How pensions work
With auto-enrolment the provision of pensions is now mandatory
A pension is a financial product that you put money into so that you can build up a fund to use when you retire. The idea is that a retirement pot is built up by investing over a number of years. The money that you save into a pension gets a boost from tax relief, so effectively you are saving out of untaxed earnings.
In retirement, you can then access your pension to buy yourself an income or draw on it. Alternatively, for a limited number of people in the public sector or employed by the larger companies, you will have a defined benefit scheme, often known as final salary, where your employer promises you a set income in retirement for life and picks up the tab.
The two types of work pension you need to know about
There are two main types of pension that you will hear mentioned, defined contribution and defined benefit schemes.
DEFINED CONTRIBUTION
Most work based pension including auto enrolment schemes are defined contributions. Defined contribution schemes do not promise any set pay out in retirement, instead you must invest to build up a savings pot that can eventually be used to provide an income. The name comes from the fact that it is your contributions that are defined. With a work defined contribution pension, people are usually able to decide how much they want to pay in as a percentage of their salary and their employer will match some or all of the contributions. The money saved into the pension is invested, typically into funds that hold shares or bonds, and grows over the years to deliver a retirement pot. With these pensions it is your responsibility to build up the pot you need for retirement. You can track which investments your money is going into and how they are performing and change them if you wish.
DEFINED BENEFIT
Defined benefit schemes pay you a set annual income in retirement. The name comes from the fact that the benefit you receive is defined, they are often called final salary schemes.
Tax relief on your pension
You receive tax relief pension on contributions, which increases the amount that goes in. This effectively means that you are investing into your pension out of untaxed income. Everyone gets basic rate tax relief of 20 per cent automatically; higher rate taxpayers must claim the rest of their 40 per cent relief themselves. This tax relief is not unlimited and there are annual limits on contributions and lifetime allowance.
How does an employee start a pension?
People are most likely to start a pension through work. Under auto-enrolment rules, most employers should now be offering workplace pensions and putting people in them, unless they opt out. With a defined contribution scheme, your employer will have chosen a provider to manage the pension and you will make contributions out of your salary and your employer will also put money in. This money is then invested in the stock market or government and company bonds, usually through funds. When you start a pension you will need to decide on your investing strategy and how much risk you want to take. Employers usually place a limit on your contributions that they will match, for example 5 per cent of your salary. You can change your level of contributions over time. It is also important to keep an eye on charges as these can have a big impact on your returns.
When can an employee access the money and what can they do with it?
The earliest you can normally access a pension is currently age 55. You can take a 25 per cent lump sum tax-free, but you can then either buy an annuity or keep the rest of your pension invested through a process called drawdown and take money out when you want – and taxed at your usual income tax rate. Alternatively, you can also forgo the 25 per cent tax-free lump sum in one big chunk and keep a pension invested and draw on it as you choose, with the first 25 per cent of each withdrawal tax-free and the rest taxed at your usual income tax rate.
Pension auto enrolment
1.Background
To encourage more people to set aside money for retirement, the Government introduced workplace pensions for eligible workers. Under rules introduced in October 2012, employers are required to automatically enrol all eligible staff into a workplace pension scheme from their staging date and pay a minimum contribution into the pension fund.
2.What does the employer need to do
- now your staging date, this can be obtained from the website of TPR – www.tpr.gov.uk/staging
- Assess the workforce
- Check payroll software
- Choose pension provider
- Communicate with staff
- Enrol eligible jobholders
- Register with The Pension Regulator
- Keep records
The changes will undoubtedly have financial implications and employers should plan for the additional cost of contributions and administration.
3.Assess the workforce
The regulations require you to sort your employees into the following groups:
- Eligible jobholders – aged 22 to state pension age and earning over £10,000.
- Non-eligible jobholders – 16 to 21 and from state pension age to 74 earning above £10,000. Or 16 to 74 earning below the earning trigger up to £10,000.
- Entitled workers – Aged 16 to 74 has qualifying earnings equal to or below the earnings trigger for automatic enrolment
Eligible jobholders must be automatically enrolled; non-eligible jobholders do not have to be automatically enrolled but have the option of opting in; entitled workers do not have to be automatically enrolled, they must be able to elect to opt in but no employer contributions need to be paid.
4.Payroll software
You will have to ensure that your existing administration and payroll software can accommodate auto enrolment; payroll packages supplied by smaller firms may not be compliant. The HMRC free PAYE software is unlikely to be able to perform any auto enrolment functions at all other than handling deductions through the payroll, so you will probably need to move to a commercial system before your staging date.
5.Choosing a pension scheme
Once you have completed your assessment you need to choose a qualifying auto-enrolment scheme. Further details of the minimum features can be found on the Pensions Regulator’s website or the employer may wish to seek professional advice.
6.Communicate with staff
Employers are required by law to write to all workers (except those under 16 and over 75) explaining what auto enrolment into a workplace pension scheme means for them. There are different information requirements for each category of worker.
7.Contributions
Contribution are payable between the lower earnings trigger for automatic enrolment and the higher threshold. Rates will be increased over time: –
| Date | Total Contribution | Employee’s Contribution | Employer Contribution |
| 6th April 2019 onwards | 8% | 5% | 3% |
8.Opt out
Employers cannot avoid their obligation to auto enrol eligible jobholders into a qualifying scheme, opting out refers to a jobholder’s right to opt-out of the pension scheme after being enrolled. Opting out can only occur after an employer has selected a pension scheme and the first months contributions have been made.
If an employee then wishes to opt-out he must notify his employer using a document called an ‘opt-out notice’. Employers cannot use their own opt-out notices, these can only be obtained by pension providers or their agents. Opt out notices must be kept until a re-enrolment event, which usually occurs every three years. Opt out rates have been lower than expected and for the larger employers has averaged less than 10%.
9.Postponement
Postponement allows an employer to postpone auto enrolment for a period up to three months. It is envisaged that postponement will be used:-
- When dealing with temporary staff
- For new joiners to reduce payroll and communication administration.
- You can also postpone from your staging date, however, it doesn’t change your staging date.
You must write to tell the staff whose automatic enrolment you are postponing, you will have six weeks from the date postponement starts to write to them.
10.Penalties
The Pension Regulator (TPR) holds the position of the regulator of work-based pension schemes in the UK and is responsible for monitoring the introduction of auto enrolment. TPR has warned employers about the consequences of failing to comply with escalating penalty notices (EPNs). EPNs are issued to employers that have failed with a compliance notice and a fixed penalty of £400. If the recipient of an EPN does not comply with its requirement within 28 days they will be liable for a fine which increases daily:
- For employers with 1 to 4 employees EPN fines increase by £50 per day, and
- For employers between 5 to 49 employees increase at the rate of £500 per day.
Employers who deliberately and wilfully fail to comply with their duties may be prosecuted.