How do pensions work? Beginner's guide to pensions

Pensions may not seem the most exciting subject, yet their benefits can last a lifetime. So, how can pensions work for you? On this page we look at defined contribution pensions, which are the most common pensions these days.

Read on to find out:

• What is a pension?
• What is the pension life cycle?
• What types of pensions are there?
• What are the main pension benefits?

What is a pension?

In its broadest sense, a pension is the money you live off when you are older and no longer working.

There are different sorts of pensions that behave in different ways but, in general, you pay into a pension during your working life and use the money saved to create an income in retirement.

What is the pension life cycle?

From setting up a scheme to withdrawing money when you retire, the pension life cycle generally follows these stages:

1. Set up a pension and start paying in

Join your company pension scheme or set up a private pension such as a Self-invested Personal Pension (SIPP).

Key things to remember:

• You won’t be able to access your money until age 55 (rising to 57 in 2028)
• Your employer might automatically enrol you into their scheme and make contributions too
• The earlier you start, the better because of the impact of compounding over time

2. Keep in mind tax allowances and reliefs

The Government offers a range of generous tax incentives to encourage retirement saving. 

Key things to remember:

• Tax relief tops up the money you pay in
• If you’re a higher-rate or additional-rate taxpayer, you can get further tax relief via your tax return
• You’ll need to stay within the annual allowances

3. Choose your investments

The money you pay into your pension doesn’t have to stay in cash. If your scheme is set up as a defined contribution plan, it’s used to buy investments. The idea is that these investments grow over time, helping you build a large enough pot to see you through retirement.

Key things to remember:

• The performance of your investments will have a significant impact on the amount of money you receive in retirement
• You’ll need to make some investment decisions. Different types of pension schemes have different investment choices. For example, SIPPs give you lots of choice, but many people in workplace pensions have limited options
• Your investments aren’t guaranteed to rise and can also fall in value

4. Account for pension fees

You’ll need to pay fees to your pension provider for looking after your money, and to any investment companies investing on your behalf. There may also be other fees depending on the service you choose, for example you may want to pay someone to manage your investments.

Key things to remember:

• Fees vary a lot and the more you pay, the less money you have to invest
• Cheapest isn’t necessarily best
• You should be able to review any fees on your annual pension statement

5. Save for the long term

A small monthly pension contribution can easily build up over time, especially when tax relief and employer contributions are factored in. Try to save with the long term in mind.

Learn about the power of compounding

6. Review your pension’s performance

Although you’re not going to use the money for a long time, you shouldn’t ignore your pension. Regularly review your investments to ensure you’re comfortable with your choices and they’re performing well.

Key things to remember:

• Check your investments are still right for your needs
• Think about whether your contributions are large enough
• You could potentially transfer to a new provider if you’re not happy

7. Withdraw your savings when you retire

You’ll have a range of options to create a pension income on retirement, although some pensions offer more flexibility than others.

Key things to remember:

• You generally can’t take any cash out until you’re 55 (rising to 57 in 2028)
• You can normally take 25% of your pot as a tax-free lump sum
• Lump sum withdrawals, annuities and income drawdown are popular choices

What are the main pension benefits?

The benefits of entering a pension scheme in the UK include:

• Tax relief – you’ll receive a 20% top-up on your contributions automatically. Higher-rate and additional-rate taxpayers can claim an extra 20% and 25% respectively
• Employer contributions – company pensions give you the chance to instantly boost your pot with monthly contributions from your employer
• Tax-free cash – it’s normally possible to withdraw a quarter of your retirement savings as a tax-free lump sum when you retire
• Support for your family – nominate a loved one as a beneficiary to help ensure your pension pot goes to the right place when you die

Please see Important information below