What is a Pension & How do they work?
This post is the first in our Pension Basics: The Essentials series.
Pensions can be confusing, but they don’t have to be. In this introductory series, I will set out the essential information you need to understand how pensions work in the UK. From paying money in to taking money out, from tax to transfers; I will cover all the basics for you.
In this first post, lets talk about what pensions are and how they work.
What is a Pension?
A pension is a financial product designed to give you money to live on after you retire and stop working. The income you receive can be an income for life or paid over a period of time with lump sums that are usually tax free.
To build a pension pot, you make deposits or contributions. These are made either by you, your employer or a combination of the two. If you make personal contributions, you will receive a 25% top up from the government in the form of tax relief.
Your pension money is invested so it can grow over time. Growth is dependent on regular contributions and the performance of the investments plus any fees and charges taken.
You can access your pension from the age of 55 (or 57 after April 2028).
A note on the State Pension
The State Pension is a weekly amount, claimed from the Government when you reach state pension age. Your entitlement here will depend on how long you have been making National Insurance contributions. Currently, to qualify for the full state pension, you must have been contributing for 35 years.
Types of pensions
Pensions can be classified in a few different ways but, to keep it simple, we will talk here about Workplace Pensions (also called Occupational Pensions) and Personal Pensions.
Workplace pensions
You will likely have an occupational pension set up by your employer. It is a legal requirement for employers to offer a workplace pension for anyone over the age of 21 earning more than £10,000 per year. You will usually be auto-enrolled in your workplace pension if you qualify.
For most types of workplace pension, your employer must pay a minimum contribution of 3% of your salary. The minimum personal contribution you will make is 5% (4% from your salary, 1% from tax relief) although there are some workplace pensions that do not require employee contributions.
When you retire you will have a number of options including the ability to take up to 25% as a tax free lump sum and the rest as taxable income. You may qualify for an income for life, calculated based on the value held in your pension.
Defined Contributions vs Defined Benefits
The majority of pensions today are Defined Contribution (DC) schemes. These work essentially as decribed above. As the name suggests, these pensions are based on the amount of contributions made to the scheme.
Defined Benefit (or Final Salary) schemes are an older form of pension. They only now really exist as legacy products or for those working in the public sector (NHS, Teacher Pensions, Armed Forces pensions). Instead of being based on contributions, these pensions are usually based on your pay when you stop working.
DB schemes have gradually been closed or withdrawn over the years. This is simply because they became too expensive for private sector employers to maintain. If you are lucky enough to have one, keep hold of it!
Personal Pensions
These are private pensions that you can set up by yourself either directly or through a financial adviser. A personal pension is usually fully funded by contributions you make personally. Your employer may agree to contribute for you (although they don’t have to). You may want to open a personal pension if you are self-employed.
A basic personal pension will have one or more investment profiles that you can invest in as you see fit and based on your current needs. A Self-Invested Personal Pension is a type of personal pension that has a wider range of investments, including Commercial Property.
As with a workplace pension, your contributions attract tax relief. You can also be more flexible and contribute as much or as little as you like and at any time. As these pensions are a type of DC pension, the amount of income at retirement will depend on the amount paid in, the performance of investments and any fees and charges.
Your options at retirement are usually very similar to a workplace pension. Many offer drawdown pensions for a more flexible income arrangement. For an income for life, you may need to transfer away or buy an annuity.
Summary
- A pension is essentially a savings plan made for the purpose of giving you an income after you retire.
- You and your employer can make contributions that are invested with the aim of growing enough money to sustain you in your retirement.
- A workplace pension is set up by your employer. As part of auto-enrollment rules, they must contribute at least 3% of your salary.
- Personal pensions are set up by you and can serve as an extra retirement pot or be used if you are self-employed.
- Any contributions that you make will usually qualify for tax relief. This is a top up from the government.
- You can draw money from your pension when you turn 55 (57 in 2028).
This post provides general information about pensions. It is for educational purposes only and does not constitute financial advice. Please consult a financial adviser for advice tailored to your individual situation or consider speaking to MoneyHelper.
