A recent report by the Work and Pensions Committee found that savers ‘struggle to navigate the pensions minefield’. Despite pensions being vital to support income in retirement, many people are still largely underinformed and unaware of the rules around pensions and how to navigate them. With this in mind, here are 5 of the most common myths around pensions – and the reality behind them.
I will receive a State Pension
Not everyone realises that there are certain criteria to obtain a State Pension. It is also not a given that you will receive the full amount at State Pension age as your entitlement depends on your National Insurance record and the current requirement to receive the full State Pension is 35 qualifying years. It’s also worth bearing in mind that the age at which the state pension starts for both men and women has risen from age 65 to between ages 66-67 and is set to increase further to age 68 by 2037.
Even if you receive the full state pension, currently £185.15 per week, this is unlikely to provide enough money to see you through retirement. There is likely to be a significant gap between what you need in retirement and what the state pension provides. Therefore, a workplace or private pension, or other investments, can help to bridge the gap.
All pensions are the same
There are a number of different types of pension contracts in use and the type that you have will dictate what you can and can’t do with the pension pot once you retire.
Alongside the state pension, the two main types of pensions are:
Defined Contribution:
Money is paid in by you and/or your employer over time and is invested by the pension provider. The size of your pension pot at retirement depends on how much was paid in and how well the underlying investments have performed.
Within this, there are varying nuances, including whether the pension is an old-style contract that requires an annuity to be purchased at retirement to provide a guaranteed income for life, or whether it is a new-style contract that allows for flexible access throughout retirement.
Defined Benefit:
Sometimes referred to as a ‘final salary’ pension, defined benefit schemes are usually workplace pensions, where contributions are based on your salary and future benefits are linked to your final salary and years of service. This type of pension provides a guaranteed income for life and the income is usually index-linked so it keeps a pace with inflation over time.
As there are so many different rules attached to pensions, it is worth seeking independent advice from a qualified financial adviser before you make any decisions to enter, leave, or take benefits from a pension.
I have a pension through work, so I don’t need to worry about it
If you’re earning a minimum of £10,000 from a single job and are aged 22 or over, you’ll automatically be enrolled into your employer’s workplace pension scheme, unless you ‘opt out’.
Under current rules the minimum contribution amount is 8% of annual relevant earnings, made up of 5% of your own salary (including government tax relief) and 3% from your employer.
Despite many people having workplace pensions for most of their working lives, the average pension pot upon retirement is £61,897 (according to FCA retirement income market data 2019/20). For the majority of individuals, this is unlikely to be enough to see you through retirement.
I have other assets, so I don’t need a pension
If you have built up a portfolio of investments over the years, such as ISAs, Collective Investments, or you have a business or an investment property, it may be that you have other sources from which to draw income in retirement. However, the tax treatment, liquidity and disposal of these assets should be a key consideration, along with the timing of how and how much you can access, as and when it is required.
The favourable tax treatment of pensions is also worth serious consideration. Capital gains tax is not levied on pensions and for inheritance tax, any money held within a defined contribution pension generally falls outside of a person’s estate for inheritance tax calculation purposes. If the pension holder dies before age 75, the whole pot is passed to beneficiaries, free of all taxes. No other asset is treated so generously from a tax perspective.
Your pension dies with you
Many people have no idea what happens to a pension fund once the pension holder dies.
Under a defined benefit pension there is usually a continuation of income for a spouse until their death, albeit this is usually a lower amount. If this death benefit is not offered or the pension holder had no spouse, the income generally ceases upon their death.
Under defined contribution pensions, following Pensions Freedoms in 2015, purchasing an annuity at retirement is now less commonplace, and defined contribution pensions are more frequently used to flexibly provide regular and/or ad-hoc benefits throughout retirement. The funds that remain in the ‘pot’ after death of the pension holder can be passed on to nominated beneficiaries and doing so is usually a very tax-efficient way of cascading wealth.
Pensions can be one of the most powerful tools available to individuals as a means of saving for later life. For more information or for a review of your current pension arrangements, please get in touch.