FINANCIAL SERVICES LECTURE 5 : Pensions in UK Chara Charalambous CDA COLLEGE 1

Outcomes An overview of pension schemes Why have a pension? Different types of UK-registered pension schemes and related benefits. Chara Charalambous CDA COLLEGE 2

What is a pension scheme? A pension is an income for your retirement. A pension scheme is a special type of savings plan, designed to provide an income in retirement. It can be set up by you or by your employer for you. While you are working, your salary is your income. When you retire you need to replace that income. The Government will provide you with a minimum income, but that is designed to cover only very basic living costs. If you want to have a more comfortable retirement, you need to provide an income for yourself. A pension scheme is specially planned for this purpose. There are many different types of pension schemes but the aim of each - saving now to provide an income at retirement - is the same. Chara Charalambous CDA COLLEGE 3

An overview of how pensions work If you are employed you may be offered membership of your employer's workplace pension scheme. It is likely that you will need to pay contributions and these will be deducted from your salary and paid into the scheme by your employer. Your employer is likely to contribute to the scheme too, to add to your savings. The contributions are invested until you retire. The earliest you can open your pension pot is usually age 55, unless you are retiring because you are suffering from ill health. You will be able to take some as a cash lump sum, and the rest in the form of a pension. If you are self-employed, you can set up a pension yourself with a provider. Providers include: insurance companies, banks, building societies. Chara Charalambous CDA COLLEGE 4

When you take your pension, it will be taxed in the same way as your salary - that is under the pay as you earn system. You cannot take out the money you put into your pension arrangement and use it for another purpose, because the purpose of the scheme is to give you an income in retirement. It can only be transferred to another pension scheme, or used to provide your benefits at retirement or death. Chara Charalambous CDA COLLEGE 5

Lump sum: a relatively large sum of money which is paid on a single time. Chara Charalambous CDA COLLEGE 6

Why have a pension?  Provision of regular income to replace earnings in retirement, or early retirement due to ill-health  Provision of lump sum benefit income for surviving dependants  Investment growth which is free of tax;  The ability to take some of your benefits at retirement as a cash lump sum.  Tax Reliefs Income Tax and relief on employee contributions Employer contributions not taxed Pension schemes do not pay income or capital gains tax on investment returns. Part of your retirement benefit may be paid as tax-free cash sum Chara Charalambous CDA COLLEGE 7

Different types of UK-registered pension schemes and related benefits Some will only be available if your employer offers them and others you can set up for yourself. You are not restricted to paying into only one pension scheme at a time. You can pay into several at the same time if you want to do so. Chara Charalambous CDA COLLEGE 8

There are three types of UK registered pension schemes:  Workplace pension schemes  Contract-based pension schemes  Other pension-related benefits Chara Charalambous CDA COLLEGE 9

Workplace pension schemes: There are two kinds of pension plans: defined contribution plans and defined benefit plans. Most employers give you the opportunity to join a workplace pension scheme. By 2018 all employers will have to do this. There are different types of workplace schemes available, and each works in a different way. Workplace pension scheme: A pension scheme set up by an employer to give their workers a retirement income.  Defined contribution schemes provide benefits at retirement, based on how much is paid in, and how the chosen investments perform.  Some schemes may provide benefits at retirement, based on your service and earnings. These are called defined benefit schemes. Chara Charalambous CDA COLLEGE 10

Defined contribution plans have become increasingly more popular. In this type of plan: ÜThe employer contributes funds to a third-party trust for benefit of employees. Companies usually require employees to contribute to the retirement plan as well. ÜThe funds are invested by trustee for the benefit of the employees and the fund balance is paid to employees over time after retirement. ÜThe accounting for this type of plan is relatively simple: the employer’s expense is the amount it is obligated to contribute to the plan and a liability is recorded only if the contribution has not been made in full Chara Charalambous CDA COLLEGE 11 There are two kinds of workplace pension plans: defined contribution plans and defined benefit plans.

Note H k Savings Plan The Company maintains a defined contribution, 401k Savings Plan, covering all employees who have completed one year of service with at least 1,000 hours and who are at least 21 years of age. The Company makes employer matching contributions at its discretion. Company contributions amounted to $73,000, $77,000, and $81,000 for the fiscal years ended January 31, 1999, 1998, and 1997, respectively. The following is an example of the accounting for a defined contribution plan from the annual report of The Sharper Image. The company matched contribution to the plan by its employees and recorded an expense in its income statement for the amount contributed to the plan. Chara Charalambous CDA COLLEGE 12 Definition of '401(k) Plan' A qualified plan established by employers to which entitled employees may make salary deferral (salary reduction) contributions on a post-tax and/or pretax basis. Employers offering a 401(k) plan may make matching or non-elective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings accrue on a tax-deferred basis.

Chara Charalambous CDA COLLEGE 13 Your pension pot is put into various types of investments, such as shares (shares are a stake in a company). The amount in your pension pot at retirement is based on how much has been paid in and how well the chosen investments have performed. Normally, when you retire, you can take some of your pension pot as a tax-free cash lump sum. You can use the rest to buy yourself an income, on which you might pay tax. These are also known as 'money purchase' schemes.

Chara Charalambous CDA COLLEGE 14 Examples of defined contribution schemes are money purchase, group personal pension plans, group stakeholder pension schemes and group self invested personal pensions.

Chara Charalambous CDA COLLEGE 15 Money purchase schemes Although your employer is responsible for supporting the scheme, in most cases a board of trustees runs it. The amount of pension you will be able to take from a money purchase scheme depends on the following: the amount of money you and your employer pay into the scheme; the charges taken to pay for the cost of investing and administering your pot how much your pension pot grows, based on your chosen investments; and how you choose to use the money when you retire.

Chara Charalambous CDA COLLEGE 16 Group personal pension plans A type of personal pension, set up by an employer to give a group of workers a retirement income. A Personal Pension is a pension you set up yourself direct with a pension provider. You pay regular monthly amounts or a lump sum to the pension provider who will invest it on your behalf. The fund is usually run by financial organisations such as building societies, banks, insurance companies or unit trusts.

ÜThe plan agreement defines the benefits employees will receive at retirement ÜAll of the pension assets belong to employer - no funds are paid to a third party ÜIf plan is under funded, employees must look to employer for the deficit. This can be a problem if the employer becomes insolvent. ÜIt provide benefits at retirement, based on your service and earnings. ÜThe amount of the pension liability and expense are a function of the amount of the pension obligation to the employees and the returns on the pension fund assets. Chara Charalambous CDA COLLEGE 17 The defined benefit plan is the second type of plan in use today. For this type of plan:

The amount you get at retirement is based on a number of things. These could include your earnings and how long you have been a member of the pension scheme. In most schemes, when you retire you can take some of your pension as a tax-free cash lump sum. The rest you get as a regular income, on which you might pay tax Chara Charalambous CDA COLLEGE 18

Chara Charalambous CDA COLLEGE 19 Examples of defined benefit schemes are final salary and career averaged revalue earnings schemes (CARE schemes).

Chara Charalambous CDA COLLEGE 20 Although your employer is responsible for supporting the scheme, in most cases a board of trustees runs it (except for most public sector schemes). The trustees are responsible for paying retirement and death benefits.public sector schemes You contribute to the scheme and it promises you a certain amount of pension at retirement. The amount of pension paid to you depends on the following:  the length of time you have been in the scheme (pensionable service);pensionable service  your earnings close to retirement (final pensionable salary); andfinal pensionable salary  the scheme's accrual rate - the rate at which pension benefits build up for you. You get a certain amount for each year of your pensionable service. So, if your scheme has an accrual rate of 1/60, you will get 1/60th of your final pensionable salary for each period of service you complete. In some cases, this will be worked out in complete years, in others years and months, or even years and days. accrual rate For example: (pensionable service multiplied by pensionable salary) divided by 60 = pension Final salary schemes:

Chara Charalambous CDA COLLEGE 21 Career average revalued earnings (CARE) schemes Although your employer supports the scheme, in most cases a board of trustees runs it (except for most public sector schemes). The trustees are responsible for paying retirement and death benefits. public sector schemes You contribute to the scheme and it promises you a certain amount of pension at retirement. The amount of pension paid to you depends on the following:  the length of time you have been in the scheme (pensionable service);pensionable service  your 'career averaged' earnings (your pensionable earnings increased in line with prices and then averaged over your pensionable service); andpensionable earnings  your scheme's accrual rate - the rate at which pension benefits build up for you. You get a certain amount for each year of your pensionable service, so, if your scheme has an accrual rate of 1/60, you will get 1/60th of your final pensionable salary for each period of service you complete. In some cases, this will be worked out in complete years, in others years and months, or even years and days. accrual rate

Chara Charalambous CDA COLLEGE 22 For example, you may build up a pension benefit of 1/60 th of earnings for each year of service, and retire in 2015 with 30 years' service. Your pension would be worked out as shown below: Each year's pensionable earnings figure is increased by the rate of inflation from that year until retirement. All the increased earnings are then added together to give a total pensionable salary. The total pensionable salary figure is then divided by 30 (in this example, the amount of time you were in the scheme) to give your career averaged earnings. That figure is then multiplied by 30 and divided by 1/60 (the accrual rate in this example). For example: (career averaged earnings multiplied by 30) divided by 1/60 = pension

Chara Charalambous CDA COLLEGE 23 Tax Saving into a pension is a tax-efficient way to save. Normally:  you get tax relief on your payments to the scheme; and  your savings grow free of tax. Tax relief means that some of your money that would have gone to the Government as tax, goes into your pension instead. When you take your benefits or open your pot, you can take a cash lump sum free of tax, and your income will be taxed under the pay as you earn system.

Chara Charalambous CDA COLLEGE 24 How is my pension taxed? When you take your benefits or open your pot, the income you take is a taxable benefit, subject to income tax in the same way that your salary was when you were working. This is the case even if you choose to use income drawdown. income drawdown You are likely to pay income tax if your taxable income, including your pension and state pension, is more than your personal tax allowance. Income tax is deducted from any income above that allowance. personal tax allowance Your scheme or provider will usually deduct and pay any income tax you owe automatically, from your pension, using a tax code. The tax code tells them how much to deduct before they pay you.

Chara Charalambous CDA COLLEGE 25 Income drawdown Some defined contribution pension schemes allow you to take an income directly from your pension fund rather than using it to buy a regular retirement income. Your pension fund stays invested, so its value can go up and down. There are upper and lower limits on the amount of income you can take. These limits are set by the Government and are reviewed regularly. The income you get is taxable.defined contribution pension schemes

Appendix: Some definitions…… A capital gain is a profit that results from a disposition (disposal, transfer) of a capital asset, such as stock, bond or real estate, where the amount realized on the disposition exceeds the purchase price. The gain is the difference between a higher selling price and a lower purchase price. Conversely, a capital loss arises if the proceeds from the sale of a capital asset are less than the purchase price. Capital gains may refer to "investment income" that arises in relation to real assets, such as property; financial assets, such as shares/stocks or bonds; and intangible assets. Chara Charalambous CDA COLLEGE 26

Some countries impose a tax on capital gains of individuals or corporations. Not all countries implement a capital gains tax and most have different rates of taxation for individuals and corporations. Tax relief or exemptions may be available for capital gains in relation to holdings in certain assets such as significant common stock holdings. Reasons for such exemptions are to provide incentives for entrepreneurship, to compensate for the effects of inflation, or to avoid "double taxation“. Chara Charalambous CDA COLLEGE 27

Capital gains taxes are only activated when an asset is realized, not while it is held by an investor. An investor can own shares that appreciate every year, but the investor does not incur a capital gains tax on the shares until they are sold. Capital gains tax laws vary from country to country. In the U.S., individuals and corporations are subject to capital gains taxes on their annual net capital gains. It is important to note that it is net capital gains that are subject to tax because if an investor sells two stocks during the year, one for a profit and an equal one for a loss, the amount of the capital loss incurred on the losing investment will counteract the capital gains from the winning investment. Chara Charalambous CDA COLLEGE 28

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