Main types of pension

There are two types of pension scheme and different rules apply to each:

  • Defined benefit schemes. These schemes pay you a guaranteed income each year. How much you’ll get depends on your earnings and how long you’ve been a member of the scheme.
  • Defined contribution schemes. Money paid into a defined contribution scheme is invested in funds chosen by you or your company. At retirement, the value of your pension pot will depend on how much has been paid in, plus any growth or decline in the value of your investments, minus any charges.

Options for defined contribution schemes

Your defined contribution pension scheme won’t automatically pay you an income. There are a number of options to convert your pension pot into an income. You can also choose to take some or all of your pension pot as cash.

Take a cash lump sum. The first 25% of your pension savings can be taken tax-free. Anything over this is added to any other taxable income you have and taxed. The amount you can take in tax-free lump sums is limited. This limit is called the lump sum allowance and is normally £268,275. This limit may be higher if you have protection from the lifetime allowance.

Buy a guaranteed income for life. An annuity will provide you with a guaranteed income for life. Your pension pot is passed to the insurance company of your choice (minus any cash you take), and the insurance company pay you an income for the rest of your life.

Use income drawdown. With income drawdown, you leave your pension savings invested, but take an income when you need it. You can take what you want, when you want, but there are no guarantees. If you make poor investment decisions, markets perform badly, you take too much income or live longer than you expected, your money could run out.

Choose ‘uncrystallised funds pension lump sum’ (UFPLS). With UFPLS, you don’t take a tax-free lump sum upfront. Instead, 25% of each payment of income is treated as tax-free. This means you do get a tax-free amount, but it’s spread over each payment. These tax-free amounts also count towards the lump sum allowance.

Options for defined benefit schemes

A defined benefit scheme will automatically pay you an income. However, there are two options to consider:

Should you take a tax-free lump sum? In a defined benefit scheme, you can exchange part of your pension for a tax-free cash sum. This is called ‘commutation’. For example, you may be offered £15 cash for each £1 of pension you give up.

Should you transfer your defined benefits? There may be reasons to think about transferring your defined benefits into a defined contribution scheme, but this decision should not be taken lightly. Defined benefit schemes are the ‘gold standard’ in pension planning.

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