Employer pension contributions can potentially be more effective than personal pension schemes and your retirement savings can get an extra boost with monthly contributions. It’s also a tax-efficient way to ensure your financial future. It is legally required for employers to enrol workers into a reliable private pension scheme and both employers and employee have the obligation to pay pre-determined monthly contributions into the pension program.
How Do Employer Pension Contributions Work?
Employer pension contributions work by taking a portion of your salary based on the scheme’s rules. With automatic enrolment, you will always pay the minimum contributions. This means that you can choose to pay a larger amount to build larger savings and ensure more comfortable lifestyle during retirement if you like. In the United Kingdom, from 6 April 2019 onwards, the minimum staff contribution is 5% and minimum employer contribution is 3%, making the total minimum earning contribution in the pension scheme is 8 percent.
How Are Pension Contributions Defined?
With this type of pension, pension contributions are defined as a specific percentage of earnings. You must confirm that a percentage of your salary will be taken by pension provider and you decide what components of earnings are to be used for pension contributions. As an example, your basic pay can be used to pay pension, but not overtime payments or bonuses. It is recommended to use automated payroll to ensure deductions from your monthly salary and the pension scheme must be compatible with the company’s payroll system. A representative from the pension provider may evaluate the payroll system to ensure compatibility and resolve any issue.
Automated Payment System
The automated payment system also ensures that contributions for the pension scheme are paid on time. The company may decide the due date, which is typically the same date when staff gets paid. The system calculates your contribution, depending on the amount that employees earn. For the first £6,240 you earn for the year, you don’t need to contribute to the pension scheme. You also don’t need to contribute further if you earn less than £50,000 for that year. However, the more you contribute to the pension scheme, the more flexible your retirement budget would be.
What Is A Defined Benefit Pension?
A defined benefit pension is a type of pension which ensures that employees get a specific, pre-determined amount of money from a pension scheme when they retire. It is also called DB Plans, a final salary pension, or a career average pension. Unlike a defined contribution pension, a defined benefit pension guarantees that you will earn a set figure to fund your retirement. When you reach retirement age, the pension provider uses the amount of your salary and the duration of your professional career as a guide to determine the amount you will receive. For example, if your final annual salary is £50,000 and you have worked for 40 years, the pension provider takes into account your “pension accrual rate”. If the pension accrual rate is 1/60, you multiply it with final salary or £50,000 multiplied with 1/60 is £833. The annual pension income is calculated by multiplying this with the duration of your employment, £833 x 40 = £33,333 each year.
Providers Unable To Fund Defined Benefit Pensions
The amount you get during retirement depends on the rules of the pension scheme and the monthly contributions. As a defined financial program, the pension provider promises that you will get an exact amount every year during retirement. At the earliest, you can start getting the pension payments at the age of 55. Defined benefit pension schemes can become increasingly expensive for providers, because, today, people have a much longer life expectancy. Some pension providers have stopped offering defined benefit pension programs to new members. Because the scheme has an open-ended nature, the provider may not have sufficient funds to continue paying out to retirees. The UK government counters this with PPF or Pension Protection Fund.
State Pension Scheme
In the UK, the state pension scheme is another source of income for retirees, which is similar in concept with defined benefit pension. There are two components of state pension in the UK, basic state pension and S2P (State Second Pension) scheme. After contributing payments for a period time to the national insurance record, retirees in the UK can get basic state pension. The most that retirees can get from basic state pension is £134.25 each week.
What Is A Defined Contribution Pension?
With a defined contribution pension scheme, employees can set up and grow their pension pots with both their employer’s contributions and their own personal contributions. If applicable, they can also use tax relief and investment returns to further increase their pension funds. After agreeing to participate in this scheme, employers will deduct monies from your salary, before it’s taxed, to make contribution to the pension scheme. Alternatively, you can decide on the amount of your contributions, if you want larger pension pot and a more comfortable lifestyle during your retirement.
Unlike a defined benefit pension, the pension provider invests your money in safe stocks and other investment platforms while you’re working. This ensures that your fund will steadily grow over the years. Again, you can decide on the investment platforms to choose if you like, however, investment values can fluctuate, and you might want to leave this up to a financial expert. You can access the pension pot as early as the age of 55. However, if you decide to work longer and use the pot later, you can gain more benefits from the defined contribution pension scheme.
There are four alternatives to use the defined contribution pension:
Take It In One Go- you can take the entire pension pot in one go as a lump sum. Remember, 25% of the pot is tax free and the remaining is taxed in a normal way with the UK Income tax. If you choose to take a big lump sum, you will be subjected to higher tax bracket.
Take As Needed- you may take the amount as needed from the pension pot. For each lump sum, a quarter of it is tax free and the remaining is subjected to Income Tax.
Take A Quarter- when you take a quarter of the pot, it is generally tax-free. You may use the remaining total of the pot later, but it will then be considered as taxable income.
Convert Into Annuity- with this method, a quarter of the pot can be taken as a tax-free lump sum. The rest of the fund can be converted into annuity or taxable retirement income.
What Is The Pension Protection Fund?
In today’s post pandemic economy, even well-paid employees need to make sure that they will be safer financially. Unexpected situations may cause companies go bust and this will put employees in a difficult situation. The PPF (Pension Protection Fund) was created in 2005 by the UK government as a sort of lifeboat fund. Affected workers can request a ‘bail out’ through the PPF, if they don’t have enough money in their defined benefit pension or defined contribution pension to fund their retirement period. Without a reliable safety net, new pensioners could be left financially vulnerable. PPF offers more than 800 DB Plans that can meet unique situation of each pensioner.
Pension Age And The Pension Protection Fund
Pension schemes don’t go into the PPF automatically and it may take up to a year to assess whether you are eligible for a specific scheme. Depending on your situation, pay-outs of PPF can be different. There’s a cap to the amount that members can get from the PPF, and members can take from PPF if they have passed the normal pension age when the employer becomes insolvent. If you reach the normal pension age, you can take a pension without facing any consequences based on the rules of the scheme. If you are at a normal pension age, your pension payment will be 100% of the agreed scheme, when the employer becomes insolvent. A surviving spouse who inherits the pension, can also benefit from the PPF program. If you haven’t reached the normal pension age when the employer becomes insolvent, you will get 90% of the agreed pension scheme.
Pension Payments May Increase With Inflation
Pension payments may increase in line with the annual inflation of the year up to 2.5% each year. However, payments of pensionable services taken before the insolvency date are not affected. Your pension payment will not increase, if the UK inflation rate is 0% that year. During a deflation, your annual payment will not be reduced. If you want to retire early after the employer becomes insolvent, you can receive the pension earlier. People at 55 years old or younger can apply for early retirement. PPF will confirm whether you are eligible for early payments. However, the amount of money you get from PPF will be lower if you retire early.