How pensions work

With auto-enrolment the provision of pensions is now mandatory

A pension is a financial product that you put money into so that you can build up a fund to use when you retire. The idea is that a retirement pot is built up by investing over a number of years. The money that you save into a pension gets a boost from tax relief, so effectively you are saving out of untaxed earnings.

In retirement, you can then access your pension to buy yourself an income or draw on it. Alternatively, for a limited number of people in the public sector or employed by the larger companies, you will have a defined benefit scheme, often known as final salary, where your employer promises you a set income in retirement for life and picks up the tab.

There are two main types of pension that you will hear mentioned, defined contribution and defined benefit schemes.

Defined contribution

Most work based pension including auto enrolment schemes are defined contributions. Defined contribution schemes do not promise any set pay out in retirement, instead you must invest to build up a savings pot that can eventually be used to provide an income. The name comes from the fact that it is your contributions that are defined. With a work defined contribution pension, people are usually able to decide how much they want to pay in as a percentage of their salary and their employer will match some or all of the contributions. The money saved into the pension is invested, typically into funds that hold shares or bonds, and grows over the years to deliver a retirement pot. With these pensions it is your responsibility to build up the pot you need for retirement. You can track which investments your money is going into and how they are performing and change them if you wish.

Defined benefit

Defined benefit schemes pay you a set annual income in retirement. The name comes from the fact that the benefit you receive is defined, they are often called final salary schemes.

Tax relief on your pension

You receive tax relief pension on contributions, which increases the amount that goes in. This effectively means that you are investing into your pension out of untaxed income. Everyone gets basic rate tax relief of 20 per cent automatically; higher rate taxpayers must claim the rest of their 40 per cent relief themselves. This tax relief is not unlimited and there are annual limits on contributions and lifetime allowance.

How does an employee start a pension?

People are most likely to start a pension through work. Under auto-enrolment rules, most employers should now be offering workplace pensions and putting people in them, unless they opt out. With a defined contribution scheme, your employer will have chosen a provider to manage the pension and you will make contributions out of your salary and your employer will also put money in. This money is then invested in the stock market or government and company bonds, usually through funds. When you start a pension you will need to decide on your investing strategy and how much risk you want to take. Employers usually place a limit on your contributions that they will match, for example 5 per cent of your salary. You can change your level of contributions over time. It is also important to keep an eye on charges as these can have a big impact on your returns.

When can an employee access the money and what can they do with it?

The earliest you can normally access a pension is currently age 55. You can take a 25 per cent lump sum tax-free, but you can then either buy an annuity or keep the rest of your pension invested through a process called drawdown and take money out when you want – and taxed at your usual income tax rate. Alternatively, you can also forgo the 25 per cent tax-free lump sum in one big chunk and keep a pension invested and draw on it as you choose, with the first 25 per cent of each withdrawal tax-free and the rest taxed at your usual income tax rate.

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