The Retirement Newsletter: Understanding pension gobbledegook
Issue Number: -53 — what does it all mean?
Welcome
Welcome to issue -53, Understanding Pension Gobbledegook — what does it all mean?
Pension gobbledegook
We all have jargon in our lives.
In my work, we use a lot of jargon to get across complex ideas and concepts. Most professions are guilty of using jargon or ‘in-house’ terms. It shows that you know what you are talking about and are part of the “in-crowd”.
One of my favourite pieces of jargon is in Medicine, where the doctor cannot say they don’t know the cause of a particular complaint or illness but instead refer to it as idiopathic. Why not say you don’t know?
Jargon can be confusing and is sometimes used to obfuscate what is happening. It can be discriminatory.
When my pension started, it was jargon free. You paid your contribution, and for each year you paid in, you got 1/80 of your final salary as the pension. Easy. Then it was replaced with something I didn’t understand and which came with new jargon.
So, let’s look at my top ten examples of jargon in the pension industry.
1. Final Salary Scheme — now called a Defined Benefit Scheme
To me, this sums up the problem — why change the name of something that describes what it does, ‘Final Salary Scheme’, to something that means nothing — Defined Benefit Scheme? What are they trying to hide?
A final salary scheme (or as it is now known — Defined Benefit Scheme) is a rare beast, and very few pensions of this type still exist as they are deemed too expensive.
In a final salary scheme, the employer and employee contribute, and at retirement, the employee receives a lump sum, usually a multiple of their final salary, and a pension. The pension is then calculated by taking the number of years of contribution and dividing it by usually 75 or 80, with a maximum value of 0.5. This means an employee could retire with a pension of 50% of their final salary. Not bad.
The UK Government State Pension is now like a final salary pension because you need 35 years of contribution to get the full state pension. If you don’t have 35 years, you get a fraction of the state pension. You can check out your contribution record at Check your National Insurance record.
2. Defined Contribution — also known as a Money Purchase Scheme
The final salary schemes (Defined Benefit Scheme) have been replaced with Defined Contribution Schemes, also known as Money Purchase Schemes.
In a Defined Contribution Scheme, the employee pays in and depending on the scheme, so may the employer (don’t assume the employer is contributing). In the Defined Contribution Scheme, the money is invested, and it is hoped that there are enough funds for a pension at retirement.
Typically, the money from the Defined Contribution Scheme is used to buy an annuity (see number six below) or is released in small chunks (drawdown, see five below) to fund the pension.
3. Additional Voluntary Contributions (AVCs)
AVCs are a way of ‘topping’ up your pension if there are any gaps in payment years, that is, you have taken a Contribution Holiday (see below). With an AVC, you make additional contributions to pay for the missing years of investment.
There is also a type of AVC for the UK National Insurance scheme that pays for the UK state pension. Have a look at National Insurance for more details.
4. Pension Commencement Lump Sum
The Pension Commencement Lump Sum is at least self-explanatory. It is a lump sum you get when you retire. The lump sum can be in addition to the pension lump sum — check your pension for details. A lump sum may also be paid from any AVC. Again, check with your pension provider.
However, you must be careful with your lump sum, as when you take it and how much you take can have all kinds of tax implications.
5. Pension Drawdown — also called Income Drawdown or Flexible Retirement Income product
Pension Drawdown links to the lump sum mentioned above (number four above) and the Defined Contributions (number two above).
In Pension Drawdown, you take a fixed percentage or amount (being careful about tax) from your pension pot each year. The idea is your pension pot is at zero when you die. However, this approach has two problems: you may run out of money before you die or leave cash in the pot.
6. Compulsory Purchase Annuity (CPA)
A Compulsory Purchase Annuity is an annuity you must buy when your pension matures. You have no choice; it is part of the scheme.
An annuity is a ‘financial device’ in which you sign over a large sum of cash and get an income from the money. A company manages the annuity and keeps the lump sum upon your death.
As I understand it, there are three types of annuity:
No increase (also called a Level Annuity) — the income will stay the same each year. This type of annuity will have a higher starting income, and inflation will reduce the value of your income over time.
Fixed-rate increase — Your annuity income increases yearly at a fixed rate. If your rate is above inflation, you see a net gain; if below, your spending power erodes.
Inflation-linked — The annuity income increases each year in line with inflation.
The advantage of an annuity is that there is an income for as long as you live. The disadvantage is they can be poor value if you die shortly after setting up the annuity, as you will not get a good return on your investment.
7. Annual Allowance
The Annual Allowance is the amount of money you can build up in your pension tax-free for a given financial year. Something I have never had to worry about!
8. Salary Sacrifice
Salary Sacrifice is a tax-efficient way of saving for your pension.
In salary sacrifice, you agree with your employer to a reduction in pay and the amount your pay is reduced is paid by your employer, along with their contribution, into your pension. This means, on paper, you earn less, and so pay less tax on your earnings. That is, it reduces your tax liability.
9. Contribution Holiday
A Contribution Holiday is, in my opinion, something that should be avoided, if possible. A Contribution Holiday is when you stop paying into your pension, and it is not a good idea as it will impact your final pension.
10. SERPS — State Earnings Related Pension Scheme
State Earnings Related Pension Scheme (SERPS) was a scheme in the UK run by the government that topped up your UK state pension. SERPS finished in 2002. If you worked before 2002, you might get some pension top-up from SERPS if you paid in. In 2002, the State Second Pension (S2P) replaced SERPS. The new UK State Pension replaced S2P in 2016.
OK, so those are ten pension terms that give me problems, and I would still not claim to understand them all fully.
Are there any key terms I have missed, or have I got any of the above wrong? If I have missed terms or got them wrong, please comment below.
Useful links
UK Government Website:
Some pension ‘jargon-busting’ sites:
Glossary of Terms — Pensions — Institute and Faculty of Actuaries
Pensions Glossary — Royal London
Pensions Glossary — Profile Pensions
Pensions Glossary — Pension Bee
Glossary of Pension Terms — Berkshire Pensions
Pensions Jargon Buster — The People’s Pension
Next week
Next week is issue -52, and that is an important issue. So, if you have not subscribed to this newsletter, why not subscribe now so you don’t miss it?
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Until next time,
Nick
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Please note: I am not a financial advisor. I am writing about money and financial matters based on things I have read over the years about money and preparing to retire. IT IS NOT FINANCIAL ADVICE.