Do you know your annuities from your elbow?
If you don’t, you’re not alone. Pensions jargon can be seriously off-putting for anyone trying to get to grips with their options both before and after retirement.
Here, we unravel some of the most common pension terms you’re likely to come across.
This is the maximum amount that you can pay into your pension each year before you have to pay tax. The current Annual Allowance is £40,000, or 100% of your earnings – whichever is lower.
Your Annual Allowance may reduce in certain circumstances, for example if you earn over £110,000 a year, or if your income plus any pension contributions, totals £150,000 or more.
An annuity provides you with a guaranteed income in retirement. You hand over some or all of your pension to an insurance company, and in return they agree to pay you a set amount each year. This can be either for a specified period, or for the rest of your life.
You don’t have to go for the annuity offered to you by your pension provider – in fact you should always shop around so that you can be certain you’ve got the best possible deal, as the rates you’re offered by different annuity providers can vary widely.
In 2012, the government introduced auto-enrolment, a process by which employees are automatically enrolled into their company pension scheme once they start work, with the aim of encouraging more people to save for retirement.
Under current rules, enrolment is automatic for anyone aged 22 or over earning a minimum of £10,000 from a single job. Whilst it’s not usually recommended outside of exceptional circumstances, you can choose to opt out if you want to.
Defined contribution pension
A defined contribution pension is a type of pension where the money you pay into your pension – plus any contributions your employer makes if you belong to a company scheme – is invested, usually into stocks and shares. The value of your pension can move up or down in line with how these investments perform. Some pension providers automatically move your money into less risky investments, such as bonds or cash, the nearer you get to retirement.
The amount you get when you retire will depend on how much you paid in, how your investments have performed, and how you decide to take an income from your pension. Defined contribution pensions are also called ‘money purchase’ pensions.
Defined benefit pension
A defined benefit pension is a type of company pension that promises to pay out a guaranteed income when you retire. These pensions are often known as ‘final salary’ schemes.
If you have this kind of pension, a special formula is used to calculate your retirement income, which is based on a proportion of your final year’s pay, multiplied by the number of years you’ve belonged to the scheme. You’ll normally have been given a booklet when you first joined the scheme giving you details of how much you’re likely to get when you retire. If you’ve lost track of this, ask your pension administrator how your plan works and how much you’re likely to receive.
Drawdown, often known as ‘flexible drawdown’ or ‘flexi-access drawdown’, is a way of taking an income from your pension in retirement. Instead of purchasing a guaranteed income through an annuity, you simply continue to manage your pension as if it was an investment pot and withdraw sums of money as an income when you need to.
Final salary pension
This is essentially another name for a defined benefit pension – see above.
Flexi-access drawdown allows you draw as much or as little income from your retirement savings as you want. You can leave the rest of your pension pot invested.
Guaranteed annuity rate
Some older defined contribution or money purchase pension policies, usually those sold before the late 1980s or early 1990s, promised to pay a ‘guaranteed annuity rate’ at retirement. This means they must provide you with an income at a set rate for the remainder of your life. If you’re not sure whether your pension has a guaranteed annuity rate, check with your pension provider.
When you use your pension pot to buy an annuity, you’re essentially buying a guaranteed regular income. An index-linked annuity ensures that this income will increase in line with living costs.
If you have a medical condition, such as heart disease or diabetes, or you’re a smoker, you may be eligible for an impaired annuity. Also sometimes known as an ‘enhanced’ annuity, this entitles you to a higher level of income because your life expectancy is considered to be lower than someone without any medical issues.
Joint lives annuity
This is a type of annuity which will provide you with an income until you die, at which point a percentage of this income is then paid to your spouse or another chosen beneficiary who will continue to receive these payments until they die.
The Lifetime Allowance is the maximum you can hold in your pensions without having to pay extra tax when you take money out of them. It’s not a small amount of tax either – any amount above the allownce that you take as a lump sum is taxed at a hefty 55%. In the 2019-20 tax year the Lifetime Allowance is £1.055m and is set to rise in line with inflation every year.
Money Purchase Annual Allowance
The Money Purchase Annual Allowance replaces the standard Annual Allowance once you’ve started drawing an income from your pension. It isn’t triggered if you take your 25% lump sum and no income.. Once it kicks in, it means that the amount you can pay into your pension each year to top it up, reduces to £4,000 or 100% of your earnings, whichever is lower.
Money purchase pensions
These are essentially the same as a defined contribution pension – see above.
Normal retirement age
Although the minimum age you can access your retirement savings is 55, most workplace pensions set a normal retirement age when you’re expected to take your pension, typically 60 or 65. If you have a personal pension, you can choose your retirement date.
This is a free government service designed to give you guidance on your pension options when you reach retirement. The service can’t make specific recommendations, so if you think you’re going to need more help, you should seek professional independent financial advice.
State pension age
This is the age at which you can start claiming your state pension. It is worked out based on your date of birth and you can find out your state pension age on the Government website here.
The state pension is a weekly payment that the government makes once you reach state pension age. The amount you get depends on your age and your national insurance contributions record. The current full State Pension in the 2019/20 tax year is £168.60 a week, but to get this you’ll need to have at least 35 qualifying years of national insurance contributions. You’ll usually need at least 10 qualifying years of contributions to get any state pension. Learn more about the state pension and whether you’re eligible on the Government website here.
Tax-free lump sum
You can take up to 25% of your pension as a tax-free lump sum from the age of 55. Remember though, that taking a lump sum will reduce the amount of income you can get from the rest of your retirement savings.
Tax relief essentially means you get money back from the taxman on your pension contributions which can make it a very cost-effective way of saving for retirement, provided you stay within the annual limits. If you’re a basic rate taxpayer, a £100 contribution into your pension will only cost you £80. If you’re a higher or additional rate taxpayer the same contribution will set you back only £60 or £55 respectively.
This is a pension pot which you haven’t yet taken any money out of.
Uncrystallised funds pension lump sum
If you leave your retirement savings in your pension fund and only take out lump sums when you need to, you’re said to be taking ‘uncrystallised funds pension lump sums’ (UFPLS) from it. Your pension pot is only considered to be ‘crystallised’ once you’ve started taking an income from it. Every time you take a lump sum, the first 25% is tax-free and the rest is taxed as income. If you take lump sums in this way, the maximum amount you can pay into your pension each year and receive tax relief on is £4,000. You can’t take a UFPLS from a defined benefit or final salary pension.