Certificate for Introduction to Securities & Investment (Cert.ISI) Unit 1 Lesson 47:  Retirement planning  The purpose of pensions  The state pension scheme 47cis

Retirement planning in the UK Most people in the UK retire between the ages of 55 and 75. They stop earning wages or salary. They rely for their income on their pension and/or start drawing down their savings BBC News 29 July 2010 Fixed retirement age to be axed The government is planning to scrap the default retirement age in the UK from October Under the proposal, employers would not be allowed to dismiss staff because they had reached the age of 65. Activists, who have long campaigned against the rule, welcomed the proposal as a "victory" against ageism. Currently, an employer can force an employee to retire at 65 without paying any financial compensation. For many people, their pension and their house are their main assets. A pension is an investment fund into which contributions are made, usually during the individual’s working life. The fund is designed to provide a lump sum upon retirement plus an annual pension payable thereafter.  Until recently, any male employee in the UK could be forced to retire at 65  Until recently, any female employee in the UK could be forced to retire at 55

Tax incentives for pensions savings The government has been trying for many years to encourage people to make provision for their own pensions. The state cannot afford to pay it all  Pension funds are not subject to income tax and capital gains tax (CGT), so the pension fund can grow tax-free  Tax relief on contributions made by individuals and employers Pension contributions are tax-effective. Contributions to pensions (up to a certain limit each year) are exempt from tax (they are granted “tax relief”). The main tax incentives are:  The ability to take a pension from the age of 55  An option to take a tax-free lump sum at retirement  The option to include death benefits as part of the scheme Payments from a pension are subject to income tax when they are received

Pensions provided by the state The basic state pension, then known as the "Old Age Pension" was introduced in the UK in January It was equivalent to £19 per person in present day terms, and was payable to a person with an income below £1,600. The qualifying age was 70. The government’s objective was not to provide a high replacement income for most wage-earners but to provide a safety net against old-age deprivation. The National Insurance Act 1946 introduced the Basic State Pension. People pay NI contributions (NICs) – but the rates are now determined by the overall budgetary needs of the government and are not directly related to either future pension benefits or current pension funding needs. The State Pension Scheme today now comes in two parts:  The Basic State Pension  The Additional State Pension, or State Second Pension The State Pension is provided out of NICs, with no investment for future needs. This means that people in employment are funding the pensions of people who have already retired. In 2002, the dependency ratio (the proportion of working people to retired people) was 4 : 1.  By 2030 the dependency ratio is forecast to be 3 : 1  By 2050 it will be 2.5 : 1

By 2030, it is estimated that there will be 5.2m more people aged over 65 in the UK than there are today Between 2008 and 2051, the proportion of people aged 65 and over is projected to increase from 16% to 24%. This will lead to a significant rise in government spending on the state pension Longevity and the rising dependency ratio Government spending on pensioners has already risen by nearly £14bn since 2005/06. That figure will rise by an additional £4bn by The dependency ratio: the number of people not working versus the number of people working  According to the Department for Work and Pensions, a staggering 800,000 people will reach the current pensionable age of 65 in 2012 – 150,000 more than in 2011.

A report by the UK insurance company, Aviva, estimates that the UK’s pension shortfall is £317.5bn, worse than any other major country in Europe except Germany.  It means that the average UK citizen needs to save into their pension schemes £10,300 every year for the remainder of his or her working life in order to ensure enough money to live comfortably in retirement The difference between the pension provision that people retiring between 2011 and 2051 will need for an adequate standard of living in retirement, and the pension amount they can currently expect to receive (Source: Aviva, ONS) The pension “gap” in the UK

The State Pension At present, the State Pension is payable from age 65 for men and 60 for women.  The pension age for women is being increased gradually to equalise it with men  By April 2020, both men and women will be entitled to their pensions at the same age of 66  The Basic State Pension is paid at a flat rate to people who have made National Insurance Contributions (NICs) during their working life.  The Basic State Pension is paid in full to people who have paid NICs for a minimum of 30 “qualifying years”  People who have paid NICs for fewer than the minimum of 30 “qualifying years” will have their State Basic Pension reduced proportionately  If people have had long periods of unemployment of invalidity, and have not been able to make NICs for 30 years, they can get they pension topped up through the Pension Credit Guarantee  This is a “means-tested” benefit, i.e. the government will check on the earnings and assets of the applicant National pension as a percentage of average earnings

The Additional or Second State Pension In 2002, the State Second Pension (S2P) was brought in to replace the State Earnings Related Pension Scheme (SERPS).  S2P gives a more generous pay-out to employees earning up to £28,700, with most help going to those in the lowest range of earnings – i.e up to £12,500 (limits as of tax year 2006/07)  Workers who contract out of the S2P pay reduced NICs, which should enable them to pay more into their own pension schemes  The old SERPS scheme was earnings-related: the higher the earnings, the bigger the pension. S2P was brought in to provide a more generous additional state pension for those on low-to- moderate income levels, and for certain carers and disabled individuals  Workers can “contract out” of the State Second Pension Scheme if they have an occupational pension scheme, personal pension scheme or stake-holder scheme Private sector worker’s NICs and state pensions

Pensions provided by the private sector The private sector also provides pensions. The most common form is an occupational pension scheme provided by companies on behalf of their workers  Final salary schemes  “Defined benefit” In final salary pension schemes, the employee is entitle to an annual pension equivalent to a percentage of the employee’s last salary before retirement Most final salary schemes have been discontinued for new employees in the private sector because of rising life expectancy and volatile returns achieved by the funds invested to provide the pensions  Contributory or non-contributory schemes  “Defined contributions”  The exact percentage will depend on the number of years served with the company  A typical scheme would entitle the worker to 1/40 th of his/her final salary for every year of service In defined contribution schemes, the size of the pension is determined by the contributions paid into the investment fund and the performance of the fund itself.  In some schemes the employee contributes nothing at all to the fund

Pension reform Since 2006, the rules have been changed to allow much more flexibility in allowing tax relief for different types of contribution to pension funds. The tax rules have also been harmonised between the different types of registered (i.e. approved) pension schemes. Much of the reform of pensions in the UK is in response to the recommendations of the 2004 report of Lord Adair’s UK Pensions Commission.  The state pension age will rise from 66 years in 2024 to 68 years by 2044  Rises in the state pension and the “guarantee” element of the pensions credit will be linked to rises in average earnings after 2012  From 2010, the number of years of NI contributions to qualify for a full state pension has been cut to 30 years for men born after 1945 and for women born after  From 2012, workers not enrolled in an occupational pension scheme will be automatically enrolled into an existing scheme or a new national pensions savings scheme (formerly known as Personal Accounts)  For the first time employees and employers will be forced to contribute to a NEST pension on behalf of the employee, unless they choose to opt out or unless they already contribute to an alternative qualifying workplace pension.  The worker will contribute 4%, the employer 3% and the government (through tax relief) will contribute 1%  This will be known as The National Employment Savings Trust – NEST.

Private pensions, or personal pensions Private, or personal pensions, are individual pension plans. They can be schemes used by employees of companies which does not offer a group scheme, or by employees who have decided to opt out of their company’s scheme  Personal pensions are all defined contribution schemes Many employers organise personal pensions schemes for their employees. They will arrange the administration of these schemes with an insurance company or asset management firm. They will often pay contributions into their employees personal pension schemes.  The individual can often choose from a variety of investment funds being offered  Personal pensions are often used by the self-employed Coverage of voluntary private pension plans in UK (Source: OECD)  In personal pensions the individual chooses the investments that his/her pension makes, e.g  Funds in a scheme administered by an insurance company or asset manager  The actual individual investments in a self-invested plan (SIPPs)

Private pensions, or personal pensions – SIPPs Individuals also have the right to run their own Self-Invested Personal Pension (SIPP).  particular stocks and shares quoted on a recognised UK or overseas stock exchange;  government securities;  unit trusts;  investment trusts;  insurance company funds;  traded endowment policies;  deposit accounts with banks and building societies;  National Savings products; and  commercial property (such as offices, shops or factory premises). Subject to HM Revenue and Customs guidelines, the individual decides which investments are included in the scheme. The administration of the scheme is usually handled by a stock-broker or Independent Financial Adviser on behalf of the individual. Most SIPPs allow you to select from a range of assets, such as: HMRC will not permit the following to be invested in SIPPs:  Vintage cars;  Wine;  Stamps;  Art;  Residential property

Small Self-Administered Schemes (SSAS) Smaller companies can also make independent pension arrangements by setting up a Small Self-Administered Scheme (SSAS) The directors keep full control of the scheme (i.e. they do not appoint trustees to run these scheme for them).  The directors keep full control of the investments  The directors decide, within limits, the size and timing of contributions to the scheme The SSAS is required to appoint a pensioner trustee who is independent of the company  The independent is responsible for ensuring that the fund’s investments are in accordance with HMRC’s regulations Contributions to an SSAS are tax-deductible and there is no tax on investment income or capital gains.

Stakeholder pensions A stake-holder pension is a type of personal pension that incurs low charges. It is available from banks, insurance companies and building societies. Stake-holder pensions must satisfy a number of minimum government standards to ensure they offer value for money and flexibility:  Low charges  Low and flexible contributions  Transferability  Default option  People joining a stake-holder pension scheme after April 2005 will pay a maximum annual management charge of 1.5 for the first 10 years, reducing to 1% thereafter if they remain in the scheme  The minimum contribution cannot be greater than £20 and there cannot be a requirement for regular monthly contribution  There must be no charges for transfer to another scheme  Pension funds can allocate funds between different kinds of investment. A stakeholder scheme must provide a default for those unwilling to choose their own allocation between – say – UK shares, overseas shares or bond funds.

Pensions summary