Workplace Pension: How Does it Work?
In this blog, Dennis Hall explains how your workplace pension works, how it’s invested, if a default strategy is the right option for you and whether it will provide enough income.
Introduction
To make an effective start on our retirement financial planning, we need to establish what kind of lifestyle we would like to lead in retirement and, then calculate how much money we need to support this lifestyle. This is covered in more detail on the latest episode of our podcast, The Century Plan.
Recently we’ve been focusing on workplace pensions, as these are likely to be the major source of retirement income for most people in the UK. Workplace pensions are not always fully understood so now feels like a good time to dig a little deeper into how workplace pensions came about and how they work.
What you should know about workplace pensions.
A key change in the pension landscape was auto-enrolment which was introduced into the UK workplace in October 2012. The aim was to give more workers easy access to a workplace pension scheme. Under auto-enrolment, employers have to automatically enrol eligible workers into a qualifying scheme. The roll out across all UK employers was staggered over a four and half year period with all firms enrolling their staff by April 2017.
Unlike many of the former schemes that were run by larger employers where benefits were linked to a person’s final salary at retirement (or at the date of leaving if earlier) a workplace pension is built up on a defined contribution basis. This basis builds up a sum of capital which is accessed at retirement to provide pension benefits.
The minimum contribution into a workplace pension is 8%. This is made up of 3% from the employer and 5% from the employee (which includes 1% tax relief).
Understanding Your Workplace Pension
How much can an employer contribute to a workplace pension?
According to a paper put together by Nest Insight in 2022, 4 in 10 employees work for companies that pay more than the 3% minimum contribution.
Large companies are more likely to offer more. And the larger contributions tend to go to high earners, and those who have been with a company for more than 5 years.
Interestingly, when those employers who contribute the minimum of 3% were asked why they pay this amount:
- One third said it was because it was the government recommended amount.
- 1 in 5 were driven by the default setting in their payroll software or pension provider set-up.
- 1 in 20 said they didn’t know it was possible to contribute more.
Can I contribute more to my workplace pension?
The simple answer is yes.
You can choose to increase savings into your workplace pension or you may be asked to supplement your pension through additional voluntary contributions (AVCs) into an individual plan. These are extra contributions you make on top of your standard contributions to build up more retirement savings, and some employers may agree to match some or all of your increase. You may be able to do this through ‘salary sacrifice’ otherwise you will benefit from the same tax relief as your standard contributions.
Workers often choose to boost their pension pot as they approach retirement, but there’s no need to wait this long. The earlier you start, the more you will benefit from the effect of compounding.
Each payment you make into your pension benefits from 20 percent tax relief (more if you’re a higher-rate taxpayer). This means that every pound in your pension only costs you 80 pence in contributions.
Where is my workplace pension invested?
Unless you have chosen to self-select, your pension is likely to be invested in a default fund. This is a fund chosen to reflect the needs of a wide range of investors. But the one-size-fits-all approach won’t be right for everyone.
Many default strategies have a lifestyling approach, meaning when you’re younger, your fund will hold a higher proportion of equities, typically 70% equities, 30% bonds and cash. A de-risking phase will typically start 10 years before retirement when your investments are gradually switched out of equities into bonds and then ultimately into cash.
This means that at the time you retire your pension will be in cash and will have missed out on the possible growth of equities in that 10 year run up to retirement. Unless you intend to purchase an annuity, you will also be poorly positioned for the retirement phase of your life. Retirement doesn’t mean you no longer need to be invested. The days of everyone taking an annuity are gone and your money will need to keep working for anything up to 40 years through your retirement phase.
Alternatives to the workplace pension default strategy.
The majority of workers in the UK have their workplace pension invested in a default strategy. Often because they are unaware there are other options, or there is limited access to advice.
Default investment funds will have been selected by your pension provider. These funds are based on the needs of the average scheme member and will aim to cater for a range of ages and risk appetites. Few of us match the profile of an average pension saver, and someone in their twenties has different needs to someone in their fifties. Choosing a more personalised investment strategy will deliver better benefits over the long term.
Someone in their twenties can absorb increased volatility from 100% equity funds whereas someone in their fifties may wish to have a small buffer of less volatile investments as they approach retirement.
Will my workplace pension be enough?
Although, for many of us, a workplace pension will likely be our main source of income in retirement, it should be part of a number of options you have within your financial plan.
Some people will plan to downsize their property to release capital which they can then invest and draw down alongside their pension. People, particularly higher earners, will have been restricted from making large pension contributions and will be accumulating savings and investments outside the pension regime. This will include Individual Savings Plans (ISAs) and other saving and investment plans.
The State Pension is also a significant factor in many people’s retirement plans, and it is always a useful exercise to check whether you have made sufficient National Insurance contributions to receive the full State Pension.
Conclusion.
With over 22 million employees enrolled in the workplace pension, it’s clear this is a significant part of our overall retirement planning. However, the majority of employees are invested in default funds and life-styling strategies that are likely to deliver sub-optimal returns.
In the early years the amounts invested in a workplace pension may appear relatively small and probably not worth spending time on, but the benefits of compounding works over a long period of time. Making the right decisions at the outset will have a significant impact at the time the pension is finally accessed.
ABOUT YELLOWTAIL
Founded by Dennis Hall, Yellowtail are the trusted financial planners who advise individuals & families across the UK. Yellowtail’s experts provide the clarity, control and confidence to guide you through financial planning, estate planning, pension transfers and investment management directing your journey towards a prosperous retirement and financial peace of mind.