How does a pension work?

Pensions aren't the most straightforward financial product, so we've written a short guide to cover some of the key things you need to know about how a pension works.

According to personal finance website Finder, 35% of British people do not have a pension. We understand that pensions can be confusing, and you might not feel the need to have one, but pensions are a great way to set yourself up for your retirement. In this blog we’ll be talking you through what a pension is and how a pension works so that you’re aware of the benefits they can provide for you in the future.  

What is a pension?

To put it simply, a pension is a retirement plan that provides a tax-efficient source of income which you receive later in your life. The amount that you receive depends on how much you’ve contributed during your lifetime. A pension is similar to a savings account, but it’s designed for the long term, to support yourself when you’re older. Pensions are often only accessible at a certain age, for example private pensions can often only be accessed at 55 and state pensions at 67.

What are the benefits of a pension?

Pension schemes have a lot of benefits compared to normal savings. By putting some of your savings into a pension, you benefit from tax relief on the contributions you have made. This means (up to certain limits) the government will also contribute to your pension for as long as you keep adding money to it. When you do retire, you can withdraw up to 25% of your pension tax free too. Pensions are a very tax-efficient way of saving for the future and the government rewards you for saving with tax relief.  

Pensions are often invested in financial products too. When your pension is invested, it can benefit from capital growth (increasing in value) over time. If you’re saving for 30 or 40 years, the value of your investments can really benefit from capital gains, meaning you’ll retire with more money in the future.  

What type of pensions are there?

There are 3 main types of pensions in the UK;  

  • State pension  
  • Workplace pension  
  • Personal pension  

Each type of pension is different and it's important to know the difference between them before starting to plan your retirement.

State pension

A state pensions is a type of pension you can claim from the government once you’ve reached the state pension age. The state pension age rose in 2020 to 66, and the government have set a timetable for continued rises in future.

The amount you receive from your state pension depends on the number of qualifying years of national insurance contributions. You need somewhere between 10 to 35 qualifying years to get a share of the new state pension. If you wanted to receive the full state pension, you would need to have had 35 qualifying years of national insurance payments. From looking at the government’s website, it’s £185.15 per week currently. The state pension rises with time, so if you’re retiring in 20 or 30 years from now, it’s likely you’ll receive more.

If you haven’t made enough qualifying national insurance payments, you can top up your national insurance payments before reaching the state pension age to ensure you receive a state pension. To read more about the new State Pension click here.

Workplace Pension

For many people, receiving the state pension is not enough to live off for retirement, which is why many decide to use a workplace pension to top up what they already have. Under the Pensions Act in 2008, employers in the UK must ‘auto-enrol’ their staff into their workplace pensions and contribute towards it if they’re eligible. Members of staff can opt-out of the pension scheme if they wish to.

With a workplace pension, contributions are taken from your salary, your employer, and the government. Every month, you will contribute a percentage of your salary and your employer will match – sometimes exceed – your contribution. You also benefit from tax relief from the government on your pension contributions. For every £80 you put in, the government will give you £20, making your total contribution £100. Your employer matches this amount, meaning you’ll pay £200 into your pension. There's also another way you can make pension workplace contributions, tax relief is sometimes received without having to claim it through a net pay arrangement. You can read more about this here.

There are two common types of workplace pensions your workplace may offer; defined benefit and defined contribution.  

Defined benefit – The employer promises to pay you a certain amount of money after you’ve retired, regardless of how the investments within your pension plan has performed.  

Defined contribution – This is a common workplace retirement plan where the employee pays towards their pension through their salary and the employer typically matches their contribution to add to their pension plan.

The age that you can access your workplace pension is 55 however with the Defined Benefit scheme, the age can vary between 60 and 65, meaning you could retire earlier than the state pension age if you had enough savings. Withdrawing your money from your pension before you are 55 can end up costing you a lot of money unless you are seriously ill or have a defined retirement date, something sports players often have due to their short careers. There are strict penalties in place if someone somehow accesses their pension before 55 unless there’s a valid reason such as being terminally ill.  

Personal Pensions  

Personal pensions are a pension you set up yourself and are often used by the self-employed or by those who want to save more than their workplace pension. As with an employee pension, you benefit from tax relief on your contributions.

As with workplace pensions, the money that you put into your personal pension is invested into financial products by the pension provider you choose to go with. It’s up to you to choose how you would want to pay into your pension, whether that’s by monthly payments or lump sums.

How much can I pay into my pension?

In the UK, you have an annual pension allowance. Your annual pension allowance is the maximum contributions you and your employer can contribute towards pensions in one year before being subject to tax. Your allowance generally depends on your UK relevant earnings but can also be impacted if you do not work, earn over a certain amount or have accessed a pension. Any tax relief received will also count towards your allowance.  

Please be aware of your Pension allowance as going over could result in a tax charge. There are instances where you can invest more than your allowance by utilising previous years’ allowances using a rule called ‘carry forward’. You can find out what your pension allowance is on the government’s website here.

It’s also worth noting that your annual allowance applies to all the private pensions you may have such as defined contribution and defined benefit schemes. If you have any unused allowance from the previous three tax years, you can carry it over, however there is some rules around this which you can learn more about here.

Can I transfer my pension?

There are many reasons you may want to transfer your pension. Maybe you want to save on your investment fees or simply consolidate your pensions into one for easier management. If you do want to transfer providers, you would need to ensure that your new plan is suitable and that you’re aware of any exit fees as well as knowing whether you’ll be opted out of any entitled benefits or guarantees.

At OpenMoney we offer a free advised pension review to check if transferring your pension to us, benefits you. Our expert advisers help you throughout the whole process by getting in touch with your pension provider on your behalf. We then create a recommendation on whether transferring your pension to us is in your best interests, if it’s not, we’ll simply let you know so that you can make the final decision.  

These are the following pensions that we do not currently review:

- Current Workplace Pension Schemes

- Defined Benefit Pension Schemes

At OpenMoney, our total annual fees are 0.51%* or lower, which means you get to keep more of your money. To find out if we can save you money on investment fees, submit a free existing pension review here.

Remember, capital is always at risk when investing.
Fees correct as of 20/04/2022 and may exceed the stated value.

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