What is a pension and how does it work?

Saving money in a piggy bank

By understanding what your pension is and how it works, you will be ready to make the important decisions that may help you and your family when you retire.

A pension is a source of regular income to live on when you retire. 

You are paying in now, while you are working, for a regular income when you retire.  On top of your local government pension scheme (LGPS) pension you will also get a state pension from the government when you retire.

Your pension is an annual amount, paid on a monthly basis to you, for the rest of your life once you retire. Inflation is added to your pension every year so it keeps up with the cost of living too.

Your contributions and your pension in the LGPS are different. Often people think that their contributions are their pension – but your contribution is just that “a contribution” towards the cost of the pension scheme.

Your pension is worked out using a defined formula. This is used to work out every year what your pension will be when you retire.

Your contributions are a percentage of your pay, which are deducted from your salary every month. As well as your contribution your employer also contributes to the fund (you pay a third of the cost and your employer pays two-thirds). Your employer contributes to the scheme and is responsible for ensuring there is enough money at the time you retire to pay your pension. Every three years, an independent actuary calculates how much your employer should contribute to the scheme.

These contributions go into the Avon Pension Fund, from which the pensions are paid to those drawing their pension. Contributions pay for the cost of the scheme (including paying out pensions and paying death in service grants).

The LGPS is a defined benefit scheme which means that your pension will continue to be worked out using a set formula – under the 2014 scheme it’s based on 1/49th x your pay + cost of inflation added (to keep up with living costs). This is worked out every year and added to your pension account.

Your pension isn’t determined by the performance of investments, stock markets and cost of annuities. Schemes which rely on investments are known as money purchase schemes, where you pay in to a fund and when you retire what you’ve paid in goes to buy an annuity which will pay you a pension – this is not how the LGPS works. You are in a defined benefit scheme, guaranteed by the government.

Although your pension is guaranteed and does not rely on investments in the stock market it is a “funded” scheme and is invested in a number of ways to increase its value. But remember it is safe and will be paid when you retire, rather than you having to look for an annuity or other arrangement to pay your pension.

Most people who have a pension want to take a cash lump sum when they retire, perhaps to pay off debts, buy a property or invest it to provide an income.

When you retire you can elect to give up some of your pension for a cash lump sum (which is tax-free). For every £1 of pension you give up you will get £12 cash lump sum.

If you were in the pension scheme before 1 April 2008 you will automatically get a tax-free lump sum equal to three times your pension.

Personal pensions

A personal pension is one that you take out yourself, for example if you're self-employed or your employer doesn't offer a pension arrangement. They are a type of money purchase pension. You choose the provider and make arrangements for your contributions to be paid.

Stakeholder pensions

Stakeholder pensions are money purchase pensions and must have certain features. Some of these are:

  • limited charges
  • low minimum contributions
  • flexible contributions
  • penalty-free transfers
  • a default investment fund – a fund your money will be invested in if you don't want to choose.

Company (occupational) pensions

An occupational pension is a private pension scheme run by some employers and is also known as a works pension, company pension or superannuation.

Group personal pensions (through your employer)

Some employers offer these schemes. They build up a personal fund for each employee which is converted into an income when you retire. They are a type of money purchase pension. The scheme is run by the pension provider that your employer chooses, but it is an individual contract between you and the provider.

Defined benefit schemes (such as the LGPS)

Defined benefit (DB) schemes usually provide a pension income based on:

  • The number of years you’ve been a member of the scheme – known as pensionable service
  • Your pensionable earnings – this could be your salary at retirement (known as ‘final salary’), or salary averaged over a career (‘career average’), or some other formula, and
  • The proportion of those earnings you receive as a pension for each year of membership – this is called the accrual rate and some commonly used rates are 1/60th or 1/80th of your pensionable earnings for each year of pensionable service

These schemes are run by trustees who look after the interests of the scheme’s members. Your employer contributes to the scheme and is responsible for ensuring there is enough money at the time you retire to pay your pension.

Defined contribution (DC) /money purchase schemes

You build up a pension fund using your contributions and your employer’s contributions (if they make any) plus investment returns (if any) and tax relief. When you retire you can take a tax free lump sum from your fund and use the rest to secure an income – usually in the form of an annuity.

State pension

In addition to any pension arrangements you make you may also qualify for a state retirement pension paid by the government. The Basic State Pension is based on the National Insurance contributions you pay, or which are given as credits, during your working life.

An annuity converts your money purchase pension into an income for the rest of your life.

Annuities are sold by life insurance companies and you can add different options and get different types depending on your needs and circumstances.

As the local government pension scheme is a defined-benefit scheme you do not need to buy an annuity when you retire.

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