Topic 10: Pension Products

Question 1

What is the defined-benefit pension scheme?

Answer 1

An occupational pension scheme where the final benefits are defined, usually as a fraction of final (or near final) salary or career average earnings for every year of membership in the scheme. Eg, a 1/60th scheme would provide a benefit of 1/60th final salary for every year of membership. The employer is responsible for ensuring the promised benefits are provided, so carries all the risk.

Question 2

What is the Defined - contribution pension scheme?

Answer 2

A pension scheme where the individual has their own pension pot, either as part of an occupational scheme or a personal pension. Contributions from the individual and perhaps their employer are invested, and at retirement the individual’s pot is used to provide the benefits. The final benefits are not guaranteed, and so the risk lies with the individual.

Question 3

What is a Pensions annual allowance?

Answer 3

The annual limit for pension contributions for claiming income tax relief. Individuals can contribute the lower of their earned income or the annual allowance and relief income tax relief. An employer can also contribute, but if the total from both sources exceeds the annual allowance the individual will be subject to a tax charge on the surplus.

Question 4

What is a Tapered annual allowance?

Answer 4

If an individual has ‘adjusted’ income above a certain figure, their annual allowance is tapered (reduced) by £1 for every £2 above the stated figure. The adjusted annual allowance cannot fall below a stated figure.

Question 5

What is a Money purchase annual allowance (MPPA)?

Answer 5

If an individual draws benefits from their defined contribution (personal pension, etc) pension using flexi‑access drawdown or takes an uncrystallised funds pension lump sum (UFPLS), they can continue to fund their pension, but their Annual Allowance is reduced significantly.

Question 6

What is a Flexi-access drawdown?

Answer 6

When taking personal pension benefits, the plan holder can take the tax-free pension commencement lump sum and leave the rest of the fund invested. Technically the remaining fund becomes a drawdown account. They then withdraw income from the fund (drawdown) as and when they want, with each payment being taxable as income. There is no requirement to take income at all or to take a regular amount – the income element is totally flexible.

Question 7

What is a Uncrystallised funds pension lump sum (UFPLS)?

Answer 7

When wishing to take pension benefits, the individual does not move the account into drawdown by taking the tax-free pension commencement lump sum. Instead they take a series of lump sums as and when they want, with 25% of each withdrawal being tax free and the balance being taxed as income.

Question 8

What is Direct Pay Arrangement?

Answer 8

Relates to pensions, where the employer deducts the employee’s pension contribution from their gross salary and sends it to the pension provider.

Question 9

Threshold income is calculated through the following steps:

Answer 9

1. Calculate total net income for the tax year.
2. Deduct any gross pension contributions that benefited from relief at source
   (but excluding any employer contributions).
3. Deduct any lump sum death benefits from registered pension schemes.
4. Add any reduction of employed income for pension provision through
   salary sacrifice schemes and flexible remuneration arrangements made
   after 8 July 2015

Question 10

Adjusted income is calculated through the following 6 steps:

Answer 10

1. Calculate total net income for the tax year.
2. Add claims made for tax relief on pension savings paid before tax relief
   was given.
3. Add pension savings made to pension schemes where tax relief was given.
4. Add any tax relief claims on pension savings made to overseas pension
   schemes (for non‑domicile individuals).
5. Add employer pension contributions.
6. Deduct any lump sum death benefits received from registered pension
   schemes.

Question 11

What is Lifetime Allowance?

Answer 11

If the total value of an individual’s pension benefits exceeds the lifetime allowance at the point when benefits are taken, there is a lifetime allowance tax charge. The pension provider will deduct the tax before any benefits are issued. There are different tax rates charged depending on how the money is paid out, with lump sums attracting a higher charge than funds taken as income or withdrawals.

Question 12

What is the ‘Marginal Rate’ of tax?

Answer 12

A person’s highest marginal rate of tax is the highest rate
that they pay on their income. For example, a person whose
taxable income falls within the higher‑rate band would pay 20
per cent on their income up to the basic‑rate threshold and 40
per cent on any income that lies above that. As they only pay higher‑rate income tax on part of their earnings, they would
only receive tax relief at the highest rate (40 per cent) on that amount of their pension contributions (eg if £5,000 of income was within the higher‑rate band, then £5,000 of pension contributions would be eligible for an additional 20 per cent tax relief). Any contribution in excess of that amount would
receive tax relief at the basic rate.

Question 13

When and how can benefits be taken?

Answer 13

Benefits can generally be taken from normal minimum pension age, which is currently age 55 (rising to 57 in 2028). When benefits are drawn the scheme member can usually take up to 25 per cent of the fund tax free as a pension
commencement lump sum (PCLS).
The rules regarding to taking the remainder depend on the type of scheme.

Question 14

When and how can benefits be taken from a Defined-benefit scheme?

Answer 14

The balance over and above any tax‑free PCLS
must be used to provide an income, typically as a scheme pension direct
from the pension fund

Question 15

When and how can benefits be taken from Defined-contribution scheme?

Answer 15

The balance once any tax‑free PCLS has
been taken can be used to provide income in the form of an annuity or
flexible access drawdown (FAD). An alternative is to take a UFPLS – we cover
these options in more detail in section 10.5.3. Providers are not obliged to provide customers with the option of taking UFPLS, but customers have the option of switching providers should they wish to do this.

Question 16

What is Pension commencement lump sum?

Answer 16

The sum (up to 25 per cent of the individual’s pension fund) that may be taken at retirement tax‑free.

Question 17

What is the Collective defined-contribution pension schemes?

Answer 17

There is a demand for a third type of scheme, which can provide more
predictability for scheme members than defined contribution, without the
cost volatility for employers associated with defined benefit. The Pension Schemes Act 2021 provides a framework for the UK’s operation and regulation
of collective money‑purchase schemes (commonly known as collective
defined‑contribution pensions). The new collective defined‑contribution
(CDC) pension will see both the employer and employee pay into a joint fund, with pensions paid out from this shared pot. The benefits of the new scheme include that it offers predictable costs for the employer and is more resilient against economic shocks. The Royal Mail and Communication Workers Union will be the UK’s first CDC scheme and a case study will be done on how UK workers receive the new scheme and how successful these schemes can be in
practice.

Question 18

Explain topping up defined-benefit schemes?

Answer 18

As people are now living longer and spending a longer period in retirement, employers are finding defined‑benefit schemes increasingly expensive to
run. As a result, many are reducing their commitment and transferring
responsibility for pension provision to individuals. Many people may therefore
wish to supplement their retirement income by contributing more to their
occupational schemes, or contributing to private arrangements. The following
are tax‑efficient pension arrangements:
- additional voluntary contributions (AVCs);
- free‑standing additional voluntary contributions (FSAVCs);
- personal/stakeholder pension plans.
AVCs and FSAVCs are available to employees who are members of occupational
schemes. Personal/stakeholder pensions are generally available to anyone
under the age of 75

Question 19

What are additional voluntary contributions?

Answer 19

AVCs are additional contributions to an occupational scheme. Sometimes,
such contributions purchase additional years’ service in a final salary scheme.
However, most AVCs operate as defined‑contribution arrangements and the
employee will only have a limited choice of funds.
The employer will usually cover some or all of the administration and fund
management costs. Contributions to AVCs are deducted from gross salary and
the employee therefore receives full tax relief at the same time.

Question 20

What are Free-standing additional voluntary contribution?

Answer 20

As an alternative to an AVC, an individual might choose to contribute to an FSAVCs defined‑contribution fund provided by a separate pension provider.
FSAVCs are available from a range of financial institutions, including insurance companies, banks and building societies.
Contributions to FSAVCs are made from taxed income. Tax relief at the basic rate of 20 per cent is claimed by the pension provider and added to the individual’s pension fund. Higher‑ and additional‑rate taxpayers need to claim additional relief separately through their income tax self‑assessment.

Question 21

What are Workplace pensions?

Answer 21

Under auto‑enrolment, employers must enrol ‘eligible’ workers in a qualifying
workplace pension and contribute a specified minimum amount to the scheme.
Many existing occupational pensions already qualified as a suitable pension
scheme for this purpose; those employers who did not have a scheme already
could set one up, or enrol their employees in the National Employment Savings
Trust (Nest).

Question 22

Explain the National Employment Savings Trust (NEST)?

Answer 22

As an alternative to setting up or using their own pension
scheme, employers can meet their obligations by enrolling
their employees in Nest.
Nest is a trust‑based occupational pension scheme established
to support workplace pension provisions; it can be used by an
employer either alongside or instead of its own occupational
pension scheme.
Nest offers a range of investment funds from which the
member can choose, and there are default fund selections for
members who do not wish to make their own choice. Charges
are capped. Benefits can be taken from age 55 and must be
taken no later than age 75.

Question 23

What are the criteria for auto-enrolment into a workplace pension?

Answer 23

• is not already in a pension at work;
• is aged 22 or over;
• is under state pension age;
• earns more than £10,000;
• works in the UK
  An employee can choose to opt out of the scheme, but only after they have
  automatically been made a member.
  A minimum of 8 per cent of an employee’s earnings have to be paid into the
  scheme, made up of an employer contribution of 3 per cent, an employee
  contribution of 4 per cent and tax relief of 1 per cent.

Question 24

What is a Personal Pension?

Answer 24

All forms of non‑occupational pensions are arranged on a defined‑contribution
basis. Personal pensions are individual arrangements provided by financial
services companies such as life assurance companies, banks and building
societies. Contributions receive basic‑rate tax relief at source, even for
non‑taxpayers. A higher‑ or additional‑rate taxpayer needs to claim additional
relief separately through self‑assessment.

Question 25

What is a group personal pension?

Answer 25

A collection of individual personal pension plans all administered by an
insurance company on behalf of a single employer.

Question 26

What is a self-invested personal pension (SIPP)?

Answer 26

A SIPP is a personal pension arrangement that gives access to a wider range of
investment options than would be available through a conventional personal pension. For example, it may be possible to hold a direct shareholding or
commercial property within a SIPP. While access to a wide range of investments
is permitted, a SIPP will also allow a scheme member to use the provider’s
range of conventional pension funds.
A SIPP may appeal to someone who has the confidence to make their own investment decisions.

Question 27

Retirement planning has two phases:

Answer 27

• an accumulation phase when savings are made into a pension to build up
  a fund;
• a decumulation phase when benefits are drawn.

Question 28

How are Defined- benefit schemes invested?

Answer 28

In respect of a defined‑benefit scheme there is, generally, a pension fund
operated by or on behalf of the employer into which contributions are paid.
Investment decisions are taken at scheme level, with the objective being
to ensure that the scheme can continue to pay pension benefits already in
payment and the benefits of current members who will reach retirement age/
draw benefits in future. The scheme will usually be invested in a mixture
of equities, gilts, corporate bonds and cash; individual members are unable
to make decisions on how their contributions are invested but have the
reassurance of the promise of a certain level of pension benefits.

Question 29

How are Public sector/ public service schemes invested?

Answer 29

These schemes are operated by the government and most of
them are ‘unfunded’. There is no pension fund as such and
contributions form part of general government revenues. The
schemes do provide a promise in terms of pension benefits
and this is provided by the government out of its funds.

Question 30

How are Defined-contribution scehemes invested?

Answer 30

Within defined‑contribution arrangements, the scheme member has much more choice and control over how their contributions are invested. The pension provider usually offers a wide range of investment funds from which the member can select, and pension benefits depend, in part, on the value of
the fund when benefits are taken.

Question 31

How can benefits be taken from a defined-benefit occupational pension?

Answer 31

A member of a defined‑benefit occupational pension has an option to take
a tax‑free PCLS, with income in retirement generally provided by a scheme
pension paid direct from the pension fund.

Question 32

How can benefits be taken from a defined-contribution pension?

Answer 32

There are a number of ways in which benefits can be taken from a
defined‑contribution pension such as a personal/stakeholder pension. While
a defined‑contribution pension fund remains invested, it is referred to as ‘uncrystallised’; once benefits are taken, in full or in part, the portion of the fund providing retirement benefits is referred to as ‘crystallised’.

There is an option to take up to 25 per cent of the accumulated fund as a
tax‑free PCLS. As all personal/stakeholder pensions are defined‑contribution
schemes, there might (subject to the scheme rules) be a range of options as to how the balance of the fund is used to provide income, and/or further lump
sums (which would be taxable).

Question 33

What is Annuity Purchase?

Answer 33

Annuity purchase involves the payment of a lump sum from the pension fund
in exchange for an income.

The benefit of an annuity is certainty: the annuity provider promises a
guaranteed rate of income – an annuity rate – based on the annuitant’s
circumstances. It is not necessary to buy the annuity from the company used
during the accumulation phase: pension providers must inform their clients
that they can ‘shop around’ for the most appropriate benefits structures and/
or higher annuity rates. This is known as the open‑market option.

Once an annuity has been purchased, investment risk is removed but there is no longer any prospect of further investment growth.

Question 34

What is a Flexi-access drawdown?

Answer 34

Flexi‑access drawdown (FAD) involves drawing the pension fund, after any PCLS has been taken, and reinvesting it into a fund to provide income. The fund remains invested so there is potential for further growth but there is also
the risk that the fund value might fall and, consequently, income levels may not be maintained.
The withdrawals can be structured however the member wishes: as smaller, regular payments to provide an income, or as larger, perhaps one‑off payments.
As any payment beyond the PCLS is taxable, care must be taken not to trigger a large tax charge.

Question 35

What is Uncrystallised funds pension lump sum?

Answer 35

pting for a UFPLS means the pension fund remains invested. Unlike FAD,
none of the fund is drawn or reinvested and no PCLS is drawn. The member is able to use their pension fund to draw a series of lump sum payments to meet
their income/capital needs.

Question 36

Death benefits for Defined-benefit schemes?

Answer 36

If a member dies before retirement age, referred to as death in service, a lump sum death benefit is usually available. This can be a multiple of earnings or a fixed sum. Additionally, there might be a spouse’s and/or dependant’s pension, paid from the scheme to the spouse, civil partner or dependants of
the deceased. This can be a proportion of the member’s pension rights.
On death after retirement, a defined‑benefit scheme may:
- continue to pay the pension income for a period of time, a ‘guaranteed
period’; or
- pay a spouse’s/dependant’s pension as a proportion of the pension that
was being paid to the member.

Question 37

Death benefits for Defined-contribution schemes?

Answer 37

On death before crystallisation, the pension fund can be used to provide income and/or lump sum benefits.

On death after retirement, there are a range of ways in which a
defined‑contribution scheme will be able to provide benefits to the spouse/ civil partner or dependants of the deceased:
- continuing scheme pension;
- lifetime annuity continuing for an agreed period post‑death;
- lifetime annuity paying an annuity protection lump sum – this would be the balance of the funds used to buy the annuity as compared with how much had already been paid out as income at date of death; or
- continuing drawdown income.