Pensions demystified: A plain English guide to understanding the British pension system

As you are reaching your 50s, or if you are well within them, you may be thinking more about your future and life after work. Your 50s could actually be the decade in which you can save the most for your retirement. With so many options available, we are going to try to demystify the British pension system, helping you to make informed decisions.

Not only is the British pension system not the easiest to understand, but it also keeps changing. My three general principles for retirement planning are: understand, plan, act.

What are you eligible for?

If you reach State Pension Age (SPA) on or after April 2016 with between 10 and 35 years of paying National Insurance Contributions, you may be eligible to the new State Pension. Its full rate is about £6,030 a year. Go to www.gov.uk to check your SPA (between 65 and 68, depending on your gender and age, and it is planned to increase) and estimated State Pension.

If you are employed, in addition to your State Pension, you may be a member of one of two types of pension arrangements: defined benefit (DB, known as final salary) or defined contribution (DC or money purchase).

If you are a defined benefit, DB, scheme member:

Ask your employer whether you are a DB scheme’s member. With a DB your employer pays you a retirement income after reaching normal retirement age (typically 65), set out in the scheme’s rules. Income is calculated by a formula – the benefit is defined. For each year of membership in the scheme (pensionable service), you get a fraction (accrual rate) of your pensionable salary, which could be your final salary when retiring or an average of your salaries over your career.

For example, after working for 30 years, with £40,000 final annual salary and accrual rate of 1/60, your pension is £20,000 a year. Some schemes allow early or late retirement, for higher or lower pension payments, respectively. It may include death-in-service benefit, as well as a partner receiving 50% of the pension after the member’s death. Your employer must give you all relevant information upon request.

With a DB you do not need to invest the contributions. You know what your pension is going to be for the rest of your life.

If you are a defined contribution, DC, scheme member:

DC is different. Your employer deducts a percentage of your salary every month, adding it into your pension fund. Your employer may contribute as well. You decide how to invest the contributions. Often, if you make no choice contributions are invested in a default fund.

From October 2012 or later most employers must enrol eligible jobholders into a pension scheme under automatic enrolment. However, contributions might be quite low. You can set up a personal DC pension, whether or not you already have one (DB or DC) arranged by your employer.

When can you start spending?

Normally, when reaching age 55 you can access your pension pot. Its value depends on how long you have been saving, the amount of contributions and the investment returns. From April 2015 you have three ways to withdraw money: annuity, flexible drawdown and/or cash lump sum.

Annuity is a financial product, purchased from an insurance company, paying a guaranteed income for the rest of your life. Annuity rates depend on current long-term interest rates, your circumstances (such as your age) and product features (such as indexing with inflation). Annuity rates are very low now, with typical rates of 5%. This means on every £100,000 you saved, an annuity pays £5,000 per year.

Annuity’s advantage is peace of mind – you know what you will get. Its main disadvantages are present low rates and inflexibility since currently you cannot access the money you used to buy the annuity (until a market for selling annuities is introduced).

Flexible drawdown allows you to take variable income from your pension pot when you need it. The remainder of your money stays invested in your pension.

When you take a cash lump sum, 25% of it is tax-free (whether you take it in one go or spread lump sums over different tax years). The rest is subject to income tax.

How much can you contribute?

Most individuals can contribute into pension schemes up to £40,000 a year (it could be lower for high earners) without paying income tax on contributions. Over your lifetime your pension value can grow by up to a maximum of £1 million before paying tax. You pay no taxes on money while it is in the pension, but you pay income tax when taking it out. Spreading withdrawing money over tax years can minimise the tax bill. Pensions are a valuable shield to reduce and defer taxes.

Consider diversifying the ways you withdraw your pension. Use tax-free lump sum to pay off debt, buy a property or spend it. An annuity can give you some stable income alongside State Pension to satisfy minimum financial needs for the rest of your life. Keep the remainder invested to preserve capital considering inflation and providing some additional income.

Use other tax-efficient saving vehicles, such as Individual Savings Accounts (ISAs), to complement pensions, as well as consider buying your home and perhaps property to let.

This was a taste of pensions. Before making any decisions, consider taking professional advice. Visit www.pensionsadvisoryservice.org.uk  for more information.

Saving and Investing for retirement by Yoram Lustig

Yoram Lustig is the author of the new Financial Times Guide: Saving and Investing for Retirement. It is out now, priced £26.99 from FT Publishing, and available from Amazon.