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NARRATOR
Saving for retirement is important to ensure you have enough to live on in your later years, and a private pension is a tax efficient way to do so. That’s because when you put money in, you automatically get tax relief, so your pension pot is effectively topped up by the government.
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If you take your employer’s pension, they also have to contribute to your pot, so you effectively get a pay rise. Though, as you’ll almost certainly be paying into a pension yourself, it means you’ll have less in your pay packet when you start to save this way.
The most common type of pension, these days, is a money purchase pension. It’s simply a pot of cash you and your employer can pay into which you get tax relief on over many years. There’s no way to know how much your pot will be when you come to draw on it. The size of your fund will depend on what you contribute and how investments in the fund perform over the years.
When you draw money from a defined contribution scheme, which you can do from age 55, you have a number of choices. You can take 25% of it as a tax-free lump sum, you can use the fund to buy an annuity where you give your pot to an insurance company in return for an annual income, or you can withdraw cash from your fund and spend or invest it as you wish. This has become an option since 2015. It’s best to get financial advice before choosing as it’s a crucial, but also complex, decision.
The other type of pension is a defined benefit or final salary pension, only available via an employer. These days, most people who start a new pension will have a money purchase pension, as defined benefit schemes are expensive for employers to run because people are living longer and investment returns have fallen.
What you get in a defined benefit scheme is clearer. It is based on a formula of your salary and a number of years that you and your employer have paid into the scheme. An example is, if someone is in a scheme for 20 years that pays 1/60 of their final salary with that firm, then they get a third of that final salary a year when drawing from their pension. On a 30,000 pound year final salary, their pension will be 10,000 pounds a year.
Some defined benefit schemes use the salary in the final year before retirement. But, in recent years, it’s become increasingly common to use the average annual salary during the membership of the scheme. This normally reduces the pension, as the salary in the last year of employment is usually higher than the average.
So if you’re in a defined benefit scheme, you have some certainty about your future pension income. If you’re in a defined contribution scheme, you do not have certainty about the final size of your pension fund.