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A pension is a pot of money that provides an income in retirement. Most of us are banking on this to provide us with a decent retirement fund. It could ultimately be the difference between spending your later years in penury or enjoying the lifestyle for which you have worked your whole life.
But how many of us truly understand how pensions work? Are we putting enough money away? And is a pension our best option?
Here, Telegraph Money explains what you need to know to get started. In this guide, we will cover:
- What is a pension ?
- How does a pension work?
- What are the different types of pension schemes?
- Is it worth having a pension?
- How do I open a pension?
- How much do I need to save?
- How much can I pay in?
- What are tax allowances?
- How do I access my pension?
What is a pension?
A pension is a pot of money that you’ll have saved into during your working life, which is usually invested in a bid to help it grow. When you reach retirement, it’s there to provide an income when you stop working. Increasingly, many of us will rely on several pensions to have a comfortable retirement – whether that’s the state pension, workplace pensions and/or private pensions.
How does a pension work?
Typically, you put pay into a pension and the money is locked away for the future. Often, contributions will be made by you, your workplace (if it’s a workplace pension) and the Government (to pay tax relief). It’s also possible for parents, grandparents, godparents or friends can pay into pensions for children (but only parents or guardians can set up the pension in the first instance).
Currently, once you reach 55 you can access up to 25pc tax-free from your personal or workplace pensions, but from April 2028, the age will rise to 57.
What are the different types of pension schemes?
The three most common types of pension are workplace, private and the state pension.
Workplace pensions
Most employees have a workplace pension. Under this system, both the employer and employee make contributions, which need to add up to a minimum of 8pc of your pre-tax salary (3pc from the employer, and 5pc from the employee). Many employers will pay in more than this – and might also match your contributions if you choose to pay in more than 5pc.
Often, pension contributions will be deducted from your salary, and your workplace’s pension scheme invests them on your behalf. Our guide on how to boost your workplace pension reveals how to maximise this “free money” from your employer.
Private pensions
A private pension is something you can set up either instead of or in addition to other pension pots. You might do this if you’re self-employed, for instance, or if you just want to put extra money away for your retirement.
State pension
The state pension is a weekly payment from the Government that most people can claim once they reach state pension age, which is currently set at 66. It is set to rise to 67 by 2028, and 68 between 2044-46.
What you get depends on your National Insurance contributions; you’ll need at least 35 years to get the full new state pension, and at least 10 years of contributions to get anything at all. The current new full state pension is £203.85 a week, but this will increase to £221.20 from April.
The basic state pension, also known as the “old” state pension, is for those who reached the state pension age before April 5 2016.
You can check your National Insurance record here: https://www.gov.uk/check-national-insurance-record. In order to do so, you will need a Government Gateway user ID and password.
You can check your state pension forecast by visiting the Government website at: https://www.gov.uk/check-state-pension
State pension rates increase each year, thanks to the Government’s triple lock policy, which promises to increase state pension payments every year in line with the highest of the previous September’s inflation, wage growth or 2.5pc – whichever is higher.
It is important to make sure that you are getting the most out of your state pension when you are planning your retirement, as some extra help will put less strain on your other pensions.
Now read our guides on how to claim National Insurance credits, and how to pay voluntary National Insurance contributions to help boost your state pension.
Workplace pensions – defined contribution vs defined benefit
Your employer decides which type of pension scheme to offer and which pension provider they use.
The most common workplace pension is a defined contribution (DC) pension. In this scheme, your money is invested over the course of your working life, and the value of your pot will fluctuate according to stock and bond market moves.
Defined benefit pensions (in some cases known as “final salary” pensions) are now very rare outside the public sector. They promise a guaranteed income in retirement, regardless of stock market moves.
For those of us outside the public sector, long-gone are the days of final salary pensions complete with a generous income that rises with inflation.
Is it worth having a pension?
Benefits
Employer contributions
If you’re contributing to a workplace pension, your employer must contribute at least 3pc of your monthly salary, and often they will offer more. This is in addition to your salary, so it costs you nothing.
Tax relief
You get tax relief on pension contributions. If you’re a basic-rate taxpayer earning up to £50,270, the Government will provide 20pc tax relief on your pension contributions. So, if you put in £100 a month, it will actually only cost you £80, since the Government adds the other £20.
If you are in a higher tax bracket, you can claim tax relief up to the amount of income tax you pay. You’ll automatically get 20pc, but you can claim the additional relief either via your tax return, or by contacting HMRC.
Tax-free lump sum
When you decide to draw your pension, you can usually take a tax-free lump sum from the age of 55. For most pensions, this is 25pc of your pot.
Your fund grows over time
As you save towards retirement, the money is invested by your pension provider. This is important as without it, the money you put away now would be worth a lot less when you retire decades later due to inflation. You can usually set which level of risk you’d like your provider to take, which will impact your returns.
A guaranteed income in retirement
Almost everyone will need an income when they give up work. For most people, this comes from their pensions.
When you retire, you might choose to buy an annuity with some or all of your pension pot. There are a number of different types, but it usually means buying a guaranteed annual income for a set number of years or for life.
Other considerations
Pensions are widely regarded as an important investment for the future, but there are drawbacks. You have to decide how much you can afford, what your future needs might be and how much risk you’re willing to take with your fund. This can be difficult, particularly if retirement is decades away.
There are also major mistakes you can make if you take your pension without carefully considering your options.
How do I open a pension?
Workplace pension
In 2012, the Government introduced a system known as “auto-enrolment”. It means that businesses are legally obliged to offer a pension saving scheme to eligible staff, and enrol them unless they actively opt out. To be eligible, staff must be earning at least £10,000 a year and aged between 22 and state pension age.
If you’re younger than this, or earn less, you might still be eligible to opt in if you meet certain criteria.
State pension
You don’t need to set up a state pension as it is based on the number of full years in which you made National Insurance contributions. You’ll need a minimum of 10 years of contributions to qualify for a state pension, and 35 years to receive the maximum amount.
Private pension
To set up a private pension, you find a provider yourself and start making contributions. This is usually monthly, but some will let you pay in larger amounts as and when you want.
How much do I need to save?
This depends on the lifestyle you want to live when you retire, and how much you can afford to put away in the meantime. Most people currently don’t save enough.
Nigel Peaple, of the Pensions and Lifetime Savings Association, said: “Not all people are the same. They will have their own expectations and requirements when it comes to visualising their retirement and saving for a pension will inevitably help them achieve their desired destination.
“To work out what this might look like and what they might aim for, savers should ask themselves what kind of lifestyle they have today and whether they want to maintain this in retirement.”
How much can I pay in?
You can pay as much as you like into a pension. However, there are certain tax allowances which may affect your decision.
What are the tax allowances?
Annual allowance
You can put up to £60,000, or 100pc of your income – whichever is lower – into pension savings each year without paying tax. This includes contributions from anyone else, such as your employer, and tax relief. If you go over this, you or your pension provider will have to pay tax.
Lifetime allowance
The current Lifetime Allowance is £1,073,100. If your pension fund exceeded that and you took it before April 6 2023, you were subject to charges.
The charges were removed from that date and from April 6 2024, the Lifetime Allowance will be abolished.
The new Lump Sum Allowance will limit the amount people can withdraw tax-free as a lump sum to £268,275. Any other payments will be subject to their normal rate of income tax, but not the previous charges due under the Lifetime Allowance.
How do I access my pension?
Private and workplace pensions
You can access your pension early, but you will lose 55pc of what you withdraw in tax. This is unless you meet certain eligibility criteria, like being unable to work due to ill health or terminally ill with less than a year to live.
Once you reach 55, you can access your pension if you choose to. From April 2028, this minimum age will increase to 57. Your provider should get in touch about your options before then, but you can also contact them.
There are a variety of options available. Mr Peaple added: “At retirement, savers face choices in drawing their pension, opting for fixed monthly amounts (annuity), flexible but unguaranteed withdrawals (drawdown), or lump sum cash. Importantly, a wealth of information and advice is accessible through government-backed services like MoneyHelper and Pensions Wise or personalised guidance from independent financial advisers can help with this decision.
“This multifaceted approach empowers savers to shape a secure and tailored pension plan for their desired retirement.”
State pension
You don’t get the state pension automatically – you have to apply for it. Generally, people receive an invitation letter around four months before they reach state pension age. You don’t need this in order to apply, though.
If you’re within three months of state pension age, more information on how to apply is here: https://www.gov.uk/new-state-pension/how-to-claim.
This article is kept updated with the latest information.