12/09/2023
Trainee Solicitors in the Pensions team, Angus Kirkwood and Asha Patel share some insight on everything that they have learnt about pensions in one week.
What are pensions?
A pension is a tax-efficient way of saving your money for when you retire, meaning the contributions you make are tax-free. Once you retire, the general principle that applies is you are allowed to ‘cash-out’ up to 25% of your pension, a lump-sum amount that is tax-free.
There are a vast amount of pension products that exist in the UK and understanding which one is the best for you to invest in can be confusing. To put simply, pensions can broadly be split into two categories: workplace pensions and personal pensions.
Workplace pensions
Workplace pensions can again be split into two main types: defined benefit and defined contribution.
As the name suggests, if you were to opt to invest into the defined benefit type pension scheme, the benefit you would receive are defined by the rules of the scheme itself. The result is that the employer takes on the risk as they guarantee the employee a future income, irrespective of the scheme’s performance. An example of a defined benefit pension is a final salary scheme. This involves benefits that increase over time based on your duration working at the company and your final salary at date of leaving. More commonly, defined benefit schemes are based on career average revalued earnings instead of final salaries in order to make the pensions more affordable. However, the basic principles of this type of scheme have not changed. The benefits are based on an average of your career earnings as opposed to your final salary. Those working in the public sector or for a very large private sector employer are likely to be provided with a final salary scheme as these really are viewed as the gold standard of workplace pensions.
The second type of workplace pension you can get is a defined contribution. In contrast to defined benefit, defined contribution schemes do not have a promise or a guaranteed benefit, instead the amount you will receive from your investments is unknown at the outset and dependent on the performance of those investments. Therefore, it is the employee as opposed to the employer that takes on the risk. Although these schemes carry more risk to the employee, they also provide the employee the significant advantage of being able to control how much they would like to invest and, to an extent, how these investments are structured. This can be based on an array of factors including: how many years until you’re retirement, how much you want to currently save, maintaining your current lifestyle and expenditure, impact of pension charges and how your pension is performing.
Personal pensions
Personal pensions are nearly always defined contribution vehicles. A personal pension provides you with the greatest amount of control over where your money is invested and the UK pension industry provides a plethora of options of personal pension funds to invest in, namely cash, and other money market investments : property via, SIPPS (self-invested personal pensions), gilts and bonds and stocks &shares. Deciding which one(s) to invest in can be daunting, especially when they all seem so similar at surface level, however one factor that may help steer your decision is investing into a pension fund that is environmentally friendly if this is something of importance to you.
Types of ESG investing funds
The demand for ESG (environment, social and governance) investments has increased dramatically in the last three years with more ESG investment and pension funds being introduced in the UK. Whilst each fund shares the same ambition of providing financial returns to their investors, their approaches to meeting their ESG criteria may differ. At present, the three key investment approaches are: ESG exclusionary (a value-based approach which excludes working with companies operating in sectors such as fossil fuels and tobacco); ESG inclusionary (a score-based approach that assesses companies based on their ESG initiatives); and impact investing (a theme-based approach that works with companies that are progressively developing their ESG strategies, such as reducing carbon emissions and reaching net zero standards).
Will we have enough in our pension pots?
The adequacy of pension contributions within the UK has been a hot topic for some time. The factors that influence people’s pension contribution and determine their adequacy are explored below:
1. Public policy (auto-enrolment, minimum contributions and tax incentives)
In an attempt to boost the amount people save into their pensions, in 2012, the government introduced auto-enrolment. Auto-enrolment requires all eligible workers to be automatically enrolled into a pension scheme while being provided the option to opt-out afterwards. The minimum contribution for automatic enrolment pension schemes was set at 8% (3% from the employer and 5% from the employee). While auto-enrolment has increased the amount that people contribute towards their pensions, it seems that the minimum contribution levels may not be sufficient. Chief executive of Abrdn, Stephen Bird recently called for doubling of the minimum pension contributions from 8% to 16% of pay, which would take the level close to that seen in other developed economies.
Another government initiative, which aims to boost the amount that people save into their pensions is through tax incentives. The government pays tax relief on pension contributions at the highest rate of income tax that the individual will pay. Additionally, no tax is payable on the investment growth of pension pots. Therefore, due to the combined effective of tax reliefs and compound interest, saving into a pension scheme provides an unrivalled investment opportunity. There is a caveat to this though in that income drawn from pension pots is taxed at the applicable marginal rate, therefore, the tax liability is delayed rather than avoided entirely.
2. Economic conditions
According to a UK survey by the investment platform Hargreaves Lansdown, 14% of people stopped and 8% cut back on pension contributions during the cost of living crisis. Out of the 18-34 age group, the quantity either stopping or cutting back on pension contributions was almost one third. Poor economic conditions lead people to prioritise their resources to support their current financial position. The ability to plan for retirement becomes a luxury and, as a result, people’s pension pots can become compromised and the benefit of any tax incentives can be lost.
3. Changing demographics
We have an aging population in the UK. People are living longer due to medical advances and lifestyle changes. In addition, the proportion of the population in the retirement in increasing due to declining birth rates. This means that people are likely to need to rely on their pension income for longer, which means they will require larger pension pots. It also means they are likely to work for longer, so they are able to contribute to that pension pot over a longer period.
4. State pension
Given that we have an aging population, the cost to the government of providing state pensions is increasing. Compounding this is the fact that we have proportionally fewer people at a working age funding this through their taxes. As a result, the government has made changes to eligibility for the state pension, with the state pension age being increased to 66. It is due to increase again between 2026-27 to 67. At present, a full state pension would be just over £10,600 a year. The Retirement Living Standards suggests that a single person would need at least £12,800 a year to cover a ‘minimum’ retirement lifestyle. Therefore, the state pension can only ever function as an adjunct to a personal or occupational pension.
5. Fragmentation of pension pots
The majority of workers hold numerous pension pots in multiple pension schemes. This is associated with the trend toward protean careers, which involves people moving more frequently between employers and being enrolled into many different occupational pension schemes. The lack of consolidation increases the risk of people losing track of their pension pots. It also makes it difficult to plan effectively for retirement, as people do not have access to the information necessary to make informed decisions about pension savings and investment allocations.
For further discussion, please contact Nigel Bolton, Partner, Angus Kirkwood, Trainee Solicitor and Asha Patel, Trainee Solicitor.
