What is a pension and how do they work?

Chris Torney / 31 March 2016

Simple guide to how pensions work to help you save for retirement with an explanation of the different types of pension available.

A pension is a type of savings scheme that allows you to put money aside while you are working to help pay for your retirement. 

You can set up your own pension or pay into a pension run by your employer. And if you pay national insurance contributions, you will gain entitlement to the state pension.

There are tax incentives to save into a pension, and in general the money in a pension can only be accessed once you’ve reached a certain age.

Final salary pensions

Until recently, most companies offered their employees final-salary pensions: these guaranteed to pay a retirement income at a certain rate based on each worker’s earnings and length of service at the point they retired.

Employers took money from their workers to invest and finance the pensions, but if there was any shortfall, it would be down to the company to make up the difference. As shortfalls became more common and businesses increasingly struggled to meet their pension commitments, final-salary schemes began to be phased out.

Most company pensions are now known as “defined contribution” pensions: workers know how much they put in, but there are no guarantees as to how much income they will get in retirement.

One advantage of workplace pensions is that employers will typically add to any contributions their employees make.

Think you have an old pension from a former employer? Read our guide to tracing all of your pensions.

Auto enrolment

Recently, the government has introduced a programme called auto enrolment, which means that by 2017, practically every company will have to offer their workers a pension scheme, provided they 22 or older and earn more than a minimum amount. 

Under auto-enrolment, employees pay in at least 4% of their salary, with a further 3% coming from their employers.

Workplace pensions are usually invested with a single scheme provider – typically a big insurance company. Workers may have some choice over what type of investments they hold, however, and how much risk they are happy to take.

If you stop working for the company, you can move your pension to a new scheme or leave it where it is – albeit with no more contributions added.

Find out more about auto enrolment.

Personal pensions

A personal pension is very similar to a defined-contribution workplace pension: you don’t get any employer contributions, but you do have more choice over where it is invested.

If you don’t want to spend a lot of time choosing which investments to include in your personal pension, you can go for a scheme offered by one of the major insurance companies. 

As an alternative, however, a Self-Invested Private Pension or SIPP gives you far more choice over how your pension savings are used.

You can hold individual company shares, as well as a vast range of investment funds in a SIPP, and you can make decisions over when to buy and sell shares and funds whenever you like. However, the charges for running a SIPP are likely to be higher than on a standard personal pension, especially if you trade regularly.

What is a SIPP?

Tax relief on pensions

The government encourages workers to make regular contributions to their own pensions by offering tax relief on the money they save. This means that contributions are treated as if they came out of pre-tax income – so for basic-rate taxpayers who pay income tax at 20%, each £80 they save is topped up to £100.

Higher- and top-rate taxpayers can claim extra tax relief through the self-assessment system.

The state pension

The full state pension is available to UK citizens provided they have paid in sufficient years’ worth of National Insurance (NI) contributions. This provides a weekly income of £119.30 in the 2016-17 financial year.

People who have made extra NI payments during their working lives may be entitled to extra payments through the State Second Pension (S2P).

A new state pension system is being introduced for people who retire on or after 6 April 2016. This will pay a higher weekly rate of £155.65 – but the S2P is being phased out.

To qualify for the full state pension under the pre-April 2016 system, workers needed a total of 30 years’ NI contributions. But this is rising to 35 years for the new scheme.

The age at which people become eligible for the state pension is changing as well. Until 2010, men got it when they turned 65 and women at age 60.

But over the course of this decade, the state pension age for both groups is rising to 66.

Read Paul Lewis' guide to the new flat-rate state pension.

Taking income from your pension

You can only take money out of a workplace or personal pension once you reach the age of 55 – although there are some exceptions, for ill-health, for example.

Until recently, most people at retirement used their pension savings to buy an annuity: this is a financial product which converts a large sum of money into a guaranteed regular income for the rest of the customer’s life. But since April 2015, it has been much easier to leave the pension invested in the stock market while taking a regular income.

It is also now simpler to withdraw a whole pension and use it for other investments, such as buy-to-let property.

Read more about releasing your pension fund at 55.

Tax on pensions

A quarter of any pension fund can be taken free of tax, but any further withdrawals or income payments are subject to income tax – this could be zero, 20%, 40% or even 45% depending on what other income you earn in the relevant tax year.

For more tips and useful information, browse our money articles.

The opinions expressed are those of the author and are not held by Saga unless specifically stated.

The material is for general information only and does not constitute investment, tax, legal, medical or other form of advice. You should not rely on this information to make (or refrain from making) any decisions. Always obtain independent, professional advice for your own particular situation.