A brief guide to pensions and auto-enrolment

As you will no doubt be aware, this month, many employees who are part of an auto-enrolment workplace pension have seen their pension contributions rise from 3% to 5%, with minimum employer contributions increasing from 2-3%. For many, this week will be the first time employees will see the difference on their payslip, and HR may need to prepare themselves for the barrage of questions heading their way. So, here are all the pensions basics your people need to know to make sure they’re maximising the value of the most popular employee benefit out there, and making the right decisions for their futures:

A short glossary of pensions terminology:

Workplace pension: This is a pot of cash an employee, their employer, and the Government pays into, as a way of saving up for retirement. Employers arrange for the employee’s chosen payment to be removed from their pay before it is taxed.

Defined Benefit (DB) pension: This is a pension scheme where the income an employee gets from their employer relates to the years worked there, and the salary earned.

Defined Contribution (DC) pension: This is a pension scheme where the value an employee receives upon retirement depends on the amount they and their employer has contributed, the fund’s investment performance, and tax relief.

Automatic enrolment/Auto-enrolment/AE: Employers are required by law to automatically enrol all eligible employees into their workplace pension scheme. Employees can opt out if they want to.

Eligible employee: This is someone aged 22 or over, but under the State Pension age. They must earn more than £10,000/year and work in the UK.

Minimum contribution: As of April 2019, the minimum contribution in an auto-enrolment pension is 8% of salary, with employers contributing at least 3% of the total.

Tax relief: This is an amount of money that an employee would have paid in tax on the earnings that have instead gone into their pension. It is a ‘bonus’ from the government that goes into their pension pot rather than to them.

Annual allowance: This is the maximum amount that an employee can contribute to a pension in a tax year and gain tax relief. Pension holders can get tax relief on contributions of up to £40,000, plus any unused allowance from the previous three tax years. For employees earning more than £150,000 the allowance will be tapered gradually so that an individual earning more than £210,000 will have a reduced allowance of only £10,000 per year. 

Default fund: Contributions to workplace pensions will be automatically invested by the employer into a default fund. Employees are usually provided with a choice of other funds in which to invest their contributions once their membership has started.

State pension: This a regular payment from the government most people can claim when they reach state pension age. It currently sits between £129.20/week and £168.60/week.

State pension age: Currently, the state pension age is 65, and will increase to 66 for men and women by next year. However, this changes. Using the state pension calculator, you can see how – for the bulk of the ‘millennial’ generation, for example – the state pension age will be at least 68.

Qualifying years: A ‘qualifying year’ is a full tax year (6^th April-5^th April) where you have been paying or credited with National Insurance contributions. Your date of birth determines how many qualifying years you need in order to claim the full state pension. The full list can be found here.

Annuity: An annuity is a product sold by an insurance provider. For DC pensions, employees can take up to 25% of their retirement pot as tax-free cash. The remainder can then be used to buy an annuity, which pays them a monthly income thereafter, which is taxed as earned income.

Pension credit: This is an income-related benefit which gives a guaranteed minimum income for those over state pension age. It’s made up of two parts:

• Guarantee Credit – which tops up a retiree’s weekly income to £167.25 for single people and £255.25 for couples if they earn below this amount.
• Savings Credit – which is an extra payment (up to £13.73 for single people and £15.35 for couples) for people who saved some money towards their retirement.

Pensions contributions:

Now that the final planned increase to minimum contributions under AE has taken effect, the average worker is set to see their pension payments increase by £700/year. While there is no ‘right’ or ‘wrong’ amount to save into a pension, this increase in minimum contributions is the government’s way of steering people towards saving more for their futures. However, according to 2018 figures from the ONS, employees are paying less into their pensions than they did in 2012, despite there being more people enrolled into a pension than ever before thanks to AE. There are many factors that influence the amount that individuals should save. Money Saving Expert suggests that a “rough rule of thumb” for contribution percentages should be the age you start saving, halved. A person who begins their pension aged 22 would need to contribute 11% for the duration of their career. However, according to The Pensions Policy Institute, an employee generally needs to contribute around 14-27% of their salary as a minimum (including employee and employer contributions as well as tax savings). Other important factors will be growth rates of the funds as well as the expected length of planned retirement.

Pension limitations:

For 2019/2020, the largest amount an employee can pay into their pension and get tax relief is 100% of their salary, or £40,000 – whichever is the lowest. This is known as the ‘annual limit’ or ‘annual allowance’. Anything they pay in above the annual allowance will be assessed for an additional tax charge. Employees over the age of 55, that may have already taken some income, will additionally be limited to just £4,000 per year of pension contribution. This is called the Money Purchase Annual Allowance.

Pension tax relief: 

Tax relief is paid on your pension contributions at the highest rate of income tax you pay. So, in England, Wales and Northern Ireland, contributions look like this:

Scotland is a little different:

If employers are using net pay arrangements for their pension scheme, then the rate of tax relief will be at the highest marginal rate. This means that employees paying tax at less than 20% will miss out on the full relief available. Any tax relief at rates above 20% for employees using relief at source schemes will need to claim the additional tax relief through annual self-assessment.

Pension products:

Research suggests that only 23% of people trust pension products – this is just over half the amount of people who trust their banks. So, what products are people concerned about? And how can employers best explain these to them?

Pension annuities:

Pensioners can buy an annuity upon retirement, which guarantees a regular income. There are many types of annuity:

• Lifetime annuity: These are the most common type of pension annuity (also known as compulsory purchase annuities or just as annuities). A lifetime annuity provides an income stream for the rest of the retiree’s life (as the annuitant) or the rest of the lives of the annuitants for a joint life last survivor annuity.
• The annuity rate is the amount of income that you will be offered for each £ of pension fund. The rate offered is based on the average life expectancy of the retiree and the investment returns for the low risk investments that the insurance company will invest your money in.

Pension freedoms products:

Since the introduction of pension freedoms in 2015, people over 55 have had more flexibility with their pension pot, meaning that they can withdraw their entire Defined Contribution pension as a lump sum if they so choose. There have been issues with this, however, as it has been found that one in ten pensioners have been targeted by scammers since this change. Here, employees should generally be aware of any cold callers offering to unlock pension funds, transfer funds, or access money early. Seeking independent advice from FCA-authorised and regulated professionals is by far the best route. Look for an independent adviser that specialises in retirement solutions.

Taking income directly from the pension pot is an alternative to taking an annuity. This process can be very complex and if too much is taken the individual might run out of pension too early. There can also be unexpected tax consequences if all the money is withdrawn. Any employee contemplating pension drawdown of this type is recommended to seek expert advice before taking this route.

Improving pensions education:

The world of pensions is broad, complex, and often difficult to understand. Although HR professionals may know this information inside-out and back-to-front, there is a strong chance that employees do not. We hope this overview helps to give you a starting point when improving employee understanding of the options available to them, but there are a whole host of products and resources out there which can help employees make the best decisions for themselves. If you would like to know more about the financial education options available, please get in touch with us, any time!