How do Pensions work?

Essentially, pensions operate on a very simple principle: you pay money regularly throughout your working life which is invested in pension funds, and when you decide to stop working, you’ll have a pot of money to fund your retirement.

Pension Basics

With a private pension, you receive certain tax benefits within the rules the government set out. To encourage people to save for the future, they offer tax relief on what you pay in, tax efficiency on your savings (as money in your pension pot grows free from UK income tax and capital gains tax) and when you choose to take your pension benefits, you could take up to 25% of your pension pot as tax-free cash lump sum. The law and tax rates may change in the future, and the value of tax relief will depend on your individual circumstances.

Let’s take a quick look at the three main elements that make a pension tick; how you save, how you help your money grow and what happens when you access your pension pot.

Saving into your pension

The money you save into a pension is called a contribution. You can pay in one off lump sums, monthly or annually – or a combination of all three! How much you save, comes down to a number of factors. If you’d like more help on how much you should be saving into your pension, head to our calculator.

Tax relief on contributions

The UK government tops up contributions by applying a 25% tax relief. If you’re classed as a UK taxpayer and fit the eligibility criteria, as a basic rate taxpayer for every £100 you contribute, the government will add £25.

As a higher rate or additional rate taxpayer, you can receive even higher levels of tax relief. If this applies to you, head here to learn more.

Limits 

There are, however, limits to this tax benefit. For the 2020/21 tax year tax relief is capped at either £40,000 or 100% of your earned income, whichever is the lower amount. This applies across all your pensions savings, not just one pension plan (i.e. Penfold). If your contributions add up to more than this then you will pay tax (at your marginal rate) on the amount you’ve gone over.

If you aren’t employed or earn under £3,600 annually then the most you can pay into a pension is £2,880 (or £3,600 with the 25% tax relief applied).

There are also limits to how much you can hold in a pension over your lifetime. This is called the Lifetime Allowance (LTA). For 2020/21 this amount is £1,073,100. It applies to contributions you’ve invested in as well as the growth you’ve achieved across all your pension savings. If you go over the LTA you will pay tax up to 55% on any funds you withdraw from your pension pots over the limit. This limit has been reduced over the last 10 years so it’s worth keeping up to date with any updates to these rules. There are protections that you can put in place to guard against these charges. If it’s something you’re worried about, it could be worth speaking to a financial adviser to discuss your options. 

How do I calculate the state pension I might get?

Visit the State Pension calculator at gov.uk to check your National Insurance Contribution record. You just need to answer a few simple questions to find out how much State Pension you could receive. It will also tell you when you can claim it and how you can potentially gain some qualifying years to help boost your State Pension income.  

Funds

What is a pension fund?

When contributions are made into your pension, in many cases the contributions are invested into a pension fund option. What your pension pot is worth at retirement depends on how much has been paid in, the length of time it has been invested and how your investment has performed over that time.

Pension funds are created by fund managers. They will consist of a range of assets including equities (company shares), fixed interest investments, property and cash. Different funds will hold a different combination of these assets, depending on the objective of the fund. The fund manager has to operate within these objectives to achieve the best return possible for their investors. 

Every time you pay money into your pension, that money buys units in the fund or funds you’ve selected to invest in. The fund is valued at regular intervals (most often, daily) and so your pension value is determined by how many units you’ve bought over time, and what they’re worth at that valuation point. Over time, the value of the assets within the fund can grow. This growth can be achieved by interest being earned on fixed interest investments and dividends paid out on the shares it holds. However, because they are invested in things that are susceptible to market forces, the value of your investment can go down as well as up.

How do I choose the right fund for me?

Your pension provider should be able to send you information about the fund options available to you. Detailed information about each fund should be provided before you choose the fund or combination of funds you want to invest in. This information should help explain the fund’s investment objectives, charges and other information such as where it invests (normally broken down into country and type of asset or sector).

Risk: A good rule of thumb when it comes to picking an investment option is taking into account your age and your attitude to risk. Generally, the younger you are the longer amount of time you have to make up for any short-term losses, and therefore a more risky portfolio may provide you with greater growth over decades of investing. Whereas, if you’re older,  you may want to invest in a low risk option because this will reduce the chance of your pension decreasing in value just before you retire.

This is why it’s important to take into account how many risk options a pension provider offers, because as you age you may want to change your investment options to a less risky option.

Ethics: You can also choose to align your investments with your ethical principles. Pension providers offer investment options where the objective is to seek positive returns and a long-term impact on society, environment and the performance of a business. 

At Penfold, we offer a Sustainable pension option that invests your pension in companies with a sustainable impact, and a Shariah pension that invests only in companies that are compliant with Shariah law. 

Penfold are not financial advisers. The information above applies general rules of thumb when it comes to investing. If you’re unsure whether investing is right for you, consider seeking advice from a financial adviser who can help you with your personal financial circumstances. And, as with all investments your capital is at risk. This means that the value of your investments can go down as well as up and you could end up with less in your pension than what you originally invested. 

As with all investments, your capital is at risk so your pension value may go down as well as up in value and you may get out less than what you invested.

How do I know what my pension is worth?

Your pension provider should send you a statement each year, providing you with the current value of your pension pot. They should also remind you of where you’re invested and may give you some information on the performance of the fund(s) over the last year. They should also give you some idea of what your savings could mean in retirement. This could be a projection or a calculation that tells you what your pot size could be when you reach your retirement age, and what this could provide you in terms of an annuity.

It’s worth remembering that these projections are only estimates that presume things like fund performance and other variable factors. However, they can give you a useful snapshot of where you measure up currently against your savings goals. 

To check your pension pot performance with Penfold, you can see your total pot gain/ loss in the top left hand corner, and also the percentage increase or decrease from investing. If you’d like to receive a printed PDF version of your pension performance, please get in touch with our customer service team.

Costs

There can be different fees and charges that a provider may charge to provide you with a pension. Here is a rundown on what these are called, and what they’re for. If you currently have old workplace or private pensions, it could be worth checking your paperwork to familiarise yourself with these charges.

Annual Management Charge (AMC)

The annual management charge, or AMC, is the fee charged by a pension provider for the administration of your investments. This is normally a fixed amount and may depend on the size of your savings pot.

Fund Management Charge (FMC) 

There may be a fee associated with the management of each fund in your portfolio. This may vary depending on the fund manager. Sometimes providers can reduce or remove fund management charges if they have an agreed arrangement with the fund management company. 

Other costs and fees

  • Set-up fee: Its uncommon now, but some providers may charge a fee for setting up a policy.
  • Platform fee: Some providers may use a platform or service that is used to host the funds available to you and allows you to choose new investments and move your pension savings around. This service can sometimes incur a charge.
  • Transaction fee: This could also be known as a switching fee. It’s a charge that applies when you buys and sell investments. There is also sometimes a difference between the cost of buying and selling price of the investment funds you’re moving between. 
  • Exit fees: Some pension providers will charge a fee to withdraw or transfer money to another plan, while others won’t. 

Penfold’s single, simple all-in annual fee

We hate hidden fees and you probably do too. We'll only charge you one fair, transparent annual fee for managing your pension that covers absolutely everything within Penfold’s pension service. 

You'll pay an annual fee between 0.75% and 0.88%, depending on the plan you choose. We'll automatically deduct a portion of your annual fee from your pension in 12 monthly instalments.

If your pension pot size is larger than £100,000 the fee is reduced to either 0.4% or 0.53% on the portion of your savings over this amount.

Retirement

Traditionally, taking your pension and finishing your working life is referred to as ‘retirement’. However, due to the increases in the state pension age and people having wider and more varied careers, when and how you withdraw money from your pension has changed considerably.

When can I access my pension?

If you’re eligible, you can claim your State Pension at 66 (for 2020/21). You can find more information in the State Pension section about how to find out how much you’ll receive and when you’re forecasted to receive it.

Most private personal pensions (including defined contribution workplace pensions) can be accessed from age 55 (expected to increase by 57 by 2028). Some defined benefit workplace pensions may have set retirement ages specific to the arrangements for that scheme, so it’s best to check any paperwork you have, or call your pension provider to find out. 

You may have set a retirement age on any personal pensions you have, when you set them up. This will help your pension provider know when to contact you about your options for retirement. There may also be some implications for the types of funds you’re invested in and the strategy they have so it’s worth reminding yourself of your set retirement age and your fund selections to ensure these still match your retirement plans.

Regardless of the age you’ve selected on your plan, you can legally access most defined contribution pensions from the age of 55.

What are my retirement options?

Once you reach 55, there are a number of options available to you. 

Firstly, you can leave your pot invested if you’re not ready to start to take any income from your pension. You can also continue to pay into your pension. There are limits, however, if you do decide to take any income from one or more of your personal pensions. This is dependent on the type of policy, and how you withdraw the money. 

It could be worth seeking some financial advice if you wish to carry on paying in, after receiving a payment from any other pension arrangements you have.  

There are four different ways you can access your pension savings: taking your full pot, lump sums, drawdown or taking out an annuity

We recommend that you speak with Pension Wise (part of the Money and Pensions Service) to help you understand the tax implications of your options as well as any impact they may have on your entitlement to any state benefits you might be eligible for. You can book an appointment once you are aged 50 or over and meet with someone face-to-face or speak to them on the phone. For more information, visit pensionwise.gov.uk or call 0800 138 3944. 

Taking your full pot

You are able to withdraw your full pension savings as a cash lump sum. However, there could be tax implications depending on the size of the pension pot.

You’ll get the first 25% as a tax-free lump sum, but you’ll need to pay tax on the remaining 75% as it will count towards your annual income. It could also move you into the upper income tax band if your pot is large enough. Emergency tax may also be deducted from your payment, but you should be able to claim this back from HMRC.

Lump sums

You can leave your money invested and withdraw it as cash lump sums as and when you wish. The first 25% of each amount you take will usually be tax-free, but the rest may be taxed as income, depending on your circumstances. The remainder of your pension pot is left invested and so it has the chance to grow but there is a risk it could go down in value also. If you choose this option, you may wish to spread your withdrawals over different tax years to minimise the tax you pay. 

Drawdown

You can usually take up to 25% of your pension pot as tax-free cash and leave the rest invested to provide a regular income and occasional lump sums if required. All payments apart from your tax-free cash will be subject to income tax. You can change or stop the amount you’re taking at any time. 

Your pension pot remains invested and has the chance to grow but it could go down in value too. If you withdraw too much or the funds your pension is invested in don’t perform as well as you’d expected, you could run out of money to fund your retirement. 

Annuity

An annuity provides a guaranteed regular income which will pay out either for a fixed time or until you die. You can take up to 25% of your pension pot as tax-free cash and use the rest to buy the annuity. There are a number of features you can include, such as requesting that payments increase in line with inflation or arranging for payments to continue to your dependents after your death. Smokers and those in poor health may be able to get a better income due to a shorter life expectancy. The income payments you receive will be subject to tax. 

What happens if I need to retire early?

You can decide to retire whenever it suits your personal circumstances. However, you won’t be able to claim your workplace or personal pensions until you’re 55. Likewise, you won’t be able to access your state pension until you reach the specified State Pension age. You’ll need to consider how much State Pension you’ll receive, and whether you’ve saved enough into any private pension and how you’ll fund your lifestyle until you receive any pension income. 

It’s not possible to get an early pension before the age of 55 unless you are unwell or meet specific conditions. HMRC apply a substantial tax charge if you access your pension early.

Pension scams

Offering early pension release is a common ruse used by scammers and you should be wary of anyone who claims they can help you do this. You could risk losing all of your pension as well as incurring fines from HMRC.

If you’re worried you’ve been approached about an early pension release scam you should report it to the Financial Conduct Authority by calling their consumer helpline on 0800 111 6768 or by visiting FCA.org.

Ill health

You may be able to access your pension early if you’re seriously ill. There are some strict conditions you need to meet and confirm to HMRC:

Ill health retirement is sometimes also referred to as being ‘medically retired’ and is when your pension scheme allows you to draw your pension before the age of 55 because of sickness, disability or a serious medical condition. It generally means you can no longer continue working at your normal job or it impacts the amount of money you could earn. There may be specific terms set out by your pension scheme regarding what conditions would entitle you to draw your pension early. If you want to request ill-health retirement, you’ll likely have to provide evidence and you may be restricted on which retirement options you can choose. 

Serious ill-health

You can also claim your pension early under Serious Ill Health rules. If you’ve been diagnosed with a condition and your life expectancy is less than one year you may be able to take the whole of your pension pot early as a tax-free lump sum (defined contribution schemes). Again, evidence will be required by your provider. 

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