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The ultimate guide to pensions

A pension is a means to provide an income when you retire, whether that’s through a workplace pension, a private pension or the state pension. Here, we take a look at everything you need to know about pensions, from why you need one and how to start one, to ensuring you get the most out of yours when you retire.

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Leanne Macardle

Freelance Contributor

At a glance

  • Find out more about the different types of pension
  • Get a summary of what to consider when investing into a pension
  • See how pensions are a tax efficient way to save
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What is a pension?

A pension is a savings plan whereby you pay in regular amounts during your working years to create a pot of money, which you then use to take an income from in retirement.
You can plan your income for your retirement using savings, investments, personal pension or occupational pension. While savings and investments are of course a viable option, a pension should be the first port of call for the majority. At its heart, a pension is still a savings plan, but it’s specifically designed to provide you with an income to live on when you retire and has numerous tax and contribution benefits.

What are the different types of pension?

There are many different types of pension arrangements available, from state pension schemes offering limited financial support in old age, private pension plans giving you the freedom to build a larger fund for your retirement and occupational pensions where your employer also contributes to your pension pot.

What are the advantages of saving into a pension?

Your pension contributions attract tax relief (which means that for every pound you invest in a pension, the Government will pay in a top-up of 20% of the value of the contribution, up to a maximum of the lower of your annual income or £60,000 per year) and can be made in various ways, either regularly or by lump sum, or a combination of both.

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How is a pension invested?

Your pension pot is invested in your choice of pension funds, from the selection offered by your chosen pension provider. The idea is that the funds grow over time, maximising the value of the fund so you can get the highest possible income in retirement.

What happens to your pension when you retire?

On retirement, up to 25% of your pension fund value can be taken as a tax-free cash lump sum (up to a maximum of £268,275). The remainder of the funds left in your pension pot is used to take an income, either by way of an annuity, or by taking cash directly from your pension fund (drawdown).

Most pension contributions are invested in the financial markets on your behalf by a pension provider in order to get the best return for your future. The income your pension provides you in retirement will vary from provider to provider and will depend on the investment choices you make, the performance of the pension funds, the level of contributions you make and the charges applied by the provider.

Remember: each pension company will vary in both charges and investment performance.

How to get advice about your pension

Pensions are a type of investment and investments are risk-based products. This means that the value of your initial investment and any income generated can fall as well as rise. If you are in any doubt we strongly urge you to contact an independent financial adviser to assist you before making a decision on which pension to choose.

We've compiled a guide all about how to get pensions advice. 

What is a workplace pension?

For many, a workplace or occupational pension will be the first option to consider. This is simply a pension plan that's offered through your employer; they’re required to automatically enrol you in a pension scheme if you're not already a member, you earn more than £10,000 per year and are between 22 and state pension age.

There are two types of occupational pension:

Final salary (or defined benefit) scheme

This is where you contribute to a pension scheme that will pay you a defined monthly income in retirement, based on how long you've been a member of the scheme and your earnings (not on investment performance). With a final salary scheme, there is no need to purchase an annuity at retirement. These schemes are now more uncommon because of the very high costs to employers of running them.

Money purchase (or defined contribution) scheme

This is where you contribute to a pension scheme that will pay you an income in retirement, based on the amount you've paid into the scheme and investment performance over the life of the pension. With a money purchase scheme, you can purchase an annuity or drawdown income to convert your pension into retirement income.

In both instances your employer helps by also making contributions to your pension – meaning you can build up a larger pot than if you were contributing alone. So if you don't join the scheme, you are effectively turning away extra money from your employer. However, the downside is that you are restricted to the pension scheme that your employer has chosen, although you may have a choice of funds if you are part of a money purchase scheme. This means you need to ensure you manage it effectively to get the best return on your savings, so make sure to check your particular scheme to see what’s available to you.

Occupational pensions don't have to stop if you leave an employer – you can still contribute to a money purchase scheme after you leave. Although your previous employer's contributions will stop, your pension will continue to grow (depending on investment performance and charges), even if you are no longer contributing. You can transfer your pension too but remember that there may be fees for moving your pot to a new provider.

There's no such thing as a ‘frozen pension’. Even a pension you are no longer contributing to remains invested and is still subject to charges from the fund and pension provider. Find out how to track lost pensions in our guide.

 

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What is a personal pension?

Personal pensions are arranged by yourself, not your employer. Employers are obliged to set up a Workplace Pension Scheme for all eligible employees and are obliged to pay into the pension plan if you join it, which means this should be your first port of call.

However, if you are self-employed or make less than a certain amount, you are not (yet) eligible for automatic enrolment in a workplace pension, which is when a personal pension should be considered. Yet it could also be an option alongside a workplace pension, depending on your circumstances; anyone can have their own personal pension, and even if you are employed, you might like to have a personal pension outside of work (you can have more than one pension provided your overall pension contributions are less than £60,000 per year), so you can decide which company your pension is with and get the most appropriate range of investments for your needs.

Pros and cons of personal pensions

  • Pension contributions attract tax relief, which means that the Government will pay in a top-up to your pot.
  • When you retire you can take up to 25% of your pension as a tax-free cash lump sum.
  •  A personal pension provides an income during your retirement.
  • Pension contributions are invested in the financial markets, which means that the value of your initial investment and any income generated can fall as well as rise.

What should you look for with a personal pension?

When choosing a personal pension, it’s important to shop around for the best deal. But what should you look out for when making a comparison?

Fund choice

The pension that offers the most choice isn't necessarily the best. Look for the pension that will offer the funds that you want to invest in. Most providers now offer ethical funds, so make sure this option is offered if this is where you wish to invest your pension.

Minimum monthly contribution

Some providers will require you to make a minimum monthly or annual investment to your pension or to each fund within your pension. If you don't meet the pension's minimum contribution requirements, you may be charged a penalty fee.

Fees and charges

Many pension plans will charge an annual management fee. If you invest in certain funds, there could be management fees to pay here as well. There may also be a fee if you wish to transfer your pension to another provider. It's worth finding out what these fees are before making an application and comparing them between providers. Pension firms cannot charge more than 1% of the fund value if you transfer out after age 55 where the pension scheme was in place before 31 March 2017. New schemes cannot charge a fee in these circumstances but could do before age 55.

Past performance

You might find it helpful to use past investment performance to help decide between providers. However, if you're comparing past performance, make sure it's over a longer period (at least five or 10 years) as investments can fluctuate quite a lot in the short term. Always remember that past performance is in no way a guarantee of how successful a firm will be in the future.

If you are in any way unsure which pension or fund to invest in, you should seek independent financial advice to help you manage your pension and make the right investment choices for your personal circumstances.

Is it worth getting a personal pension when self-employed?

If you are self-employed, earn less than £10,000 or have extra money that you can put into retirement savings each month, looking into opening your own personal pension can help to increase your retirement funds. You can pay up to a maximum of your annual employment income or £60,000 per year (if less) into your pension and claim income tax relief on this amount, though anything saved above this is taxed. Ideally you should save as much as you can into your retirement savings, but even if you can only save a small amount each month it will provide a boost to your retirement income. For example, even if you can only free up £50 per month, it could add up to an extra £16,800 in your pension over the next 28 years. And that’s before factoring in any investment gains or tax relief you may qualify for over that period.

Who can help me find the best pension plan for my retirement?

When considering your retirement strategy, it is best to seek independent financial advice. Professional guidance can really help you make sense of the options available to you and can help put your mind at rest if there's something you don't understand or are worried about.

How are pensions tax efficient?

One of the key benefits of saving into a pension is its tax-efficiency, essentially allowing you to build a larger pension pot without needing to do anything extra.

Here are three ways that pensions are tax-efficient:

  1. Personal and stakeholder pensions benefit from Income Tax contributions (up to certain limits). That means every time you contribute to your pension pot, the taxman pays some tax in as well! Here's how it works:
    Basic rate taxpayers Your pension provider automatically claims basic rate tax relief from HM Revenue and Customs (HMRC) on every contribution.
    This means that, for every £100 contribution you make, you’re actually only contributing £80 of your own money; the additional £20 comes from HMRC.
    Higher/Additional rate taxpayers

    However, although your pension provider claims basic rate tax relief from HMRC, the additional 20% or 25% is not claimed back automatically.

    • If you're a higher rate taxpayer you need to contact HMRC to claim the remaining tax relief (which may involve completing a self-assessment tax return).
    • If you're an additional rate taxpayer you will need to declare your pension contributions on your self-assessment tax return and HMRC will reimburse you.

    There’s another difference to be aware of as well: in both instances this reimbursement comes to you directly, not your pension provider. So, you'd need to either make an additional contribution to your pension as a one-off payment, or if you can afford to, make higher contributions throughout the year up to the £60,000 annual limit.

  2. Investment gains made within your pension are also tax efficient because they are exempt from Capital Gains Tax and Income Tax within the pension funds they are invested in.

  3. When you come to take your pension, at the age of 55 or later, you have the option to take up to 25% of your pension pot as a tax-free lump sum. This is capped at £268,275. While pension contributions and growth aren't taxed, when you come to take an income from your pension, this will be subject to Income Tax in the same way as earned income.

One of the most important things to remember when saving into a pension is that it’s an investment, albeit a highly tax-efficient one. You invest your money into a pension fund (or funds), be it an active choice or one that you’re defaulted into, and as with any investment, there’s the risk that your fund value could go down as well as up. This is why it’s important to regularly check the performance of your pension pot and to carefully choose where you invest, but the level of risk you want to take with your money will likely come down to several different factors.

How much risk do you want to take with your pension savings?

The best pensions allow you to hold a range of different investments. You can choose pension funds based on how much risk you want to take with your money, and can hold a number of different funds to spread your risk further across different types of investment and geographical areas.

Risk is an important part of deciding which funds to invest in within your pension. There are two main factors that will affect how much risk you wish to take:

  • Your age in relation to when you want to retire
  • Your attitude towards riskier investments

Younger pension investors can usually take on more risk as their investments have longer to turn around if a loss is made early on. It's also the case that investments tend to perform better over longer periods of time (though past performance is no guide for the future). You should also consider splitting your contributions among several different funds with varying levels of risk, to minimise the chance of one badly-performing fund wiping a sizeable chunk off your pension.

The closer you are to retirement, the more you'll want to consolidate your pension pot into lower risk investments to protect it from making a loss. Yet as with any investment decision, it's important to take independent financial advice if you are in any way unsure of which pension or fund is best for you.

When can you access your pension?

Unlike with a standard savings account or investment portfolio, your money isn’t accessible until much later, ideally prior to retirement. Under current rules, you can’t access the money held in your pension pot until you reach your 55th birthday, after which you’re free to access it as you see fit. Please be aware, though, that this minimum age will be increasing to 57 by 2028, which may affect your plans.

Pros and cons of being unable to access your money early

  • Lack of flexibility ensures that you have a savings pot locked up until retirement. Chances are that not being allowed to dip into it will mean that this pot will be bigger than if you could access the money earlier.
  • Not being able to access your money until you reach a certain age means that you can't call on that cash if you need it earlier – for example if you were struggling with your mortgage.

Consider an ISA

If you're worried about lack of flexibility in a pension it might be wise to look at keeping a pot of other savings, possibly in a cash ISA or equity ISA, that you can call upon if you need to.

The options for pension drawdown

Find out more about how you can drawdown a lump sum from your pension.

What is a Lifetime ISA?

A Lifetime ISA could be an option for those who qualify, too, offering another way to benefit from a top-up from the Government.

A Lifetime ISA is essentially a kind of regular savings account that’s specifically designed for those saving for their first home or retirement. Open to those aged between 18 and 39, it allows savers to stash away up to £4,000 each year, after which they’ll get a 25% top up from the Government – which means they’ll get an extra £1,000 each year, for free, if they save the full amount.

The bonus is paid until the saver turns 50, and under current rules, the money can’t be accessed until they’re 60 (unless it’s to buy a first home, or they’re diagnosed with a terminal illness). This can make them a useful option for saving for retirement, particularly for those who are self-employed and therefore don’t benefit from employer contributions.

What is the minimum age I can retire?

The advantage of focusing on saving into a personal or workplace pension is there’s the possibility of retiring before the State Pension age. The age in which you can get the State Pension is increasing; it currently stands at 66, but this is set to rise to 68 by 2046 at the latest, and may even rise beyond that in the future. But you can choose to retire before this by using money saved in your personal or workplace pension (which will usually allow you to access your pot 10 years before your state pension age), or by cashing in your other retirement savings or investments.

Remember, if you are planning to use money from your personal or workplace pension for early retirement you will need to look at your pension scheme rules to see at what age you can start using your pot, and make sure to think carefully about what you want to do with the money.

 

What is the State Pension?

The full State Pension for 2024/25 is £221.20 per week, but unless you’re retiring imminently, this will change by the time you retire (you can find out more about the State Pension here). Even if the amount increases it is unlikely that it will be enough for you to enjoy a comfortable retirement without supplementing it with an additional retirement income of your own, and it’s important to remember that you’ll need to have 35 years of National Insurance contributions to qualify (and you will need to have made 10 years of qualifying contributions to get any State Pension at all). This is why saving in a personal or workplace pension is so important.

Pension glossary

A

Additional Voluntary Contributions (AVC)
As a member of an Occupational Pension Scheme, payments in the form of Additional Voluntary Contributions can be made above the normal level of contribution to gain additional pension benefits.

C

Company or Workplace Pension Scheme
A Company Pension Scheme (otherwise known as a Workplace or Occupational Pension) is a pension that is set up by your employer to provide retirement benefits to you while you are employed by them. It allows you to accumulate a pension fund during your working life. You will usually be required to make regular pension contributions based on a percentage of your salary into the workplace pension scheme. Most people are now automatically enrolled into a workplace pension (unless they have opted out). Both the employer and the employee pay money into a pension which is topped up by tax relief on the employee's contribution. These also are usually a type of money purchase arrangement.

F

Final Salary Pension Scheme
A Final Salary (or Defined Benefit) scheme is a type of occupational pension where the amount of retirement income is based on your final salary. These are becoming less common in the private sector, but are still in force in the public sector.

M

Money Purchase Pension Plan
A Money Purchase Pension Plan or Defined Contribution Plan is a pension scheme where the final benefits are not linked directly to your salary. You (and maybe your employer) pay regular contributions into your pension pot. Upon retirement, the total pool of capital in your pot can be used to take an income in retirement. The amount in each money purchase plan member's account will differ from one member to the next, depending on the level of contributions and investment return earned on such contributions. All pensions other than final salary pensions and the State Pension are a form of money purchase plan.

P

Personal or Private Pensions
A personal pension is arranged by yourself, not your employer, and is a type of money purchase plan.

A personal or private pension is a tax-efficient savings plan that enables you to save for retirement. Your pension contributions attract tax relief (up to annual limits) and can be made in various ways: regularly, by lump sum, or a combination of both.

On retirement, up to 25% of your pension fund value can be taken as a tax-free cash lump sum, up to £268,275. The remainder of the funds left in your pension pot can then be used to buy an annuity (a guaranteed income for life in return for a lump sum investment) or left invested to produce an income directly from the fund via a drawdown arrangement. Alternatively, you can withdraw the whole fund as a taxable lump sum, or use it as a kind of bank account, with each withdrawal taxed at 25%.

S

Self-Invested Personal Pension (SIPP)
A Self-Invested Personal Pension (SIPP) is a type of personal pension. A SIPP is a pension plan that gives you the freedom and control to totally manage your own investment decisions by buying stocks and shares and a range of other types of assets. Any contributions that you make to a SIPP will receive tax relief, up to certain limits.

Small Self-Administered Scheme (SSAS)
Small Self-Administered Schemes (SSASs) are generally very bespoke pension schemes designed for the directors of a business. They are generally not available to other employees as they are more complex and limited to no more than 11 members.

Stakeholder Pensions
A stakeholder pension is a form of personal pension, in that you pay money into your pension to build your pension fund. However, these plans have to adhere to Government rules and minimum standards on annual management charges, access and terms to ensure they offer value for money, flexibility and security.

The scheme must be run by trustees or by an authorised stakeholder manager, whose responsibility will be to make sure that the scheme meets the various legal requirements. Contributions start from as little as £1 and you can pay weekly, monthly or at less regular intervals, and you’re free to stop, re-start or change your contributions whenever you want – there are no penalty fees. You can also switch to a different pension provider without the provider you leave charging you.

State Pensions
A state pension is also known as a Government Pension or Old Age Pension. Your entitlement to the pension accumulates during your lifetime and is paid by the Government when you reach state pension age, which depends on your date of birth. A state pension value is based on the number of years of National Insurance (NI) contributions made throughout the person's working life. You have to have at least 35 qualifying years' worth of NI contributions to qualify for a full state pension.

 

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20th July 2017

The Government announced yesterday that the planned increase to the state pension age will be brought forward by seven years, which has the potential to scupper the retirement plans of millions of workers. Will you be impacted?

The Government announced yesterday that the planned increase to the state pension age will be brought forward by seven years, which has the potential to...

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One in seven approach retirement with no pension

3rd May 2017

We all need to do more to prepare for retirement, something sharply highlighted by the finding that around one in seven people are approaching retirement with no workplace or private pension whatsoever, leaving many wholly reliant on the state.

We all need to do more to prepare for retirement, something sharply highlighted by the finding that around one in seven people are approaching retirement...

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Grandparents missing out on pension protection

18th January 2017

Grandparents who give up work to take care of their grandchildren could be missing out on valuable state pension rights. So, if you're a grandparent taking care of a little one, make sure you’re building up all of the pension that you deserve.

Grandparents who give up work to take care of their grandchildren could be missing out on valuable state pension rights. So, if you're a grandparent taking...

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Consumers are missing signs of pension scams

31st March 2016

We all like to think that we’d spot a scam from a mile away, but this may not be the case, with research finding that the vast majority of people actually miss common warning signs of pension scams – despite being confident that they’d spot them.

We all like to think that we’d spot a scam from a mile away, but this may not be the case, with research finding that the vast majority of people actually...

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State pension top-ups – what you need to know

12th October 2015

From today, millions of people have the chance to boost their retirement income by up to £25 a week through a top-up scheme. But what is the scheme, is it worthwhile, and will you take advantage? Here’s a run-through of everything you need to know.

From today, millions of people have the chance to boost their retirement income by up to £25 a week through a top-up scheme. But what is the scheme, is it...

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Should pensions go digital?

27th March 2015

As the initiation of the new pension reforms looms (6 April), the pensions industry is gearing up for the changes. But is enough being done to make access to pension pots and information simple and practical?

As the initiation of the new pension reforms looms (6 April), the pensions industry is gearing up for the changes. But is enough being done to make access to...

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