Pension
Income
Investor

Glossary of pension terms

Annuity

An insurance contract under which an individual hands a lump sum to an insurer and in return the insurer pays an annual income until the policyholder’s death. Extras such as annual increases and “spouses’ benefits” – a stipulation that the policyholder’s widow or widower will receive a payment after the policyholder’s death – are available, although they reduce the annual income received for a given amount spent. Anyone whose medical condition or lifestyle choices (such as smoking) can be expected to reduce life expectancy should seek an “enhanced” or “impaired life” annuity, which will pay more each year to reflect the policy’s likely shorter life.

Annual allowance

The maximum amount that can be paid into an individual’s pension(s) each year and still qualify for tax relief. The allowance is £40,000 in the 2018–19 tax year, although anyone whose annual income exceeds £150,000 loses £1 of the annual allowance for each £2 of extra income, down to a minimum of £10,000. The allowance encompasses all contributions, including those made by employers and the notional amount deemed to be involved in any accrual of final salary benefits over the course of the year.

Contracted out

A pension saver was contracted out of top-up state pensions such as SERPS if they paid reduced National Insurance contributions on the basis that the money was instead paid into a workplace pension plan. Contracting out has now been abolished but some people who were contracted out at some stage of their career can expect a smaller state pension as a result of their reduced NI contributions.

Coupon

Another word for the interest paid by a bond investment.

Defined benefit pensions

See final salary pension.

Dividend

The income paid by a share. Dividends can be paid annually, six-monthly, quarterly or monthly. Investment trusts and funds also pay dividends.

Drawdown

The term for the type of pension income on which this book is based – in other words, the withdrawal of dividends, coupons or the proceeds of asset sales from a pot of assets that remains invested after the saver has retired. The alternative to using drawdown is buying an annuity with the money that has accumulated in a pot of pension savings over the course of a worker’s career.

Equity income

A name given to funds that generate income by investing in shares that pay dividends, as opposed to other assets such as bonds or property.

Equity release

A means of raising money in old age by borrowing against your home. Often there is no interest to pay while the borrower is alive. Instead, the interest is added to the loan and the entire sum repaid when the property is sold, either at death or when the borrower moves into a care home.

Execution-only

A description of financial transactions where companies simply do what you ask them to do as opposed to offering you advice. An execution-only stockbroker simply takes your instructions on which share to buy or sell and executes the trade on your behalf. When you use the investment platforms referred to in this book you are doing so on an “execution-only” basis.

Final salary pension

A pension, offered by your employer, that pays you a proportion of your salary when you retire. These pensions contrast with the type that form the basis of this website, where the saver builds up a pot of money in his or her own name, sometimes with the help of contributions from employers, and that money is used to generate income in retirement. With a final salary pension your employer is obliged to pay you, until you die, a set sum each month, calculated by reference to your final salary (or sometimes your career average salary). Because of the guaranteed payments, and mandatory inflation-linked increases, these pensions are seen as highly valuable.

Fixed protection

See lifetime allowance.

Funds

A collection of assets such as shares held by an investment management firm on behalf of individual or institutional investors, who own a set fraction of the fund in proportion to the amount they invested. Funds offer the advantages of diversification, which limits the damage caused if individual investments go wrong, and professional management. The fund management firm charges an annual fee of a percentage of the amount invested.

Guaranteed annuity rate

A special feature of certain savings plans taken out in previous decades. If you agreed to save into a pension with certain companies until you retired, you would be allowed to receive a predetermined sum from an annuity taken out with the same company. Without the guarantee you would have to accept whatever rate was offered in the market at the time, which, given how annuity rates have collapsed in recent years, would inevitably be much lower. Guaranteed annuity rates therefore tend to be extremely valuable and policyholders with such a rate should think very carefully before moving the money to another pension, which would see them forfeit the guarantee.

Individual protection

See lifetime allowance.

ISA

A savings plan with tax advantages. Up to £20,000 can be put into ISAs each year and invested in cash, stocks and shares and certain other assets. There is no tax rebate on money paid into an ISA, unlike with pensions, but investment growth and withdrawals are tax-free (although inheritance tax is payable on inherited ISAs).

Lifetime allowance

The maximum value that a pension pot (or series of pots held by the same individual) can reach before tax penalties apply. In the 2019–20 tax year the allowance is £1.055m. A saver’s pension pots are assessed for compliance with the limit only at certain points: when the first money is withdrawn (whether as the tax-free lump sum, as the first income payment, perhaps from an annuity, or as an ad hoc withdrawal); at the age of 75; or if the pension is transferred overseas. Final salary pensions are included in the calculation of your total pension savings, using a notional value that multiplies your initial annual pension by a fixed figure. In some circumstances you can benefit from a higher allowance by using concessions called “fixed protection” and “individual protection”.

Market value adjustment

A kind of exit penalty that can apply to with-profits investment plans if you want to take your money out early, perhaps because you want to transfer it to a self-managed pension.

Natural yield: the income generated by an asset such as a share, bond or property. The term is used to distinguish such income from money raised by the sale of a portion of such assets. For example, if your pension fund is invested in shares you can withdraw money either by taking just the dividends (the “natural yield”) or by selling some of the shares, which some investors do on the basis that they expect the share price, in general, to rise.

Passive funds

See tracker funds.

Pension pot

A sum of money saved specifically in a pension as opposed to an ISA or other type of plan. A pension pot normally accumulates gradually over the course of a saver’s working life, thanks to contributions from the saver (and perhaps from his or her employer) and to investment growth. On retirement the pension pot is normally used to generate income, either via regular withdrawals from the pot or via the use of the pot to buy an annuity. Final salary pensions do not involve a pension pot; here the worker simply accrues the right to a certain retirement income from his employer.

Personal savings allowance

A tax perk that allows interest from non-ISA savings accounts to be received tax-free. The allowance is £1,000 a year for basic-rate taxpayers (£500 for high-rate taxpayers) in 2018–19.

Platform

An online service that allows people to hold a wide variety of investments such as shares and funds in one place and switch easily between them. Those who follow the suggestions on this website will need to use a platform. The best known platforms include Hargreaves Lansdown, Barclays Smart Investor, Fidelity Personal Investing and Interactive Investor*.

Read our guide to choosing an investment platform, including our own choice of Interactive Investor, on our page Step 2: Choose the firm (‘platform’) where you will hold your amalgamated pension pot.

Tax code

A combination of letters and numbers, issued by HMRC, that tells employers or pension companies how much tax to deduct from payments to employees or pension customers. All taxpayers should check periodically that their tax code is correct. Once you are past state pension age your tax code is likely to change to reflect the fact that you are receiving the state pension, which counts towards taxable income, without any tax deduction. There is therefore less additional income you can receive before you reach the personal allowance than there was before you became entitled to the state pension.

Tax-free lump sum

A benefit of saving in a pension by which 25% of a pension pot can be withdrawn free from income tax. Any withdrawals from the remainder of the pot are subject to tax in just the way that income from a salary would be.

Tax relief

The principal tax benefit of pensions. Pension contributions can be made from gross income, before tax is deducted. In practice this often means that savers pay into a pension from their taxed earnings and are then repaid the tax, either when their pension company claims a rebate on their behalf (and adds it to their pension pot) or when the taxpayer fills in a self-assessment return.

Tracker funds

A type of investment fund that does not attempt to “pick winners” but simply buys the shares or other assets that constitute a particular index, such as the FTSE 100. Tracker funds, also called passive funds, are becoming increasingly popular, partly because of scepticism on the part of some investors that professional fund managers can produce better returns than a tracker and partly because of these funds’ low costs.

Transfer value

The sum offered to a member of a final salary pension scheme who wishes to cash it in for a lump sum, which would then be transferred to a “pension pot” style plan. Currently some transfer values are seen as very generous – perhaps 40 times the promised annual pension – and so many savers are accepting them. This involves taking on the risk and responsibility of investing the lump sum with the aim of producing a better income than the final salary scheme promised. Some investors transfer from a final salary scheme so that they can pass on money to the next generation when they die.

Triple lock

A promise from the government to increase the state pension in line with the higher of price or wage inflation, subject to a minimum of 2.5% a year. The triple lock is seen as generous but expensive and there have been consistent fears that it could be watered down in future.

UFPLS (uncrystallised funds pension lump sum)

A new means of withdrawing money from a pension pot, introduced as part of the pension freedoms. It involves dividing the pot into a potentially large number of “mini-pots” and treating each as a separate pension from which a 25% tax-free lump sum can be taken, as opposed to all in one go. Each mini-pot is “uncrystallised” (untouched) until its tax-free 25% cash is withdrawn. In some circumstances UFPLS can be more tax-efficient than taking one big tax-free lump sum and paying tax on all withdrawals thereafter.

With-profits

A type of investment fund that attempts to smooth out the ups and down of financial markets by holding back some gains in good years to hold in reserve for bad periods. All investors’ money is pooled and an individual saver does not know how much they will get back until the plan matures. If they want their money back before maturity they may have to pay a penalty (see “market value adjustment”). With-profits investments, which started to lose favour about 20 years ago, are often held inside a pension.

Yield

The income that a share, bond or other investment produces as a proportion of its price. If a share is priced at £1 and pays an annual dividend of 4p, the yield is 4%.