How do pensions work?

Retirement seems a long way off, but if you want a financially secure one its worth setting up a pension. Ever wondered how do pensions work? Check this article.

Stack of post its with the text “How do pensions work?” and The Motley Fool jester cap logo

Setting up a pension as soon as possible is an important step when planning for retirement. If you have ever wondered how pensions work, then read on.

What is a pension?

A pension is a savings vehicle that you set up during your working life. You make regular contributions until you reach retirement age, when you can access it without penalty.

During retirement, you can receive a regular income from your pension pot. This allows you to afford the lifestyle you want when you stop working.

Saving for retirement with a pension is more tax efficient than other methods because contributions are tax free.

When considering how pensions work, you need to understand that there are three main types of UK pension:

  • State pension,
  • Workplace pension
  • Personal pension

State pension

This is the government pension that you can claim when you reach state pension age.

The amount of money you receive depends on your National Insurance contributions and the number of ‘qualifying’ years of contributions you have made.

For the full basic state pension, you need to make 30 years of National Insurance contributions or credits.

The government has been gradually raising the retirement age. In 2016, the system was changed to make it easier to understand.

To find out more about how state pensions work, including the state pension ages, go to the website.

Workplace pension

This is a pension set up by your employer when you start work. To make it easier for employees to save for retirement, the UK government has changed how workplace pensions are set up.

Employers have to automatically enrol all eligible employees into their pension schemes. The employee must choose to opt out. Further information on the workplace pension reforms is available on the website.

Workplace pensions fall into two basic subcategories, namely defined benefit schemes and defined contribution schemes.

Defined benefit scheme

A defined benefit scheme, or a final salary scheme, gives a guaranteed income for life. The income is based on your final salary and years of contributions. During your working life, you and your employer pay into the scheme.

Public sector and government employers offer this type of scheme.

Defined contribution scheme

A defined contribution scheme involves paying into a savings scheme run by a pension provider. Private companies offer this type of scheme.

Contributions are made by you, your employer and the government in the form of tax relief. So the additional income received from your employer is a big advantage.

The pension provider invests the money in stocks and shares on your behalf to grow your pot during your working years.

This means that unlike a defined benefit scheme, the amount you receive when you retire is not guaranteed. It is dependent on stock market performance.

Personal pension

This is a defined contribution scheme, but you choose the pension provider. This type of pension is used by the self-employed, but you can have one in addition to a workplace pension.

Any contributions you make will be eligible for tax relief, but there is a limit. In the 2020/21 tax year, you will receive tax relief on contributions up to 100% of your annual salary or up to £40,000, whichever is the lower. You will need to bear this in mind if you have both a workplace and a personal pension.

Additional information on personal pensions is available on the UK government website.

There are two basic types of personal pension, a self-invested personal pension and a stakeholder pension.

Self-Invested Personal Pension (SIPP)

Unlike a workplace pension, with a SIPP you can choose the types of investments you make with your pot.

In addition, there is a wider range of assets that you can invest in. These include quoted UK and overseas stocks and shares, unlisted shares, investment trusts and unit trusts.

Stakeholder pension scheme

This type of pension must meet specific government requirements which include limited charges and flexible contributions.

If you don’t want to choose your investments, there is also a default investment fund that you can use.

Final thoughts

Retirement planning is a long game and will probably be investment-based, so the sooner you set up a pension the better. A workplace pension is a good place to start, because you will receive additional income from your employer.

You might consider a personal pension if you are self-employed or you have extra income that you want to use for a long-term investment.