How Do Pensions Actually Work?

23/11/2024

For most people reading a pension statement can be like reading a foreign language and all too often because of this we don’t pay as much attention to these accounts as we should.

Hopefully, this short post will help to remove a lot of the confusion around pensions as I try to break them down by answering some of the questions I am commonly asked:

What is a pension?

So first things first. What actually is a pension?

A pension is a tax-efficient way to put money aside for later in life, to provide income for when you retire.

What type of pension do I have?

Generally speaking, there are 2 types of pensions.

Workplace – These are fairly self-explanatory. They are a pension linked to your employer. You receive contributions from your employer and in turn, you make contributions to the pension also.

Within workplace pensions, there are two main types and if you have a workplace pension it will be one of these:

Defined Contribution (DC) – Also known as money purchase pension schemes. For these types of pensions, they are linked directly to the money that is paid in. Your employer has to pay at least 3% of your gross salary each year and you have to pay at least 5% of your salary. Some employers offer higher levels of contributions as an employee benefit.

Your contributions are then invested and as you continue to work should keep growing with your contributions and investment growth. You can then access the pension at age 55 (changing to 57 in April 2028). You do not pay any tax on the contributions you make to your workplace pension.

The idea behind DC pensions is that you pay in during your working life and then have a pot of money at the end that you can use to fund your lifestyle when you are no longer working.

Defined Benefit (DB) – These pensions are most commonly seen in the public sector. So if you are a civil servant, teacher, police officer etc you will likely have a Defined Benefit pension. Unlike DC pensions these are designed to provide you with an annual pension in retirement rather than a pot of money for you to draw from.

The pension that you receive will likely be based on your average salary throughout your employment and the length of time that you are a member of that pension scheme. The benefits you receive are not based on the contributions that you pay each month.

These types of pensions used to be the norm before the introduction of personal pensions but have largely been phased out for non-public sector employers due to the cost of running them.

Personal – Personal pensions are not linked to an employer and are standalone. These are Defined Contribution pensions that you can pay money into and accumulate a pot of money to use in your retirement.

As they are not linked to employers you will be reliant on funding these pensions yourself.

How do I pay into a pension?

For workplace pensions, this is all dealt with by your employer. For Defined Benefit, you will have set contribution rates that you can’t change and for Defined Contribution, you will be able to adjust your contributions to whatever level is comfortable for you. You will see these contributions on your payslip and you will not pay tax on any money you pay into your workplace pension through your salary.

For personal pensions, the contributions work slightly differently. You can either pay lump sums or monthly contributions into the pension.

You will receive tax relief from the government for any contributions you make. This is free money and one of the best parts about investing in pensions.

For every £100 you put into your personal pension, a basic rate taxpayer will receive tax relief of £25 for free. That is a 25% uplift to the contribution before any investment growth is even taken into account.

For higher rate taxpayers you receive additional tax relief but this is via a tax return. If you are a higher rate taxpayer you will still receive the £25 tax relief but will also pay £25 less tax meaning that you have got £125 into your pension by paying only £75 net.

How much can I pay in?

For workplace pensions in the current tax year, you can pay up to £40,000 or your salary, whichever is less.

The limits are the same for personal pensions but given that you are paying in net of tax rather than directly from your salary you need to be careful about not exceeding the limit. For example, if you earn £25,000 this year, the maximum you can contribute is £20,000 net (you will receive £5,000 tax relief making a total gross contribution of £25,000).

If you earn £50,000 this year the maximum you can contribute is £32,000 net (you will receive £7,500 tax relief making a total gross contribution of £40,000).

For anyone earning over £40,000, you can possibly pay more depending on what you have paid in previous years.

When can I take money out?

At the minute the earliest most people can access a pension is age 55. This age is increasing to 57 in 2028 and the government intends to keep the minimum pension access age to 10 years before your state pension age. So if the state pension age continues to rise then its fair to assume so will the minimum pension age.

How much can I take out?

When it comes to taking money out of pensions there are various options available to you but the first thing to talk about is Tax-Free Cash.

With both Defined Benefit and Defined Contribution pensions, you will have the option to take a tax-free lump sum. For defined benefit, you will be offered an annual pension when you retire and with that, you will have to option to sacrifice some of the annual pension in return for a tax-free lump sum. The remainder of the pension is then taxable at your marginal rate of income tax.

Defined Contributions are much more flexible. You can take up to 25% of the value in your pot tax-free, but you don’t have to take this all at once at the start. Once the full tax-free cash has been taken the remaining 75% is then taxed at your marginal rate of tax.

Below are the options available to you when you retire with a pot of money in a Defined Contribution pension:

Annuity – You can use your pot of money to purchase an annual pension. These used to be the only option for personal pension holders until pension rules were relaxed in 2015.

Flexi Access Drawdown (FAD) – Since 2015 you have been able to flexibly access your DC pension in whatever way suits you best. This means you can draw lump sums or regular income in whatever way your needs dictate.

Uncrystallised Fund Pension Lump Sum (UFPLS) – This option is the act of taking a lump sum using part of your tax-free cash and is proving increasingly popular as a method of drip-feeding your tax-free cash out as income over time to ensure you pay as little tax as possible.

Where should I invest my pension?

If you have a Defined Benefit pension, your benefits are not linked to investment performance so there are no choices for you to make here.

On the other hand, if you are in a Defined Contribution pension your pot of money is directly impacted by investment performance.

Usually, workplace pensions have a default investment strategy that starts off high risk when you are younger, and the risk decreases over time as you get closer to retirement.

For personal pensions, you will have to choose where to invest the pension and this can be daunting. I have a blog post called The Basics of Investing which will hopefully help you make an informed decision.

Importance of understanding your pension

While I appreciate pensions can be incredibly confusing hopefully the above has helped to answer some questions and give you a greater understanding of pensions and how they work.

They really are so important because at some point you will not want, or not be able to, work any longer and will be reliant on your savings. You can see from the above that the tax advantages of a pension make it very worthwhile.

If you have any more questions or want to talk to an expert please feel free to get in touch.

Matt