Personal Pension schemes are plans, approved by the Inland Revenue, and run by insurance and pension companies, which are long term savings schemes, designed to provide for retirement. Because of the generous tax advantages, they have rules that must be adhered to in order to qualify for the tax concessions.

Eligibility and Qualifying Earnings

Anyone may contribute up to £3,600 per year gross (£2,808 net at current tax rates) to a Personal Pension Plan. If you want to contribute above this limit, you must have qualifying earnings to be able to put your money into one of these schemes. This means that your earnings must come from:

• self employment, or
• employment with an employer which does not have a pension scheme of its own, or
• furnished holiday letting income.

If you do not have earnings which qualify, the Inland Revenue can instruct the Pension company to repay to you any contributions you have paid.

Concurrency

An individual may pay contributions to a Personal Pension Plan as well as paying contributions to an occupational pension scheme at the same time. This is known as concurrency.

Contributions and tax relief

Contributions to a Personal Pension Plan are regulated, because the contributions benefit from tax relief.

Limits of contributions

The maximum limits of contributions to Personal Pension Plans are expressed as a percentage of the taxable income from the sources of income listed above in any tax year. The limits are as follows:

Age at start of tax year	Maximum percentage of earnings
35 or less	17.5%
36–45	20%
46–50	25%
51–55	30%
56–60	35%
61–74	40%

Note that the age is at the start of the tax year. There is also an overall limit to the contributions which may be paid in any tax year. This limit is the relevant percentage according to the table above, on the ‘earnings cap’. The earnings cap is currently £105,600.

Basis year

There are very generous rules allowing you to make contributions based on your best year’s earnings in any of the past five years. The best year’s earnings can be nominated as your ‘basis year’. This is also sometimes known as ‘benchmarking’. Note however that the earnings must be the ‘Net Relevant Earnings’ for the basis year – i.e. they cannot be earnings when you were a member of an occupational pension scheme. They must be the earnings which qualify you to contribute to a Personal Pension Scheme.

The rules are very generous because:

• The earnings are based on the year you nominate.
• The age used as the basis for the percentage of earnings is the age at the beginning of the year of payment of contribution.
• The earnings cap is based on the year of payment of the contribution.

Any contributions made in the basis year do not affect the maximum limit in the year of payment.

Tax relief

All contributions are made to the pension provider net of the basic rate of income tax, presently 22%. Thus, if a person pays £780, they will have the extra £220 paid by the government, so that the total credited to their pension plan is £1,000. This tax relief is given to all individuals, whether or not they are actually tax payers. In practice, this would only happen up to the £3,600 limit. Thus, if someone has no tax liability at all, they still only pay the net amount, and for every £78 paid, the government contributes the notional tax relief of £22.

If the person is a higher rate tax payer, the extra tax relief has to be claimed on the self assessment tax return each year. The additional tax (presently 18%) will then be refunded by way of a coding notice adjustment for directors and employees, or by the self-assessed tax paid by self-employed people. It can alternatively be claimed by completing an Inland Revenue form PP120.

You may make a special election to carry back contributions paid in a tax year to the previous tax year, as long as the limits of contributions in the previous tax year are not exceeded. Making this special election is beneficial if the rate of tax paid in the previous year was higher than the current year – for example, by paying the higher rate of tax. This election is made by completing Inland Revenue form PP43.

Excess contributions

If a person has paid contributions in excess of the maximum allowable amounts for tax purposes, the pension provider must pay back the excess. The net amount is paid to the individual, and the excess tax relief is repaid to the government.

Taking the benefits

The main condition of Personal Pension Schemes is that the benefits can only be paid between the ages of 50 and 75. There are, however, several categories of occupation which allow earlier retirement for the purposes of drawing benefits. These include many sports activities, such as wrestlers, downhill skiers, footballers, jockeys, etc. Some other types of occupation, such as models and dancers, are also included in the list.

The pension you receive is an annuity purchased by your fund. An annuity is a regular sum, paid monthly, quarterly, or annually, for the rest of your life.

The two factors affecting the amount of pension are therefore:

• the size of the fund, and
• the annuity rate.

The annuity rate represents the factor used to convert the fund into a pension. The annuity rate calculation consists of two elements:

• 1.The interest element, based on long-term government securities.
• 2.The capital element, based on the life expectancy of the annuitant.

It is worked out by actuaries using up to date information on rates of mortality, interest rates, and the age and gender of the person. The state of health of the person can also influence the annuity rate (see impaired life annuities below).

Types of annuities

• Annuities can be of fixed amounts (i.e. non-increasing), or increasing amounts.
• The increases can be of a fixed amount each year (generally 3% or 5%), or linked to the retail prices index.
• Investment linked annuities (either ‘with profit’ or ‘unit linked’) pay variable annuities, linked to the performance of the underlying investments.
• Annuities can be for the sole life of the beneficiary (known as a single life annuity), or for the joint lives of the beneficiary and his or her spouse.
• A minimum guarantee period of, say, five or ten years can be provided if requested. This means that if the beneficiary dies within that period, the survivors get the income for the rest of that guarantee period.
• The frequency of payment can marginally affect the amount of the annuity. If they are paid less frequently (e.g. quarterly, half yearly or yearly rather than monthly), they are generally slightly higher, and if they are paid in arrears rather than in advance, they are generally slightly higher.
• There are also ‘impaired life’ annuities. This means that if the beneficiary is suffering from a life-threatening illness, then because the life span is not expected to be so long, the annuity rate is increased.

• There are also some innovative annuity products offered by some pension providers, such as: Flexible annuity, which allows the fund to be invested in collective investments (such as unit trust or investment trusts) instead of government securities. There is an option to convert to a conventional annuity, and part of the fund can be retained if the annuitant dies within 10 years, to be passed to the annuitant’s survivors. Open annuity, in which the fund is invested in shares in the insurance company, and the balance of the fund remains repayable to the estate on the death of the annuitant. This is offered currently by an offshore life assurance company.
• An annuity growth account offers the annuitant the chance to buy a temporary five year annuity, and the balance of the funds is invested in growth investments. When the five years are over, the annuitant can buy another temporary annuity, or a lifetime annuity from the proceeds of the growth funds.

Death Benefit

If you die before taking the retirement benefits, then the pension policy will state what benefit your dependants will receive. In some older retirement annuity policies, the death benefit was only a return of contributions, with or without a nominal rate of interest. Currently, the best practice is for the value of the accumulated fund to be paid as the death benefit. This is certainly one of the key points to look for in a policy.

Tax Free Lump Sum

When you take your pension, you need not take all of it in the form of a regular pension. Part of the fund may be taken as a tax-free lump sum. At present, the regulations allow you to take up to 25% of the fund as a lump sum. This fund is technically known as the non-Protected Rights fund.

It is nearly always beneficial to take this lump sum. This allows you to invest the lump sum, enjoy the income, and still have the capital available if you need it, or to pass on to your survivors. Clearly this is better; otherwise the whole fund is tied up in the annuity, and there is no access to the capital.

Open Market Option

When the policy matures, and you want to take your pension, you have the right to take the fund from your pension company, and ‘shop around’ for the best value pension. This is because the pension offered by each company is determined by its own annuity rates. These rates vary, and shopping around enables you to find the best value. This ‘Open Market Option’ must be written into the pension contract to enable it to qualify for the tax advantages. The pension company must inform you of this option on the maturity of the policy.

Phased retirement

You may phase in your retirement if you wish to start reducing your working time gradually over a period of a few years. This can be done by dividing the Personal Pension scheme into a number of different policies. Then, the benefits can start to be drawn one at a time, so that the retirement benefits gradually increase, as the earnings from work gradually tail off.

Income Drawdown

When annuity rates are not high, (and particularly if this also occurs at a time when the value of the fund may be low due to prevailing investment conditions) it may be disadvantageous to take the annuity. This is because, once the annuity is taken, the benefits are ‘locked in’ to the prevailing interest rates and investment conditions.

An income drawdown plan overcomes this problem. This type of plan allows the fund to remain in place, and continue earning income and benefiting from any investment growth. In the meantime, an ‘income’ may be drawn from the fund. Although this income is liable to tax, it is strictly speaking a drawing on the capital of the fund. The beneficiary may also choose to use a part of the fund to buy an annuity in the normal way, and use the balance for a drawdown scheme.

The amount which may be so drawn down is regulated, and depends on the age of the beneficiary, and the size of the fund.

It is also subject to review every three years. The limits are:

• Maximum limit – equal to a single life annuity, non-increasing, with no guarantees.
• Minimum limit – 35% of the maximum limit.

The benefit of this plan is that the fund remains in existence.

If the beneficiary dies before taking an annuity:

• The fund can be paid to the beneficiary’s estate. This is subject to a tax charge of 35%.
• The survivor can continue to draw down from the fund, but only until the original member would have reached age 75 at the latest.
• The fund can be used to buy an annuity for the survivor.

This type of plan may only be in existence until at latest the beneficiary reaches the age of 75. At that time, the fund must be converted into an annuity.

Choosing a policy

If you are considering taking out a policy, there is a bewildering number of choices available, and an equally bewildering number of salesmen trying to sell them to you. Bear in mind that they are earning their living, in the form of commission on these policies. The adviser you use may be independent or an employee of the company, but they still have a living to earn. Some companies advertise the fact that they do not pay commission to intermediaries. However, they still have their own sales force to pay.

However, the fact that a salesman gets commission does not necessarily mean that what they are trying to sell you is not good value.

Here are some points to look for when choosing a pension:

What is the basis of the fund growth?

The funds are usually unit linked or with profit.

Unit linked means that the premiums buy you a certain number of units in a fund or funds provided by the pension company. Like Unit Trusts, there are various types of funds. The prices are quoted in the financial press, and the value of your pension fund at any time is the value of the units, multiplied by the number of units you hold. This means, of course, that the value can fall as well as rise.

With profit funds mean that the investment profits each year are credited to your account, as a ‘bonus declaration’. The bonuses are added to the value of your fund each year, and there is also usually a ‘terminal bonus’ added when the policy matures. The annual bonuses cannot be taken away once they have been added to your fund. Although it may seem preferable to have profits added in this way, the ‘with profit’ policies usually keep a reserve back in good years to even out the growth.

What is the charging structure?

Many companies pay commission, and, particularly in the case of regular premium policies, this means there is a large deduction from your fund in the first year or two. Thus, it could take your fund a long time to recuperate from this reduction. This is known as ‘front end loading’.

How flexible is the policy?

Do you want to pay regular premiums, or a single premium? Does your policy give you the opportunity to suspend premiums if necessary? If you are paying regular monthly or yearly premiums, can you add on single premiums at a later date?

What is the basis of the benefit if you should die before taking the pension?

You should always look for the fund value as the benefit, rather than return of premiums, even with interest.

Group Personal Pension Plans

An employer may offer to employees the benefits of a Group Personal Pension Plan. Under this arrangement, a pension provider typically offers better terms to a collection of plans grouped together under one employer. Although the administrative work is done by the employer, the individual contracts are between the individuals and the pension provider.

An employer may use this type of plan as an alternative to offering a stakeholder pension scheme. If so, the employer must contribute at least 3% of the basic salary of employees to the plans.

Retirement Annuity Plans

These plans were the precursors to Personal Pension Plans. They are no longer available as new plans, but existing plans continue in force. See more detail about these plans in Chapter 7.