to an ageing population, the State Pension as we know it may not be around by the time some of the current workforce reach their 60s.
When people were expected to live another 10 years or less at the age of 65, which was the case in the UK from 1946 to 1990, it was financially viable to let them retire and enjoy a life of leisure. Life expectancies in 2020 for those aged 65 was another 19.7 years for males and 22 years for females, which is projected to increase to 21.9 years for males and 24.1 years for females by 2045. That’s a long time for the government to keep giving out money.
An estimated 13.6% of boys and 19.0% of girls born in the UK in 2020 are expected to live past 100 years of age, expected to rise to 20.9% of boys and 27.0% of girls born in 2045.
This topic is often framed positively by pension providers: “Great news, you’re going to see 100!”, then very carefully digging the knife in: “and it means you’ll be working longer!”.
Therefore, it may no longer be possible for the government to offer the same standard of State Pension and it certainly won’t be at the same age.
As of late 2022, the government is being cagey about its commitment to the triple lock, a promise made in 2010 that the State Pension would not increase less than the cost of living. This was temporarily suspended in 2020 and two years on, it’s unclear what will happen to this commitment.
The State Pension Age has already increased to 66 as of 2022 and is going to increase to 68 by 2028. Further increases are inevitable.
Research is even pointing to the fact that people’s ability to stay healthy and fit to work is not increasing in tandem with the State Pension Age. In other words, without careful planning, people run the risk of having to work well past when their bodies are starting to fail.
This is why you really need to save into a private pension, no matter how far away retirement is for you. It’s not particularly exciting, but think in terms of ‘Set It and Forget It’. Small decisions today can make a big difference when you are older.
Private pensions
Private pensions can further be split into two – Occupational (workplace) pensions and personal pensions.
The majority of private pensions are occupational. This is because they are the best way for people to save, thanks to employer contributions.
In 2012, the UK government rolled out legislation called auto enrolment, which is a requirement for employers to provide pensions for its employees and pay towards them.
The only eligibility criteria are that you need to be over 22 years of age and make over £10k a year. If these are satisfied, your employer legally has to set up a pension for you.
Prior to this, it was up to an employer’s discretion to provide employees with a pension, and of course, many didn’t. Why think of the future of those you demand so much of?
The government realised a lot of people were headed for retirement with nowhere near enough money to support themselves and made auto enrolment happen.
There were approximately 44.5m occupational pensions in the UK by mid-2020, which has increased further to 44.8m by Q1 2022.
The sets of columns above show membership types of two types of private pension – defined contribution, which is the type of pension most have today and defined benefit, which is an older type of pension that is no longer offered in the private sector.
Defined contribution pensions use employee and employer contributions to invest in shares and other assets over the employee’s working life. This is the type of pension most employers offer to new employees and is what the rest of this article will focus on.
Defined benefit pensions take an employee’s salary at the end of employment and multiplies it by years in service (and an accrual rate) to pay out a sum at retirement. This is therefore sometimes known as a final salary pension.
Defined benefit pensions are considered to be much better than defined contribution, but they were far too expensive to keep offering in the private sector. Public sector workers, like teachers, are still offered these, but tend to have lower salaries to base the pension off.
Sometimes these pensions will have moved into partially being defined contribution, hence the ‘Hybrid’ mention in the bar chart above. A lot of government advice has been against this, as defined benefit pensions were seen as the Gold Standard of pension.
Most people who still have private sector defined benefit pensions are in their 50s and 60s by 2022 and closing in on retirement. For young people, this type of pension is but a dream.
Mock Boomers all you like – they’re the ones with a pension you can actually retire on.
As such, the amount of people who benefit from understanding more about pensions is significant, but most are very unclear on exactly what they are going to receive in retirement.
This graph, also from the Office of National Statistics (ONS), shows the amount of people in occupational schemes since 2012, when auto enrolment began. Sadly, it has not been updated with data post-2018, but it shows us an important trend.
The three membership types detailed here include active pensions, pensions in payment and preserved pension entitlements – dormant pensions. That is to say, pensions left behind as employees have left the scheme.
You see, when you leave a job with an occupational pension scheme, money remains in the scheme, but no further money is paid in. You can then keep the money where it is or transfer it into another scheme, with the simplest thing being a transfer to your new occupational pension. For most, this is the smartest thing to do. It makes keeping track of funds easier and helps you save on admin fees.
There are certain circumstances where leaving a pension behind is a good idea. This can be if there are additional benefits attached to the pension, such as life insurance, guarantees and bonuses. These will typically be given up in the event of a transfer to a new plan.
However, these are very rarely offered with defined contribution schemes today. It is more likely that the growth in preserved pension entitlements is rooted in ignorance and apathy towards pensions.
According to the Association of British Insurers (ABI), an estimated 1.6m occupational pensions have been lost by employees in the UK as of 2022, with an average size of £13,000. That’s £19.4b of unclaimed pensions.
According to a report from the Pensions Policy Institute (PPI), that number is over £26bn and has risen by almost 75% in the last four years.
In the mid-2010s, Millennials were predicted to have 12 jobs in their lifetime, so that means 12 different pensions. This will in all likelihood increase further for Gen Z and Gen Alpha. Some of those pensions are likely to not have very much in them, as people job-hop every few years, but that makes it even more important to keep tabs on them throughout your working life.
An entire working life’s pension savings spread across 12 different companies that you’ll need to compile when you’re entering old age, probably forgetting dates? It is much better to keep on top of things early.
The number of dormant pensions is projected to increase to 27m by 2035, with the majority of these being private sector. At the start of auto enrolment, the government projected this to be 49.6m by 2050.
More about defined contributions – what I really want you to know and act on
An occupational pension takes your and your employer’s contributions and invests the money in stocks, shares and other financial assets. These typically start off as more volatile when you’re young, because they have more of a chance to grow, then move to more conservative ones once you get closer to retiring, which is known as lifestyling. This gives you a more predictable forecast of what you will be left with once you retire.
Government information also tells you that the taxman contributes 25% to the money you put in, but the reality is that 25% will come off once you start taking money from the pension, so it’s a bit of a zero-sum game.
The real benefit to having a workplace pension over sticking the money in financial instruments yourself is the fund management and the employer contribution. As of 2019, the minimum contribution to an occupational pension is 4% from you and 3% from your employer, but most employers are kind enough to pay more than that. When you are enrolled into a pension scheme, the details of this should be made clear to you as part of the forms you fill in.
This is also something to consider when applying for a new job and reviewing the compensation package. Hopefully your new employer is willing to pay a higher salary, but don’t forget to ask about pension contributions, as this may be less than what you’re currently receiving. You can use the pension contributions calculator by Pension Wise to understand the difference.
This is essentially extra money from your employer above and beyond your salary and often employers will increase their contributions if you increase yours.
My blanket guidance to anyone enrolled into an occupational pension is to contribute as much to your occupational pension as will max out your employer’s contributions. If you take nothing else away from reading this article, please do this. Your future self will thank you for it. You can technically pay more, but there’s likely better ways to spend that money, like living for today.
It may also be tempting to just opt out of your occupational pension, in particular if you have a very tight budget. That’s a terrible choice. While you do make short term gains from not paying into a pension, you’re losing out on the additional employer contribution and the growth of the fund value, with the industry average being 9% a year. I know people who have had to do this, but unless your back is truly against the wall, do not entertain this idea.
If you do opt out, you have to ask for the forms to do so. Your employer cannot do this for you, nor can they suggest it. You have to actively want to opt out, and this has to be done regularly, as you will be re-enrolled every 2 years.
What is a personal pension?
A personal pension is one where you alone make contributions. This isn’t as good as an occupational pension, because of a lack of employer funds.
Some people may need to open one because they either aren’t making enough to be enrolled into an occupational pension, are self-employed or have other circumstances that make it a viable option.
Currently, 79% of the UK workforce has been signed up to an occupational pension, with participation rates lowest amongst those working in hospitality, arts and entertainment.
This means 21% of the UK workforce has no pension set up for them by their employer. This is really not good, even if the age and temporary gig-economy occupation means some have a lot of time, career changes and salary increases between now and reaching State Pension Age.
The latest figures from ONS tell us that 10.4m individuals are signed up to a personal pension. User data is no longer collected the same way, but in 2017, individuals under 35 made up 41% of contributors. The annual average contributions per individual was in 2019 recorded as £2,900.
A personal pension will disproportionately be necessary for those who have multiple jobs to make ends meet, as each job on its own may not pay enough to qualify them for auto-enrolment – cleaners, aestheticians, hairdressers, etc. If this happens to be you or a loved one, please open a personal pension. Also, if self-employed, don’t forget to set up a life insurance policy to cover costs like mortgage payments, should the worst happen.
The total amount of people in the UK who have more than one job is 1.2m out of a total workforce of 32.8m, according to ONS, but this may be as high as 5.2m according to pension provider Royal London.
SIPP – For the big ballers and shot callers
Some affluent and financially savvy people may want to set up a SIPP – a Self-Invested Personal Pension.
These are sort of a DIY pension, where all investments can be controlled, but this does require a level of financial understanding and time spent managing that most people don’t have.
This could be managed by a financial adviser on behalf of the plan holder, which also costs money. For the majority of people, it’s not worth using over a normal occupational or personal pension.
Ok, so when do you get your money?
When you turn 55, you can start accessing the funds in your private pension, which is set to increase to 57 in 2028 and – you guessed it! – is likely to keep increasing. Most people don’t do this and instead wait until they reach the State Pension Age. That way, they can stop working and access both pensions at the same time.
Once you are ready to retire, you can access your private pension in a few ways:
Annuity
An annuity used to be the only way you could access your pension, prior to the Pension Freedoms Act of 2015. Effectively your pension is turned into a salary and paid to you every month, based on the size of your total pension savings. This is paid in until you pass.
For public sector defined benefit schemes, this is how your pension is paid out, with many offering an additional tax-free lump sum at the beginning.
If you suffer health problems, such as diabetes, cancer or kidney failure, you may be eligible for an Enhanced Annuity, meaning you’ll get higher payments for a shorter period of time, based on your shorter life expectancy.
Drawdown
If you want to access your pension pot as and when you need to, this is known as drawdown.
You can take up to 25% of your pension tax-free, after which your withdrawals will be taxed.
This can be a little bit messy and means staying on top of what you have left and understanding the tax implications of each drawdown. For some, this is flexible, for others, it’s a headache compared to an annuity.
Taking it all in cash
This is generally a really bad option, but you can take your pension all in cash. This will be taxed and could push you into a higher income tax bracket for the year you do so, after which you would need to rely on the State Pension and other streams of income.
There are only a few very special sets of circumstance where this could be advantageous, such as if you have very little in a private pension and you could pay off the rest of your mortgage with it, but even this needs to be considered carefully. If it’s your only private pension, you’re now left with only the State Pension to provide you with an income. So, for financial liquidity, you may not actually benefit from doing this.
A mix of all three
You can also choose a mixture of all of these, such as taking 25% in cash tax free, taking another taxed sum later, then using the rest for an annuity and/or a smaller drawdown pot. It really depends on your circumstances and how much you have saved.
How much do you need?
The Retirement Living Standards, based on independent research by Loughborough University, have been developed to give people an idea of the type of lifestyle their income might give them. The three brackets of lifestyle are named Minimum, Moderate and Comfortable.
Please note that these standards are based on living mortgage and rent free, which has thus far been a possibility for people who are ready to retire. As this is increasingly not an option for people working today, payments towards these would need to be added on top of that.
To better understand how likely you are to be able to fit into any of these brackets, the pension calculator from Pension Wise is a great place to start.
What happens to the pension when you die?
if you die before age 75, your entire pension (or what remains of it, if you’ve started accessing the funds) can be paid to your beneficiaries tax-free. They can choose to receive it as an annuity, a lump sum or a beneficiary drawdown.
If you die after turning 75, your pension can be paid to your beneficiaries in the same way, but will be subject to income tax at their marginal rate. Please note that, if you chose an annuity with a guarantee period of payment, this may impact what is left.
There will normally be no inheritance tax to pay.
For this reason, make sure you’ve nominated beneficiaries with your occupational scheme. The last thing you want to put your loved ones through when you pass on is the need to wrestle money out of unhelpful pension provider staff using ancient IT systems. You should be able to access the forms to do this from your occupational pension provider directly. Choose wisely and make sure you update these as your personal circumstances change.
And that’s all you need to know
That is a whistlestop tour of pensions in the UK. I have purposefully left out some details, like Group Personal Pensions, Stakeholder Pensions and Master Trusts, but this is a fairly accurate view of pension for most.
If you want to learn about pensions SEO in the UK, I have written a companion article to this one that covers just that.
My final point will be to remind you to live your life intentionally.
So much of the programming in the West tells you to work hard, even if you don’t like your job, because that’s what people do and then you can retire and be happy. I think the facts presented in this article have shown you that this delayed happiness fantasy isn’t real for a lot of people.
70% of people I meet work jobs they are ambivalent towards that don’t pay a fair wage and spare no thought for the time when they are no longer able to work. I want to shake them and let them know that the consequences of not changing are dire, both now and in future.
Politicians, employers and other institutions aren’t looking out for you. Vote for them, pay taxes and put the hours in. That’s all they care about. You have to be in charge of where you go next.
We can’t all be Bezos or Musk, but the pursuit of a working life that fulfils you creatively, spiritually or financially – hopefully all three – is very important. The path forward may not be clear, nor simple to you right now, but keep striving, keep seeking and do not yield.
All the while, do not forget to pay into a private pension. As I told you at the beginning of this article – Set it and Forget it. Your future self will thank you.
Thanks for reading and I’ll catch you in the next one.