We know pensions can seem incredibly complex and confusing, and we’re determined to try and make them a bit easier for everyone to understand.
So, alongside our FAQ on Pensions and on Penfold, we’ve started this glossary of pension terms to pull together all the words, phrases and concepts that so often come up when pensions are discussed, and explain them in everyday language.
This is a work in progress, so if there is something we’ve missed that we need to explain, or something we’ve explained badly, please let us know either via email or commenting at the bottom.
This is the money the government currently gives each year to people over “state pension age” (which is currently age 66, but set to rise to 68, and quite likely to rise again after that).
It is currently about £8,750 a year.
To get the full amount you need to have paid national insurance contributions for at least 35 years, otherwise you will receive less than this. Each year the amount of the state pension does increase a bit, but this is to keep up with increases in living costs (inflation).
Don’t confuse the state pension with auto-enrolment, workplace or private pensions (all explained below). The state pension is totally separate to your other pensions and isn’t linked in any way to how much you save up or contribute.
If you think, like most people, that £8,750 a year won’t be enough to live on, or that you might want to stop working (or just work less) before you are in your late 60s, you should consider paying into a private pension.
This just means anything that isn’t a State Pension. This can be Workplace Pension or a Personal Pension.
This is a catch-all word for a pension that is provided by your employer (your workplace). It usually means your employer pays into your pension too, but you don’t get much (if any) choice in which pension provider you use.
This means a pension that you arrange yourself. Also known as a defined contribution pension. The amount you get at retirement is based on how much you have paid in over many years (which has hopefully grown by being invested – see below)
Confusingly, a few employers offer personal pensions as workplace pensions. This usually means you get more choice in where your money is invested. Penfold is a type of personal pension called a SIPP and we are working on a version that employers can pay into.
If you work in the NHS or for a Local authority you’re likely to have a public sector pension which is not a personal pension.
This is the money the government (HMRC) will put into your pension to encourage and incentivise you to contribute more. It’s called tax relief as it is not really the governments money they are handing out, they are just giving some of your tax back.
For example, if you are a ‘basic rate tax payer’ (i.e you earn less than £50,000), you’ll being paying 20% of anything you earn above £12,500 straight to the taxman.
Here’s an example of how tax relief might work. Say that one month you earn £1,000 – you pay 20% tax (£200), so are left with £800. If you then put that £800 into a pension, you’d get the £200 back as tax relief from the government (Straight into your pension pot).
But there are some limits:
There is a minimum amount everyone is entitled to, no matter what they earn. If you earn less than £12,500, you can pay in £2,880 into a pension and get £720 added by the government.
After that, you generally can’t get more tax added back than you actually paid on your earnings. So if you won £8,000 on a scratch card and put it all in a pension, you wouldn’t get £2,000 in tax relief unless that year you had actually paid £2,000 in tax.
Also, there is a maximum limit on tax relief in any one year. If you managed to put £40,000 into a pension in one year (including the government top-up), you’d not get any tax relief on further contributions beyond that £40,000.
This is the concept of automatically being signed up to a pension scheme through your workplace. The government now requires all employers to sign their staff up to a pension scheme and if you don’t want to take part, you have to actively ‘opt-out’. If you don’t opt out, you’ll pay at least 5% of your salary into a pension scheme, and your employer will pay at least 3%.
Opting out usually means you’re turning down contributions from your employer (at least 3% of your annual salary).
Defined Benefit Pension / Defined Contribution Pension
A Defined Benefit pension is a type of pension used in the public sector or by some large employers in the past. Your employer pays for the scheme, so no matter what you pay in, you’ll get paid a set amount each year after you retire, depending on how much you earn and how long you worked there – i.e the benefit is what defines this pension. As people started living longer, these got very expensive, and so are much rarer now.
So, most pensions available to young people today (outside of the public sector) are Defined Contribution pensions, where how much you get when you retire is based on how much you put in (contribute), and how the investments in your pension have performed. This means the more money you want in retirement, the more you need to save up, and the better you want those investments to perform.
This is the money that your employer might pay into your pension. This applies to most people who have a traditional job (i.e aren’t self employed). Employers usually only make a contribution if you also agree to make one.
Usually you’ll see these contributions on your payslip as ‘Employer/E’er pension contribution’ & ‘Employee/E’ee pension contribution’. Your employer usually holds both these back from what they pay into your bank account each month and pays the whole thing over to a pension provider.
This stands for ‘Self Invested Personal Pension’ and is the type of pension we provide at Penfold. A SIPP allows for much more flexible investing and gives you the most control over where your money is invested.
Investing just means doing something with your money with the hope that it will make you more money. This usually means buying something (an “Asset”) that may give you an income, or you can sell the asset for a higher price (or both).
Investing can be done in lots of different ways, like lending it to someone and charging them interest, buying a house and charging rent/selling it for a higher price, or buying shares in a company and sharing in their profit or selling the shares for a higher price.
All investing involves what is called ‘risk’, which is the chance you can lose money. Some investments are safer (less risky) than others. Generally speaking, the higher the risk, the more money you can potentially earn, but there is a greater chance of making a loss.
But risk is a good thing. It’s what lets you earn money on your investments and build up your Einstein Money (Compound Interest) over a long time. Sensible investing is all about managing this risk so that you are making a good ‘return’ on your investment, but limiting the chance of losing money overall.
The main way risk can be managed is by ‘diversifying’, which means buying lots of different investments that have different chances of losing money, that aren’t related to each other. You can diversify by putting some money in a bank account, some in property, some in stocks and shares, etc etc.
That way the chance of losing money on all of them in one year can be made really low, so the gains from the winners are more than the losses from the losers.
The plans that Penfold offers are all highly diversified, which means they invest in thousands of different companies (either Equities or Bonds) and other types of assets all around the world. This means you don’t have to worry as much about managing risk, as the world-class money managers that look after your money do this for you. We do let you choose how much risk you want to take within our plans though.
Basically, higher risk should means your pot potentially making more Einstein Money (compound interest) over the long term, but with more ups and downs along the way. Low risk might mean nice and steady growth with fewer bumps, but probably less money overall.
Usually, people with several decades to go until retirement pick a higher risk rating, then switch to a lower rating when they get closer to stopping work.
Equities are a very common way of investing that involves buying shares in a company and sharing in that company’s profit (owning a piece of the company, basically).
As companies make more (or less) profit over time, other people might want to buy the shares from you, so you also make money if you sell those shares for more than you bought them for.
Historically, investing in equities has meant your money grew much more over the long term than investing in other ways, although there can be ups and downs along the way.
Most pension plans are made up of a mix of equities, bonds and other investments.
Bonds / Fixed Income
Bonds are a way of investing to get a ‘fixed-income’. Think of it like lending money to someone. You pay a certain price for a bond (i.e. lend someone money), and each year you’re guaranteed a certain payment in return (i.e. the interest).
You can sell the bond (i.e. the amount you have lent and the right to receive interest) for the price you bought it, or a higher (or lower) price depending on what others are willing to pay it.
Bonds can be issued by governments or by companies, meaning you are lending them money. The amount you get paid all depends on the how likely they are to pay you back in full – and government are almost certainly going to pay you back. Usually they are much safer (so lower Risk) than equities, but the payments they return are lower. Most pension plans are made up of a mix of equities, bonds and other investments.
Einstein money (Compound interest)
This is a complicated concept, but incredibly important. Imagine you invite a friend to a party, and they invite two friends, and they invite two friends, and so on, and so on. Pretty soon 300 people are trashing your front room.
This is called “compounding”, and Einstein called it the most powerful force in the universe! This is what should happen to your money over a long time if you leave it in a pension. It’s such a big deal that at Penfold we’ve given it a new name, Einstein Money.
Basically, when your money is in a pension it works for you by generating money from investments. If it makes money one year, there is more money the next year to make even more investments, and so on.
The main thing to understand about Einstein Money is the younger & sooner you start saving, the more you are likely to get over your lifetime. For example if you put £100 in your pension at age 40 and take it out at 60, it might have ‘compounded’ to be worth £265. But if you put it in age 20 it might be worth £704!*
*This is an illustrative example assuming an assumed annual growth rate of 5%. Einstein Money is not guaranteed, but is a reasonable estimate of the effect of compound investment returns on the amount you put aside in a pension over a long period of time, using a widely used growth assumption.
An Annuity is where you hand over all your money to an insurance company, and in return they agree to give you a fixed income until you die.
For example: Say you gave them £100,000 (“Buying an £100k annuity”). They might agree to give you £5,000 a year until you die. If you live for 10 years, they’ve given you £50,000 and they make money. If you live for 30, they’ve given you £150,000, and depending on how well the invested the original £100k, the insurance company might lose out overall.
The benefit of an annuity is you can plan ahead and know exactly what your income will be each year, and they often link to inflation in some way. But the drawback is that the money is gone when you die – you can’t usually pass it on. Also, annuity ‘rates’ vary, so what the insurance company agrees to pay you each year might not be very much.