Pensions are a tax-efficient method of saving up money for retirement. And starting early can provide enormous benefits, including a more luxurious and comfortable lifestyle in the long run.
But this financial innovation can get complicated. And there’s more than one type. So, let’s explore exactly what a pension is, the various types to choose from, how they work, and discuss whether pensions are even worthwhile.
What is a pension?
A pension is a form of long-term savings vehicle. The idea is to make regular contributions from a salary as well as occasional lump sum deposits. In the early years of a career, contributions are typically small. But as individuals get closer to retirement, they often ramp up the amount set aside.
The pension pot can then be invested in a variety of financial instruments and securities. And the long-term goal is to have a portfolio of assets that provide a steady and reliable passive income stream.
As a rough estimate, most retirement planners recommend building a pension pot capable of generating 80% of a last salary.
How does a pension work?
Pensions work differently depending on their type. However, the general process is as follows:
- Contribute money to a pension
- Receive tax relief
- Have access to a pension pot that generates retirement income
- Enjoy a mojito on the beach
Putting money into a pension is quite similar to saving. However, there are several key differences, the biggest of which is tax relief on private pensions.
Whenever contributing to a pension, the government will top up the balance. This is to emulate the effect of tax-free contributions. The amount of tax relief received depends on which income tax bracket an individual falls into.
| Tax bracket | Annual gross income1 | Pension tax relief2 |
|---|---|---|
| Personal allowance | Up to £12,570 | 20%* |
| Basic tax rate | £12,571 to £50,270 | 20% |
| Higher tax rate | £50,271 to £150,000 | 40% |
| Additional tax rate | Over £150,000 | 45% |
Individuals in the basic tax rate bracket will have government contributions automatically added to their pension pot. For those fortunate enough to fall into the higher and additional tax rate brackets, the additional relief has to be claimed each year by completing a Self-Assessment Tax Return.
There are also limits on how much money can be contributed to a pension. As of the latest 2023 Spring Budget, individuals can deposit up to £60,000 annually. However, the maximum amount of tax relief that can be received is linked to an individual’s annual salary.
For example, let’s say someone earns £25,000 a year but has £30,000 saved up in the bank. This money can be contributed to a pension. However, only up to £25,000 of it is eligible for tax relief.
Types of pensions
In the UK, there are three main types of pensions. Each works slightly differently and may not be available depending on personal circumstances.
1. State pension
For those wondering what National Insurance is on their paycheques, this is it. Any man born after 6 April 1951 (1953 for women) is set to receive the New State Pension, providing they have at least 10 qualifying years of contributions and meet other eligibility criteria.3
Individuals can receive up to £185.15 per week depending on the number of qualifying years. To unlock the full amount, 35 qualifying years of contributions are needed. And payments are made every four weeks.
To claim the state pension, an individual must be at least 66 years old. However, this threshold has been steadily rising. And there are already plans to increase it to 67 between 2026 and 2028.4
The state pension doesn’t provide a stellar income. And for most people, it will be insufficient to support a comfortable retirement lifestyle. That’s why building a private pension is also crucial. But it’s worth pointing out that the state pension is guaranteed for life. And it can serve as a valuable supplementary income to other private pensions.
2. Workplace pension
Workplace pensions are provided by employers to employees (excluding contractors). Eligible workers are automatically enrolled in a company’s pension scheme. But individuals can opt out if they have better use of the money at home or would prefer to put it into a personal pension.
Contributions from employees are bolstered by additional money from their employers. In fact, many businesses have a contribution matching policy. As the name suggests, this is when a company will match the contributions of its employees up to a certain limit. And the government will also provide tax relief just as it would with a private pension.
For example, if an employee puts £500 into their workplace pension, their employer could match this, bringing the total to £1,000 before the additional tax relief from the government.
Workplace pensions require minimum monthly contributions. And in April 2019, the government set a nationwide minimum limit of 5% of a salary for employees and 3% for employers. However, each scheme has its own set of rules, so the minimum thresholds could be higher.
Workplace pensions can also fall into two primary categories:
- Defined benefit pension: This is also known as a final salary scheme. It provides a guaranteed income for life after reaching a specific retirement age. And the amount received is typically determined by the number of years of service as well as the level of the final salary received.
- Defined contribution pension: These are far more common today. Contributions to a workplace pension are handed over to a financial institution. It then invests the money on behalf of the employee into pension-suitable securities like stocks and bonds. Unlike a defined benefit scheme, income is not guaranteed. Consequently, the value of the pension pot becomes entirely dependent on the performance of the underlying investment portfolio, and the amount of money contributed over the years. If a portfolio performs poorly, an individual could have less money than what was put in.
3. Personal pension
A personal pension is also known as a private pension. And it works very similarly to a defined contribution scheme. But, the critical difference is that the individual gets to pick the pension provider.
However, this flexibility comes at a cost. While the government will provide tax relief, employers are not obligated to contribute to a personal pension. Furthermore, they’re also linked to an underlying investment portfolio. Therefore, the income generated from retirement savings is not guaranteed.
There are also specialised variants of a personal pension scheme.
- Stakeholder pension: This works very similarly to a standard personal pension. However, there are strict government rules regarding how they can be managed. Stakeholder pension schemes typically have very low minimum contribution levels, only specific asset classes are permitted, and there are limits to how much a pension provider can charge for its services.
- Self-invested personal pension (SIPP): Instead of relying on a pension provider, individuals can take their investments into their own hands with a DIY approach. SIPPs enable investors to buy individual funds, trusts, stocks, and bonds both in the UK and overseas. They typically have no minimum contribution levels and are designed for more experienced investors. But they pave the way for higher investment returns for those willing to take on additional risk.
Is paying into a pension worth it?
Generally speaking, contributing to some form of pension when possible is good financial planning, even if it’s just the occasional lump sum. The more money that can be spared today, the more will be available in the future. And a steady stream of small monthly contributions can add up to a large pension pot when retirement comes knocking.
Having said that, there are some caveats to consider.
Advantages
- Contributions can unlock compounding returns tax-free while they remain within a pension account
- Government tax relief and employer contributions can drastically increase the size of a pension pot
- Provides long-term financial security
- 25% of a total pension can be withdrawn tax-free
Disadvantages
- Withdrawing from a pension early can result in significant penalties
- Modern pensions are based on investment portfolios that cannot provide a guaranteed income
- Pension pots may also drastically decrease in value during periods of stock market and economic volatility
- Still have to pay regular income tax on any money withdrawn from a pension pot after the 25% allowance is used up
Final thoughts
Retirement planning is a long game and will probably be investment-based. So, the sooner someone starts, the better.
A workplace pension is a good place to start because employers will provide additional contributions. But it may be wise to also consider creating a personal pension, especially for self-employed individuals.