What is a pension and how does it work?
Updated 24 February 2020
Pensions provide income in later life, usually when you’ve retired from work. There are several types of pension, some of which work in very different ways from others. You may also draw pensions from a number of different sources.
This guide explains each kind of pension and how it works, so you can make your own pension decisions more confidently – whether you’re near retirement or just starting your career.
- What different types of pensions are there?
- The two main kinds of pension
- What is pension tax relief?
- How do I set up a pension?
- How do I access my pension?
- Do I pay tax on pension income?
What different types of pension schemes are there?
You can receive a pension from three different sources: from the state, from former employers, and from personal pensions (i.e. products you set up yourself). Here’s a quick summary of each pension source.
The state pension
The UK government provides a state pension to all eligible citizens once they reach a certain age. Currently this age is 65 for most people, but is planned to increase in future. The pension is paid for using current taxes, so you don’t ‘build up’ a pot of money. However, to be eligible for it you need to build up ‘qualifying years’, usually by making National Insurance (NI) contributions out of your income.
Once you start receiving your state pension, payments are guaranteed for the rest of your life. Currently the maximum state pension is £168.60 per week (tax year 2019/20). Find out more about the state pension.
Every employer must enrol their employees in a pension scheme. Both you and your employer contribute to the scheme, and the government boosts your contributions through tax relief (see below). You can opt out of a workplace pension scheme voluntarily, but no-one can pressure you into doing this.
Workplace pensions come in two distinct types:
- Defined contribution (also called ‘money purchase’)
- Defined benefit (also called ‘final salary’ or sometimes ‘average salary’)
Defined contribution pensions are by far the most common these days, though defined benefit pensions are still widely used in the public sector. You can read more about each kind below.
You can also take out a personal pension scheme yourself – for example if you’re self-employed. There are several different types of personal pension, but they are all defined contribution (‘money purchase’) schemes.
A personal pension works in a similar way to a defined contribution workplace pension, but with a few key differences:
- You don’t receive employer contributions (obviously!)
- You can sometimes take ‘contribution holidays’ where you don’t pay in to your pension
- You can choose the assets in which your pension is invested, if you have a SIPP (self-invested personal pension).
You do receive tax relief from the government on your contributions, just like with a workplace pension. Find out more about personal pensions.
The two main kinds of pension
How do defined contribution pensions work?
You can think of a defined contribution (DC) pension as being like a piggy bank: you pay money in, and the money builds up. However, it’s much better than a piggy bank, because the money is invested in fund chosen to deliver long-term growth. Over time, this builds into a larger sum, which is called your pension pot.
The amount you pay into your pension is the known figure (hence ‘defined contribution’), but the eventual size of your pension pot will vary depending on the fund’s performance (though you can make a good estimate). When you access your pension, you can use the money to acquire a pension product such as an annuity or drawdown scheme (hence ‘money purchase’).
Most workplace pensions and all personal pensions work in this way.
What is a pension fund?
A pension fund is a portfolio of assets in which your pension contributions are invested. These assets are usually made up of equities (stocks & shares) with perhaps some bonds included, and sometimes a small amount of cash. Pension funds can even include commercial property.
Choosing the right pension fund is important if you want to make the most of your pension. A young person just starting their career will want a very different pension fund from someone approaching retirement. Funds can also vary in the management fees that are charged, which can make a difference of many thousands of pounds over time. Find out more about choosing the right pension fund.
How do defined benefit pensions work?
Think of a defined benefit (DB) pension as a kind of contract with your employer. Your employer (or rather, the pension scheme they use) agrees to pay you a fixed income from a certain date, for as long as you live. The state pension itself is a kind of DB pension.
With this kind of pension, your eventual pension income is the known figure, hence ‘defined benefit’. The size of this income depends on a number of factors:
- The size of your salary when you leave their employment (or your average salary over that employment)
- How long you have worked there as a member of the pension scheme (your ‘pensionable service’)
- The pension scheme’s ‘accrual rate’
What is a pension scheme’s accrual rate?
The accrual rate of a defined benefit pension scheme is the rate at which benefits build up. For instance, if the scheme’s accrual rate is 1/80, you are entitled to a pension equal to 1/80th of your final salary for every year of pensionable service.
For example, if you have 10 years of pensionable service and leave this employer on a salary of £50,000 then your pension will be 1/80th of £50,000 multiplied by 10, i.e. £6,250 a year. This income will be guaranteed until you die.
Who offers DB pensions?
Most DB pensions are offered by public sector / government employers, though a few private sector employers still use them. They are generally considers to be very attractive.
What is a DB pension transfer?
If you have a DB pension that is not yet paying out to you, it is sometimes possible to exchange it for a pension pot (the kind you would have with a DC pension). This kind of pension transfer has pros and cons. On the plus side, you can access your money more flexibly. On the downside, you are exchanging a guaranteed income for a finite sum of money.
What is pension tax relief?
Tax relief is the biggest advantage that pensions have over ordinary investments. Whenever you pay into a pension, the government refunds the tax that you paid on this this part of your income. This amounts to a boost of at least 25 per cent on every pension contribution – so every pound you pay into your pension becomes £1.25 instantly. This is because £1.25 taxed at the basic rate of income tax (20 per cent) would be reduced to £1. Pension tax relief reverses this.
If you’re a higher rate taxpayer, you can claim even more tax relief, though you’ll have to do this through your self-assessment.
How do I set up a pension?
If you are an employee, your employer must enrol you in a pension scheme automatically. If you are self-employed, you can set up your own pension. It’s good to seek advice from a financial adviser about this. The important thing to remember is: don’t put it off. Every year of delay in setting up your pension will cost you thousands in lost income, so even if you can only make small contributions now, get that pension set up.
How do I access my pension?
You can access your pension from the age of 55, if it’s a defined contribution pension. However, most people will want to wait until their 60s at least.
If you have a defined benefit pension, this will start to pay out from a fixed date, specified by the scheme (and usually called the ‘Normal Retirement Date’ or similar).
Assuming you have a defined contribution scheme, there are several ways you can access your money:
- A tax-free lump sum of 25 per cent of the pot (everyone is entitled to this)
- Flexible withdrawals from the pot (known as ‘drawdown’)
- A guaranteed income for life (an annuity – you purchase this product using your pension pot)
Do I pay tax on pension income?
Pension income is taxed just like ordinary income, but you can take 25 per cent of your pension pot tax-free. Some DB pensions also offer a tax-free lump sum.
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