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Pensions Glossary

Penfold
Wednesday 26th June, 2019

We know pensions can seem complex and confusing, and we’re determined to try and make them a bit easier for everyone to understand.

We chat to people about pensions all day, so we hope we’ve covered most things you want to know, but if there is something we’ve missed or something we’ve explained badly, please let us know via email at hello@getpenfold.com, or by using our online chat service to talk to the team.

Annuity

An annuity is where you hand over all your money to an insurance company, and in return they agree to give you a fixed income for the remainder of your life.

For example, say you gave them £100,000 (AKA 'buying an £100k annuity'), they might agree to give you £5,000 a year until you die. If you live for 10 years, they will have given you £50,000 - meaning they make money. If you live for 30 years, they will have given you £150,000, so depending on how well they invested the original £100k, the insurance company might lose out overall.

The benefit of an annuity is you can plan ahead and know exactly what your income will be each year, and they often link to inflation in some way. But the drawback is that the money is gone when you die – you can’t usually pass it on. Also, annuity ‘rates’ vary, so what the insurance company agrees to pay you each year might not be very much.

Auto-enrolment

This is the concept of automatically being signed up to a pension scheme through your workplace. The government now requires all employers to sign their staff up to a pension scheme and if employees don’t want to take part, they have to actively ‘opt-out’. If they don’t opt out, they’ll pay at least 5% of their salary into a pension scheme, and their employer will pay at least 3%.

Opting out usually means turning down contributions from an employer (at least 3% of annual salary).

Bonds (AKA 'fixed income')

Bonds are a way of investing to get a ‘fixed-income’. Think of it like a loan with interest attached; you pay a certain price for a bond (i.e. lend someone money), and each year you’re guaranteed a certain payment in return (i.e. the interest).

You can sell the bond (i.e. the amount you have lent and the right to receive interest) for the price you paid for it, or potentially for a higher/lower price depending on what others are willing to pay it.

Bonds can be issued by governments or by companies, meaning you are lending them money. The amount you get paid all depends on how likely they are to pay you back in full – and governments are almost certainly going to pay you back. Usually they are much safer (so lower risk) than equities (see below), but the payments they return are lower. Most pension plans are made up of a mix of equities, bonds and other investments.

Compound interest

This is a complicated concept, but incredibly important. Imagine you invite a friend to a party, and they invite two friends, and they invite two friends, and so on, and so on. Pretty soon 300 people are trashing your front room.

This is called “compounding”, and Einstein called it the most powerful force in the universe! This is what should happen to your money over a long time if you leave it in a pension, and it’s an incredibly powerful tool when saving for the future. Basically, when your money is in a pension it works for you by generating money from investments. If it makes money one year, there is more money the next year to make even more investments, and so on, and so on.

The main thing to understand about compound interest is the younger & sooner you start saving, the more you are likely to get over your lifetime. For example if you put £100 in your pension at age 40 and take it out at 60, it might have ‘compounded’ to be worth £265. But if you put it in age 20 it might be worth £704!*

*This is an illustrative example assuming an assumed annual growth rate of 5%. Compound interest is not guaranteed, but is a reasonable estimate of the effect of compound investment returns on the amount you put aside in a pension over a long period of time, using a widely used growth assumption.

Contributions

In reference to saving into a pension, contributions represents the amount of money you save or ‘contribute’ to a pension pot. This term can be used to describe one-off, monthly, annual or lifetime contributions into a pension, and it's important to remember that how much you contribute has a direct link to how much you will have to live on when you stop working. As a general rule of thumb, contributing as much as possible, as early as possible is likely to equate to a more valuable pension over time. This is because of the concept of compound interest, as illustrated above.

Defined benefit pension / defined contribution pension

A defined benefit pension is a type of pension used in the public sector. The employer pays for the scheme, so no matter what the employee pays in, they’ll get paid a set amount each year after retirement, depending on how much they earned and how long they worked there – i.e the benefit is what defines this pension. As people started living longer, these got very expensive, and so are much rarer now.

Most pensions available to people today (outside of the public sector) are defined contribution pensions, where the amount received in retirement is based on how much has been contributed over time, and how the investments in the pension performed.

Employer contributions

This is the money that an employer might pay into an employee's pension. This applies to most people who are paid a traditional salary (i.e aren’t self employed). Employers usually only make a contribution if employees also agree to make one.

Usually these contributions appear on payslips as ‘Employer/E’er pension contribution’ & ‘Employee/E’ee pension contribution’. Employers usually hold both of these contributions back from what they pay into your bank account each month, and pay them directly to a pension provider.

Equities

Equities are a very common way of investing that involves buying shares in a company and sharing in that company’s profit (owning a piece of the company, basically). As companies make more (or less) profit over time, other people might want to buy the shares from you, so you also make money if you sell those shares for more than you bought them for.

Historically, investing in equities has meant your money grew much more over the long-term than investing in other ways, although there can be ups and downs along the way. Most pension plans are made up of a mix of equities, bonds and other investments.

Investing

Investing just means doing something with your money with the hope that it will make you more money. This usually means buying something (an 'asset') that may give you an income, or you can sell the asset for a higher price (or both).

Investing can be done in lots of different ways, like lending it to someone and charging them interest, buying a house and charging rent/selling it for a higher price, or buying shares in a company and sharing in their profit or selling the shares for a higher price.

Personal pension

This means a pension that you arrange yourself. The amount you get at retirement is based on how much you have paid in over many years, which is also known as a defined contribution pension (explained above).

Confusingly, a few employers offer personal pensions as workplace pensions. This usually means people may get more choice in where their money is invested. Penfold is a type of personal pension called a SIPP, and we are working on a version that employers can pay into.

If you work in the NHS or for a Local Authority you’re likely to have a public sector pension which is not a personal pension.

Private pension

This just means anything that isn’t a state pension. This can be workplace pension or a personal pension.

Risk

All investing involves what is called ‘risk’, which is the chance you can lose money. Some investments are safer (less risky) than others. Generally speaking, the higher the risk, the more money you can potentially earn, but there is a greater chance of making a loss.

But risk is a good thing - it’s what lets you earn money on your investments and build up compound interest over a long time. Sensible investing is all about managing this risk so that you are making a good ‘return’ on your investment, but limiting the chance of losing money overall.

SIPP

This stands for ‘Self Invested Personal Pension’ and is the type of pension we provide at Penfold. A SIPP allows for much more flexible investing and gives you the most control over where your money is invested.

State pension

This is the money the government currently gives each year to people over 'state pension age' (which is currently age 66, but set to rise to 68, and quite likely to rise again after that). It is currently about £8,750 a year.

To get the full amount you need to have paid national insurance contributions for at least 35 years, otherwise you will receive less than this. Each year the amount of the state pension does increase a bit, but this is to keep up with increases in living costs (AKA inflation).

Don’t confuse the state pension with auto-enrolment, workplace or private pensions (all explained above). The state pension is totally separate to other pensions and isn’t linked to any other contributions.

Tax relief (AKA ‘government top up’)

This is the money the government (HMRC) will put into your pension to encourage and incentivise you to contribute more. It can be called 'tax relief' as it is not really the government's money they are handing out, they are essentially giving some of your tax back.

For example, if you are a ‘basic rate tax payer’ (you earn less than £50,000), you’ll being paying 20% of anything you earn above £12,500 straight to the taxman. In that case, say one month you earn £1,000 – you pay 20% tax (£200), so are left with £800. If you then put that £800 into a pension, you’d get the £200 back as tax relief from the government (straight into your pension pot).

There is a minimum amount everyone is entitled to, no matter what they earn. If you earn less than £12,500, you can pay in £2,880 into a pension and get £720 added by the government. However, you generally can’t get more tax added back than you actually paid on your earnings. So if you won £8,000 on a scratch card and put it all in a pension, you wouldn’t get £2,000 in tax relief unless you had actually paid £2,000 in tax that year.

There's also a maximum limit on tax relief in any one year. If you managed to save £40,000 into a pension in one year (including the government top-up), you wouldn't get any tax relief on further contributions beyond that £40,000.

Workplace Pension

This is a catch-all word for a pension that is provided by a workplace employer. It usually means an employer pays into the pension, but people don’t tend to have much choice in the pension provider.

Now you're up to speed on the terms that people use when talking about pensions, take a look at our Big Pensions FAQ here.

We explain more about who we are and what we do in The Penfold Pension Explained.

Create an account with us today and start saving for your future.

With pensions, as with all investments, your capital is at risk and the value of your pension with Penfold may go up as well as down. You may get back less than you put in.

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