What is a pension and how do they work?

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 – as most people do automatically – 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 fairly 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.

Today, most company pensions are 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.

Visit our pensions section for more information on pensions

Auto enrolment

Recently, the government introduced a programme called auto enrolment, which means that practically every company has to offer their workers a pension scheme, provided they are 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 and 1% in the form of tax relief.

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.

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.

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.

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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.

A new state pension system was introduced in April 2016. This pays a higher weekly rate than previously, but it has seen the top-up State Second Pension (S2P) phased out.

The S2P was an extra payment available to people who made additional NI contributions – including during periods when they were unable to work.

In the 2019-20 financial year, the full state pension rate is £168.60 a week. This is set to rise from April 6 2020 to £175 a week. For those who reached state pension age before April 6 2016, the weekly basic state pension will rise to £134.24 from April 2020.

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

Over the past decade, the age at which people become eligible for the state pension has changed. until 2010, men got it when they turned 65 and women at age 60. Today, the state pension age for both groups has risen to 66.

In the past you may have decided to contract out of S2P – or its predecessor SERPS (State Earnings-Related Pension Scheme) – in order to put more money into your own company or personal pension. In this case, you may not be entitled to the full weekly state pension.

To find out how much state pension you are likely to receive, and from what date, use this government service [link: https://www.gov.uk/check-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.

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Tax on pensions

A quarter of any pension fund can be taken free of tax after age 55, 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.

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