How Do Pensions Work?

It is often difficult to convince younger people to think about their financial future, especially one that is decades away. But whatever age people begin drawing their state pension, most will not be able to live a comfortable life in retirement if they rely on the state alone.

Setting up a pension is, therefore, one of the most critical financial decisions that you can make in life.

Starting a pension scheme can be confusing for many, however with a bit of research, they can seem not quite so daunting. Try using our Pension Fund Calculator to give you a rough idea of what you might need to put away to build up a fund for retirement.

There are different pension schemes available. Therefore it is essential to understand the basics that could enable you to make an informed decision and start saving up for a prosperous future while benefiting from tax relief.

The sooner you start saving into a pension, the more the opportunity your savings will have to grow.

Getting pension planning right is therefore crucial, especially for young people, who have the time to convert even modest pension contributions into meaningful wealth in later life.

For most schemes, the longer you work, the more you expect to receive when you retire.

What is a pension?

A pension is a type of saving plan that you, your employer and the government pays into so that you can build up a fund to use when you retire.

A pension fund is built over many years and has the advantage of being tax efficient as opposed to many other saving and investment schemes, but more of that later.

After you retire, you may opt to draw money from your pension pot or sell the cash to an insurance company which in return gives you a regular income till death, which is known as an annuity.

Why get a pension?

It is sensible to keep aside some money for use when you retire so that you will have an income in your retirement years. A pension enables you to save a little proportion of your income during your working life when you are young, and this becomes a source of income later in life when you are only able to work less or when you retire. The government wants you to save into a pension. That’s why they offer tax relief on your contributions. The government will provide you with a state pension, provided you have made the appropriate number of contributions throughout your working life.

The current state pension sits at £8,450 per annum. However, you will likely require more than this if you wish to maintain your lifestyle.

What types of pension schemes are available?

There are different types of pension schemes available, but any pension scheme aims to have a money-saving plan that provides you with an income when you get older.

Pensions fall into three categories, as follows: 

  • Workplace pensions
  • Personal pensions 
  • State pensions

There are two main types of workplace pension schemes:

Defined contribution

Contribution to the plan can either be paid in by the employer, employee or both regularly. The success of the plan will be dependent on the performance of the selected funds. It is therefore not possible to know beforehand how much benefit a member will receive upon retirement. The pension provider takes a small percentage of the total amount as the management fee.

Defined benefit

In this scheme, the employer makes the contributions and guarantees a specified retirement benefit for each participant. How much you get depends on your salary and your length of service. The amount saved into the pension scheme increases per year. Your employer is also responsible for ensuring there’s enough money at the time you retire to pay your pension income. The amount can be paid in a lump sum, or you may agree with the pension provider on the percentage you will be receiving per year after you retire.

Personal Pension

The scheme works by you paying money to a service provider whom you have selected. Personal pensions invest your money with the ultimate goal of increasing its value. Anyone can save into a personal pension. At the end of the term, you can buy an annuity, or you may decide to keep your pension invested through a process called drawdown and take money out when you want. The money will be taxed at your usual income tax rate.

State pension

The State Pension is a regular form of income paid by the UK Government to the UK residents who have reached the State Pension age. It is intended to ensure that all residents have a retirement income to support them when they are old. The funding of the state pensions is from the National Insurance contributions. The amount you receive directly depends on your national insurance record other than how much you have earned.

Who is eligible for a pension scheme?

As soon as you start working, your employer has to provide a workplace pension as long as you are eligible. The employer must enrol and make an employer contribution to members of staff who meet the following criteria:

  • Employees aged between 22 years and the state pension age.
  • Those who earn at least £10,000 in a year.
  • Those who usually work in the UK, including those who travel abroad.

To get any new state pension, you will require to have at least ten qualifying years on your national insurance record but the ten years don’t have to run consecutively necessarily.

To get the full state pension, you will need 35 qualifying years if you do not have a National Insurance record before 6th April 2016.

You may be able to get some new state pension if you lived and worked abroad.

You may qualify for the pension too if you have paid married women’s or widow’s reduced rates contribution.

What’s so good about pensions?

A pension is a long-term savings plan with tax relief. Generally, you can access the money in your pension pot from the age of 55 years. Enrolling in a Pensions scheme have some significant advantages that will make your savings grow more rapidly than other types of savings as outlined below.

The pension scheme has an advantage over other saving plans as money that you save is relieved from taxation.

If you enrol in the defined contribution type of pension, your contributions are invested so that they grow throughout your career and in the long run, provide you with an income during retirement.

For Scottish residents, the UK government will pay 20% of your contributions into your pension pot.

Although they may not multiply, Pensions rarely lose money that is invested in them.

What’s the downside of pension schemes?

As much as pension funds offer a more secure way to invest and save for retirement in comparison to other saving schemes, they can also be disadvantageous in some ways:

The most glaring disadvantage of pension funds is that they lack flexibility in when you can access your money. In most cases, your money is locked away until you attain 55 years. This is a significant setback, especially to those who may opt to retire early.

In as much as the pension contribution reduces your total taxable income in the present, you will be forced to pay taxes on your retirement savings later in life when you go to withdraw. Although you can take a 25% lump sum tax-free at your retirement date, the rest of your retirement pot will be taxable.

The performance of pension funds depends entirely on the type of investment made to your contributions. Poor choice of investment means that your funds may not grow much if it grows at all. 

When can I take my money from the pension pot?

For you to access your pension pot, you must have attained the minimum age set by your pension fund provider, which is usually not less than 55 years. However, depending on your pension scheme rules, there are some circumstances when you may be able to take money from your pension pot earlier than 55. These include poor health state, disability, being in a profession where retirement is lower than usual or if you have a protected pension age lower than 55.

You can decide to withdraw the money in a lump sum or buy an annuity where you get income at fixed intervals till death or even invest in drawdowns where you can withdraw the money when you want.

The first 25% of any money you withdraw from your pension pot will be tax-free, but 75% of the remaining money is taxed at your income tax rate.

To access money from the state pension, you must have reached the state pension age. However, for this pension scheme, you cannot withdraw a lump sum, but do get a monthly payment that is based on how long you contributed National Insurance throughout your life.

What happens if I die before taking my pension?

In most of the pension schemes, upon enrollment you designate a beneficiary to receive your pension should you happen to die before you collect your pension pot. The designated beneficiary can be one or multiple. You may also nominate a secondary beneficiary in case the primary beneficiary dies before you. .If you die before having designated a beneficiary, your money will be distributed according to the regulations of the plan. In most cases, your benefits will go to your wife, if not married to your children or you’re next of kin. In other cases, the pension benefits may be paid to your estate.

The benefits will be paid out depending on the pension scheme that you belong to. Some may pay a lump sum while others pay in equal instalments over a period.

If you die while still contributing to a workplace pension, you will usually get some form of life cover, usually as a cash lump sum that is paid tax-free. 

What’s the difference between a pension and a Stocks & Shares ISA?

While the pension is a long-term savings plan with tax relief, stocks and shares Isa is a tax-efficient investment account that lets you put money into a range of investments. These include but are not limited to: unit trusts, government bonds, corporate bonds, open-ended investment companies (Oeics), investment trusts as well as individual company shares.

Thus unlike a pension scheme where risk is relatively low, with an ISA you should only invest if you’re prepared to take the risk as your investments can go down, as well as up in value. 

Whereas with a pension scheme your contributions are relieved from tax, with an ISA your contributions have already been taxed, and any gains your contributions will make are taxed no further.

Unlike pensions where you can only access money in your pension after attaining 55 years, ISAs are very flexible, and money can be accessed at any time.

With a pension scheme, you will pay taxes on your retirement savings later in life when you go to withdraw. However, with ISAs, any income paid out is tax-free. This means that investors can build a tax-free income to draw upon in retirement.

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