Introduction to personal pensions Personal pensions
What are personal pensions?
Personal pensions are defined contribution (DC) or money purchase schemes. They invest the money you pay in and give you an accumulated sum on retirement - with which you can buy an annuity to secure your pension income.
How DC schemes calculate pension income
The amount you get depends on the performance of the funds in which the money has been invested and what charges have been deducted. Although your total pension pot should increase each year you continue to pay into the scheme, there is no way of accurately predicting what the final total will be and how much pension income this will provide.
Choose your own investments
Unlike those who belong to a company’s defined benefit (DB) pension scheme, members of a personal pension have a degree of choice as to where their pension contributions are invested.
Many opt to put their money in the scheme’s ‘default fund’, but some will want to be more cautious, investing in cash funds and corporate bonds, while others may prefer a more ‘adventurous’ mix, with equity and overseas growth funds.
Those who want a wider choice of investments, including commercial property, often opt for a Self invested Personal Pension (SIPP).
Annuities and drawdown
Personal pension schemes allow you to build up a fund, which then generates pension income during your years of retirement. The normal way of doing this is to buy a lifetime annuity. The alternative is to leave your pension pot invested and draw a regular income from it each year (drawdown).
Lifetime annuities are essentially a form of insurance which removes individual risk by paying out a set amount each year for the rest of your life. How much you get depends on your age, your health and the prevailing annuity rates at the time you come to convert your fund.
The scheme provider will normally make you an annuity offer, but you are not obliged to take this and can opt instead to shop around, comparing rates from other providers. This is called exercising the open market option (OMO). For those with poor health or lifestyle factors, such as smoking or previous work in a heavy manual job, it can be particularly advantageous.
Drawdown schemes are less predictable. They continue to depend on investment performance to maintain your pension pot. If the investments do badly, or you deplete your capital by withdrawing too much in income, there is a risk of your pension income falling.
Taking a tax-free sum
Before buying an annuity, you can, on retirement, take up to 25% of your pension savings as a tax-free lump sum. This reduces the pension income you can secure by buying an annuity, but may be worthwhile if you need the money (to pay off outstanding debts for example) or decide to invest it independently.
The earliest you can draw a pension or take a lump sum is from the age of 55.
Additional pension scheme benefits
As well as providing a pension fund, some personal pension schemes offer additional benefits to their members. The most common is a ‘death before retirement’ payment to your spouse, civil partner, or anyone else you nominate, if you die before reaching pensionable age. This is a form of life insurance.
Your accumulated pension contributions may also be refunded. If you have ceased paying into the scheme at the time of death, your accumulated contributions will be returned, and normally the investment growth they have achieved.
A partner’s pension may be paid if you die after buying an annuity, depending on the type you have purchased. Some have a five or ten year guarantee, others specify a spouse’s pension for life. But if you did not choose these options, your partner will get nothing.
Pension arrangements based on defined contributions (such as money purchase occupational schemes, personal pensions and SIPPs) are protected by the Financial Services Compensation Scheme (FSCS), subject to FSCS rules on eligibility and compensation. The investments of these pension arrangements may be held by trustees on behalf of their members or they may be contracted direct with an insurance company.
FSCS only protects investments with providers who are authorised by the FSA; the level of protection depends on the type of the investment. FSCS is designed to protect against the insolvency of a direct provider; FSCS does not pay compensation for poor investment performance.
For an investment in a long-term insurance policy, if the life insurance company should fail, FSCS protection provides 90% of the contractual benefits under the policy, without limit. If a pension is already being paid, the pensioner is covered for 90% of their future pension payments, without limit.
If other types of investment are held by pension trustees, or in a SIPP, FSCS protection is 100% up to a maximum limit. From 31 December 2010, the maximum limit is £85,000 per person per firm for cash deposits and £50,000 for investments.
Defined Benefit Occupational Pension Schemes are protected by the Pension Protection Fund.
Know your rights: Who do I complain to about my pension scheme? - make sure your retirement income is protected.