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What is a Pension ?

Updated: Jun 24, 2022

In simple terms, what is a pension can be answered and defined as a tax-efficient way to put money aside for your future or retirement, in order to provide an income, hopefully for life, as and when you do retire.

What is a Pension ?

What is a Pension in detail

When we say tax efficient, we mean that there are certain tax reliefs that the UK government provide in order to encourage us to save for later life, and not rely on the state to support us. We will touch on these pension tax reliefs later in this article.

There are several different types of pension that you may have, and it is possible that other people, including your employer can make contributions into your pension as well as yourself.

Then, depending on when you decide to take your retirement from, the earliest being 55 at the moment rising to 57 in the near future, but many other pension schemes have figures nearer 60,62, 65 or even later, you will have several different options of how you can take your pension income, such as a lump sum, drawdown facility or annuity.

You are now able to take out as many pensions as you want, and make contributions and earn tax relief on those contributions up to a certain point. There are several limits and allowances that come into play with pensions regulation, so you must be careful not to breach your annual allowances or lifetime allowance.

It’s also important to understand that pensions are long-term saving vehicles, and as such are usually invested in equities, or stocks and shares. This can mean the value of your pension pot can increase and decrease on a weekly, monthly, and annual basis. This doesn't apply if you are a member of a DB or defined benefit pension scheme.

As always, pensions legislation and uk government pension rules can change at anytime, and so you need to keep up to date with such changes If you are anywhere near retirement age.

Pension Table of Contents

How does a pension work?

The different sort of pension schemes available in the UK work in slightly different ways, but in summary they all have a similar purpose and aim.

how does a pension scheme work

The key points to consider when thinking about how does a pension work are as follows;

  1. During the accumulation phase you and your employer contribute to your pension fund.

  2. Also during the accumulation phase the government contributes to your pension fund by providing tax relief both at source and through your self-assessment tax return if you are in the higher tax brackets.

  3. After many decades of saving into your pension and hopefully benefiting from investment and compound interest growth, you will have a pot of money to then decide on how to provide for your later life.

  4. You will receive the benefit of this pot of money either via a tax-free lump sum, and / or monthly distributions, or you could exchange your pot for an annuity which is a guaranteed income for life.

Should you pay into a pension?

General wisdom suggests that you should start to pay into a pension as soon as you possibly can, as that way you should be able to build a significant sum of money by the time you get to retirement age, by paying contributions that would be considerably less than if you started 10 or 20 years later.

Should you pay into a pension?

There are many studies and examples of how much cheaper your pension contributions would be if you could start at 18 or in your early 20s compared to those who start in their 30s, 40s or even 50s. However, this theory is all well and good, except having spare cash when you are young is often more difficult than said, especially if you are having to rent somewhere to live or save a deposit for a new house.

Consideration for how you are going to fund your retirement or the years after you stop working should be made as early as possible, and pension contributions are one of those methods, especially if you can get employers to contribute as well.

We mentioned that pensions were tax efficient saving vehicles earlier on in this article, and that is because you earn tax relief on payments you make into your pension fund.

By this we mean the UK government adds 25% onto your pension investment, so £100 per month investment automatically increases to £125 per month. If you are in the higher tax brackets, you could also claim a further 25% in relief from your self-assessment tax return at the end of the tax year.

Furthermore, money inside a pension fund grows free from income tax and capital gains tax and dividend tax, in order to help you maximise the ultimate value of your pension pot. This means saving via a pension is one of the most tax efficient means of long-term saving.

Finally, it is also worth considering by not saving into a pension you may be missing out on free money provided by your employer who is legally required to make a contribution into your pension pot on your behalf. By waiving your right to setting up a pension you are giving away free money.

The main types of pension

There are generally three types of pension in the UK in common use. These are the workplace pension, the personal pension sometimes referred to as a SIPP, and the government run state pension. It is possible to have either none of these, or all of these depending on your own personal circumstances.

The workplace pension

Workplace pensions can be distinguished by two main types. They will either be a defined benefit scheme or a defined contribution scheme.

Defined benefit pension scheme

A defined benefit pension scheme also known as a final salary scheme and often referred to as a gold-plated pension, is a pension that pays out a certain amount of income depending on both the final salary you earn just before retirement, combined with the total length of service you have contributed.

Defined benefit pension schemes often accrue at either 1/60th or 1/80th of salary, meaning for every year you are employed you are entitled to that portion of your annual salary upon retirement.

Therefore, by way of an example under a 1/60th DB scheme. an employee who worked for 40 years would end up with 40/ 60th of their final salary, meaning they would retire on 2/3rds of their full-time income.

Defined contribution pension scheme

With a defined contribution pension scheme, also known as a money purchase scheme, you would decide on a certain percentage of your salary to pay into your pension and your employer would also make a contribution.

Some employers pay more than others, and generous employers may match your contribution up to a certain limit such as up to five percent 7.5% or 10%. It is usually good practice to take as much free cash as you can, although this does mean you having to take home less pay each month to do so.

Nowadays employers in the United Kingdom are required by law to contribute to employees pensions and they have to automatically enroll their eligible employees once they start a new job.

Both the employer and the employee and the government all contribute minimum amounts of pension cash each month. As of 2022 the employee contributed 5%, the employer contributed 3% and there was a tax relief contribution from the government.

It is very important to understand, that unlike a defined benefit pension scheme, defined contribution pension schemes do not guarantee the size of your pension pot or the income you will derive from it.

As these pension schemes are invested in the stock market the ultimate size will depend entirely on how well your investments have performed. This means the investment risk of your pot is entirely in your hands.

The personal pension

As the name suggests, a personal pension is simply a type of pension that you can set up yourself. You are able to have a personal pension or several personal pensions even if you already have a pension through your employer.

If you do think that setting up an additional personal pension is right for you, then you will need to consider which platform are most suitable for you, how much you are going to contribute, and be aware of the pensions annual and lifetime allowances, which are currently a maximum contribution of £40,000 or 100% of earnings, and the lifetime allowance is £1.073m across or pension schemes.

what is a pension

The three main types of personal pension are:

1. The simple personal pension will allow you to make regular contributions to a limited selection of investment strategies, and will be managed by a professional pension provider based on your personal risk appetite

2. The stakeholder pension is also similar to the above personal pension, but there are some strict UK government rules that apply to these pensions including the fees that can be charged and a limited selection of investment options. Stakeholder pensions are not very flexible for more experienced investors.

3. The self-invested pension otherwise known as a (SIPP) is a type of personal pension that allows you to flexibly manage both how and where your money is invested. You can choose any number of literally thousands of different investment vehicles, and can also choose how much you contribute each and every month, so long as you do not breach the annual allowance and lifetime allowance limits.

SIPPs are very often used by experienced investors who are comfortable with taking the investment risk and choosing which funds to invest in and can also use SIPPs as a tax mitigation vehicle at the end of each tax year. Some pension platforms have annual management fees of between 0.20% and 0.45% of your holdings.

The state pension

The state pension is a pension you’ll receive from the uk government once you reach the state retirement age of 66 rising to 67 and 68 in the not too distant future. The state pension is only payable if you have contributed at least 10 years of qualifying years to your National Insurance contributions, or had credits applied for that same period.

In order to achieve a maximum UK state pension, you will have needed to register 35 years of contributions or credits.

the state pension

The current weekly state pension is circa £180 per week, and is generally increased by CPI. The uk government will then pay you your state pension on a monthly basis for the rest of your life. It is generally thought that the UK state pension is a good foundation for your pension provision, but it is unlikely it will be enough to provide a comfortable living going forward.

That is why considering both personal pensions and ensuring you are enrolled on your employers pension as early as you can be, are both essential if you wish to have a comfortable retirement in the future.

In conclusion, we very much hope we have answered your question of what is a pension in this article, but please do leave us a comment in the comments box below with any further questions.

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