What is a pension and how does it work in the UK?
Pensions are a great way to save money and financially prepare yourself for life after retirement. But what is a pension really and how do pensions work? While pension schemes may work differently in other parts of the world, in the UK a pension is an investment scheme in which, depending on the type of pension scheme you have, you or others set money aside for you to use later in life, providing a source of income that you can access after you retire. Compared to other forms of investment, pension schemes are generally regarded to be a more tax-efficient way of putting your money aside for later use.
Based on the type of pension scheme you have, either you or your employer will pay into the pension fund, while the government may also contribute to the value of the pension by providing for more convenient tax rates.
Types of pension
In most places, including the United Kingdom, you have three different types of pension schemes that you can access and pay into, depending on your personal circumstances: personal pensions, state or government pensions, and workplace or company pensions. Having one form of pension does not preclude you from having others, and one form of pension may not be sufficient for maintaining the kind of lifestyle you want for yourself after retirement.
Personal pensions refer to the pension schemes that you set up for yourself individually, and many people have personal pensions despite also having pensions set up through their employers. Under the umbrella of personal pensions there are different types of pension schemes, from self-invested personal pensions (SIPPs) and stakeholder pensions to individual personal pensions. Note that personal pensions are considered “defined contribution” pensions, in that the amount of money that you receive depends on how much is paid in and how well the pension investments have performed over time.
In each of the different types of personal pension schemes, how much you pay and with what regularity is typically something that you decide, though your specific personal pension provider may have some stipulations in that regard. However, there are some key distinctions that differentiate the three main types of personal pensions:
Individual personal pensions
In an individual personal pension the pension fund is managed by a pension provider, and your contribution to the growth of the pensions occurs through regular payments into the fund. It will be your pension provider that develops different investment strategies for you to choose from in relation to your personal preferences and financial situation.
This form of personal pension scheme, perhaps the most straightforward of the three, differs from the others in that it is subject to specific regulation on how it is managed. Due to this, stakeholder pensions are generally limited to a few investment options and usually request a lower minimum contribution into the fund, with a limit to how much the pension provider can charge. This kind of pension plan may be suited for you if you are interested in a simpler pension scheme, or plan on making lower contributions.
Self-invested personal pensions
SIPPs are a type of personal pension that puts you in the driver’s seat, so to speak. Though they are often associated with higher charges, through this form of personal pension, you have a more direct choice in how your money is invested and have a wider range of investments from which you can choose. SIPPs let you choose the investments you invest your money in and allow you to play an active role in managing them. This type of personal pension is usually considered more suitable for those who plan on making large contributions to their pension fund and have greater experience in investing.
With each type of personal pension scheme, you can decide which provider to go with, how much you will contribute, and with what regularity, making them more attractive than the other types of pensions.
The UK state pension is the pension scheme established for you by the government, which you can access once you reach the minimum age for retirement, or after reaching the minimum eligibility criteria dictated by the state: at least ten years’ worth of national insurance contributions or credits and meet the other eligibility criteria laid out by the government. As opposed to the personal pensions, in which you can actively increase or decrease (to a certain extent) the regularity and contribution that you make to the pension fund, your contributions to your state pension are based on the national insurance contributions that you’ve made throughout your life. Once you are eligible to start accessing the money invested in your state pension and state your claim to the government, the government will begin to pay you your state pension.
A workplace pension, which are also commonly referred to as company pensions or occupational pensions, is a pension scheme that’s arranged by your employer. In the UK, enrolment in a workplace pension plan through your employer is mandated, meaning that employers are required to enrol eligible employees in these pension plans, and both the employer and employee must make contributions to these pensions on each payday. A portion of employees’ wages are paid into this pension scheme and the employers also make a contribution to the pension as well. As of 2019, employees contribute around 5% of gross wages to the pension, while the employer contributes 3%.
Just as with personal pensions, there are two distinct types of workplace pensions:
Defined contribution: this is the most common form of workplace pension offered under the pension enrolment mandate. In this pension scheme, just as in the others described above, the money that you pay into the plan is invested by the pension provider. Thus, the amount you have once you decide to access the pension funds depends not only on how much you have contributed, but also the charges applied and the performance of the investments. As such, there is less certainty over the income you will receive in retirement.
Defined benefit: As opposed to defined contribution workplace pensions, in defined benefit workplace pensions, the amount of money that you have access to in the pension isn’t based on investment performance. Rather, the amount you receive from the pension is based on the salary you receive and the length of time that you work for the employer that has enrolled you. This form of pension offers greater certainty in the amount of income you will receive in retirement because it is based on the length of time you have worked for your employer and the salary you receive when you retire.
How to pay into a pension?
The way in which you contribute to a pension fund depends on the type of pension that you set up. For personal pensions, you will need to make regular payments in the amount that you agree with your pension provider, whereas in workplace pensions, your contribution to the fund is usually taken from your pay and made on your behalf by your employer on payday. Note however, that the means in which you pay into the pension may vary depending on the pension provider, so it is best to ask in advance, either to your pension provider or employer, so that you can pay contributions in the way that is most convenient for you.
Is it worth paying into a pension?
While there are many ways to save and invest in preparation for the future, pension schemes are a relatively straightforward and dependable way of making sure that you are financially prepared for retirement.
Note, however, paying into a personal pension fund offers tax reliefs that are not extended to other ways of saving and investing money. In some workplace pensions, you are able to “exchange” a portion of your salary in exchange for pension contributions, allowing you to ultimately save on tax and National Insurance contributions.