How do pensions and annuities work?

Most of us are banking on a pension to provide us with a decent retirement fund, but how many of us truly understand how they work?

A pension could ultimately be the difference between spending your later years in penury or enjoying the lifestyle for which you have worked hard.

How you manage it, save into it and access it are all critical to ensuring you have a rich retirement. But the goalposts are moving. The state pension age is rising and so too is the age at which you can dip into private pension savings without crippling tax bills.

For those of us outside the public sector, long-gone are the days of final salary pensions that provide a generous income that keeps rising with inflation. 

Industry experts say that a single person requires an income of £26,700 a year for a comfortable retirement on top of a full new state pension. Yet that would require a pension pot worth at least £645,000 by the age of 66. If you want to leave work earlier, you will need an even bigger fund.

Here, Telegraph Money explains what you now need to know about pensions, but were perhaps afraid to ask. In this guide we will cover:  

• What are the different types of pensions?
• What is an annuity?
• Annuity or pension – what is the best option for me?
• How much should I save for retirement?
• When should I start planning my retirement?
• Should I consolidate my pension?

What are the different types of pensions?

Private pension

A private pension is a way of saving money to provide you with income in old age, when you are no longer working. You can usually only access this money at the “normal minimum pension age”. This is currently set at 55, but is due to increase to 57 by 2028, and will probably increase again soon after.

Most workers have a private pension thanks to a system known as “auto-enrolment”, which was introduced in 2012. It means that businesses are legally obliged to offer a pension saving scheme to their staff, and enroll them unless they actively opt out. 

Under this system, the minimum contribution rate to your pension is 8 per cent of your salary (3 per cent from the employer, and 5 per cent from the employee). This usually happens automatically each month and your workplace pension scheme will invest your savings on your behalf. 

There are two main types of private pensions. These are “defined contribution” and “defined benefit”. 

The most common is a defined contribution pension. In this scheme, your money is invested over the course of your working life, and the value of your pot will fluctuate according to stock and bond market moves. 

Once the mainstream, defined benefit pensions (in some cases known as “final salary” pensions) are now very rare outside the public sector. They promise an income in retirement, regardless of stock market moves. 

The amount you get from your defined benefit pension depends on the number of years you have worked for your employer, your salary, and the scheme’s “accrual rate”. This is the multiple that your employer uses to calculate your retirement income – it is a fraction of your final or average salary, typically 1/80 or 1/60, and then multiplied by the number of years you have belonged to the scheme. 

Self-employed workers often opt for a “Sipp”. This is a self-invested personal pension, which allows you to choose how to invest your savings. 

State pension

The state pension is a regular payment from the Government that most people can claim once they reach the state pension age, which is currently set at 66. It is in the process of rising to 67 by 2028 and 68 by 2039. 

You must have around a 35-year track record of National Insurance contributions in order to qualify for the full new state pension. You can check your National Insurance record here: https://www.gov.uk/check-national-insurance-record. In order to do so, you will need a Government Gateway user ID and password. 

You can check your state pension forecast by visiting the government website at: https://www.gov.uk/check-state-pension

There are two types of state pension. The new state pension and the basic state pension, also known as the “old” state pension. People who reached the state pension age before 5 April 2016 will get the basic state pension. 

The full new state pension currently pays out £208.85 per week, or £10,600.20 per year. The basic state pension pays £156.20 per week, or £8,122.40 per year. 

These rates increased by 10.1 per cent this year, because of the Government’s “triple lock” policy, which promises to increase state pension payments every year in line with the highest of the previous September’s inflation, wage growth or 2.5 per cent. 

It is important to make sure that you are getting the most out of your state pension when you are planning your retirement, as some extra help will put less strain on your private pot. 

Now read our guides on how to claim National Insurance credits, and how to pay voluntary National Insurance contributions to help boost your state pension. 

What is an annuity? 

An annuity exchanges a cash lump sum for a guaranteed income until death. Their pay rates are based largely on the yield of British government bonds, otherwise known as “gilts”. 

Annuities were out of fashion for a long time because their pay rates were so low. But they spiked late last year, after a meltdown in the bond market triggered a historic spike in yields. 

At one point, a healthy 65-year-old with £100,000 was able to secure a joint annuity income of £6,532. This has fallen back a bit, but annuity rates are still much higher than they used to be.

Annuities are also priced according to your life expectancy, so a provider may ask you questions about your health, such as how much alcohol you drink and whether you smoke. If you have serious health issues, then you could qualify for an “enhanced” or “impaired” annuity rate, which will reflect a shorter life expectancy. 

The promise of a guaranteed income for life may sound appealing, but savers should note that many annuities are not inflation-linked. This means that the value of the income you have bought will be eroded each year by the rising cost of living. 

Some providers may offer you an “index-linked” annuity, which will increase your pay rate each year. However, these often come at a higher cost – or, in other words, the initial yield that they offer you will be lower. It could take several years for this kind of annuity to be worth the extra expense, if at all. 

Annuity or pension – what is the best option for me?

All that being said, there is value in having a bit of cash that is guaranteed to land in your bank account each month. Gary Smith, of the wealth manager Evelyn Partners, said: “Annuities and pensions can be used in combination to provide an effective retirement strategy. 

“Let’s assume someone has fixed monthly costs of £1,500 per month and is in receipt of a state pension of £9,600.

“Assuming an annuity rate of 6.5 per cent, they could use £130,000 of their pension funds to purchase an annuity that provides a guaranteed income of £8,400 (net of income tax) to cover these fixed monthly costs. 

“Then they could retain the remaining balance in their pension to cover any unexpected costs such as replacing a boiler, or buying a new car.” 

Remember, once you have purchased an annuity then you cannot reverse that decision. 

While you can include some forms of protection for a spouse or a dependent in your annuity, you cannot pass down its value as inheritance, unlike an invested pension pot. 

How much should I save for retirement? 

This depends on the lifestyle that you want. While some people are content with a no-frills retirement, others prefer to splash out, especially in the early decades of retirement when you are fit and healthy enough to travel. 

Industry estimates suggest that a single person would require an annual income after tax of £26,700 on top of the full new state pension in order to achieve a “comfortable” lifestyle when they retire. 

This would involve a more luxurious lifestyle, including three weeks in holiday in Europe each year, a £144 weekly budget for food and £56 on birthday presents. You can see the full breakdown here: www.retirementlivingstandards.org.uk/ 

In order to achieve this level of income, then you would need a pot of at least £645,000 if you retired at 66, calculations from the wealth manager Quilter showed. 

Someone targeting a more moderate lifestyle would need less than half that amount, at £301,000. 

When should I start planning my retirement? 

It depends on when you want to retire. The earliest age you can currently access your private pension pot is 55, although this is increasing to 57, and further rises are on the horizon. If you are aiming to take an early retirement around this age, then you should be carefully planning out your finances at least a decade before. 

This “normal minimum pension age” will likely remain around 10 years below the state pension age, so remember that you will have to plug the shortfall of the state pension with your own funds. The earlier you retire, the more money you need to rely on. 

If you want to wait for your state pension, then you should start thinking about your retirement again at least 10 years beforehand. This will give you enough time to consider your current financial position, take a realistic view of what your circumstances may be in the future, and start planning your money around that. 

Should I consolidate my pension?

If you have been working for a while, chances are that you have several pension pots from different employers. 

Having multiple pensions is not the worst situation to be in, but the admin can be difficult to manage. It also means that you are taking on more costs – each pension provider will charge a management fee. These usually start from 0.5 per cent to as high as 1.5 per cent. 

Tom Selby, of the broker AJ Bell, said: “Seemingly small differences in the percentage charge you pay can add up to big differences in the value of your pension when you reach retirement. Reducing those charges could therefore have a huge, positive impact on your lifestyle in retirement.” 

For example, let’s take a 50-year-old who has four pensions each valued at £25,000. The charges for the pensions are 0.5 per cent, 0.75 per cent, 1 per cent and 1.5 per cent. If each pension delivers investment returns of 4 per cent per year before charges are deducted, at age 60 she could have a total fund worth just over £139,000. But, if she combines her pension with a single provider, then her £100,000 pot would be worth £146,000 by the time she is 60. 

Mr Selby added that those with larger pensions could benefit even more. 

“If we take the example above but increase the value of each pot to £100,000 at the beginning, if the worker does not consolidate, she could end up with a fund worth around £558,000 at age 60.

“If she combined her pensions with a single, low-cost provider charging 0.5 per cent on the entire £400,000, by age 60 her fund could be worth around £584,000 – a £26,000 increase.” 

However, there are some important things to consider before transferring any old pensions. You should first check that there are not any valuable benefits attached to your pension that you could lose, or any exit charges. Your provider will tell you if this is the case. 

Second, if you have a defined benefit pension worth at least £30,000, then you must consult a regulated financial adviser before transferring. 

This article is kept updated with the latest information.