What is a Pension and How do Pensions Work?

A pension provides a way to save during your working life that can then deliver an income when it’s time for you to retire. There are tax efficiencies and requirements on employers to pay into a pension, which can make saving into a pension hugely attractive.

Hannah Smith, Tim Leonard Published on 29 January 2021. Last updated on 19 October 2021.
What is a Pension and How do Pensions Work?

For most of us, saving into a pension during our working life will be crucial to enjoying a financially secure retirement when we eventually give up work. Yet the chances are that sorting out your pension is not top of your priority list. Not only might it seem complicated, but your retirement may feel like it’s a long way off.

A recent NerdWallet survey found that 11% of adults in the UK have not thought about setting up a pension or how they might finance their retirement, a figure that rises to 22% of those aged 18 to 24 years old.

Often other financial priorities can get in the way of taking out a pension. For instance, our survey found that over a third of young people (34%) believe that it is more important for them to pay off a mortgage early than to start saving into a pension.

Similarly, over a third of young people think that it is more important to invest in stocks and shares ISAs (36%) or cash ISAs (35%) than to contribute to a pension or plan for retirement.

However, delve into what a pension can offer and you will discover there are some compelling reasons to start saving for your retirement via a pension.

Pension tax relief, employer contributions (if you’re currently employed) and compound interest all offer the potential for even a little money that you can save today to multiply over the decades, with minimal effort on your part.

» MORE: How to approach your retirement planning

What is a pension?

A pension is a pot of money that you save up over time for your retirement. The aim is that over the long term your pension pot will grow sufficiently to support you financially when you retire.

With a pension, your money is usually invested in the stock market through pension funds.

These are funds which pool your money with other investors to buy a wide range of shares in companies. Depending on the type of pension you have, you may be able to choose the funds that you invest in. Some pensions will also offer a default fund if you feel that you are unable to make a decision.

» MORE: How pension funds work

What are the different types of pension?

Three broad types of pension schemes are generally found in the UK.

Defined contribution

A defined contribution pension can be a workplace pension organised by your employer or a personal pension, which you set up yourself. When you retire the value of your pension will depend on how much you paid into it and how your investments have performed over the years.

Defined benefit

Also known as final salary pensions, these are workplace pension schemes that offer a set amount of income when you retire, based on your salary and the length of time that you worked for your employer.

State pension

This is the government pension most people are entitled to receive upon reaching the state pension age, which is currently age 66. The state pension isn’t paid automatically, so when you want to claim it you must either apply online or send a form to the Pension Service.

What are the advantages of pensions?

Unlike a savings account or other investments, there are extra incentives to save into a pension.

Pension tax relief

The main advantage of a pension is pension tax relief. This effectively means that the government repays the tax you pay on your earnings and puts it into your pension. As a result, it costs a basic-rate taxpayer only £80 to invest £100 into their pension, while a higher-rate taxpayer will only need to pay £60, and an additional-rate taxpayer just £55 to invest the same amount. However, there is an annual limit of £40,000 on the amount of pension that is eligible for tax relief.

Employer contributions

If you have a workplace pension, your employer must make contributions into your pension on your behalf. The amount will vary according to the generosity of your employer, but as a minimum it will be 3% of your ‘qualifying’ earnings. In the 2021/22 tax year, this was the band of earnings between £6,240 and £50,270.

» MORE: Learn more about pension contributions

Tax shelter

In addition to tax relief to top up your pension, all the money in your pension pot will be sheltered from tax as it grows. However, once you start withdrawing money from your pension you may need to pay tax on that income.

How to approach pension planning

The good news is that if you are 22 or over, employed and earning more than £10,000 a year, you may already be paying into a workplace pension (unless you have opted out). If you are working or claiming certain state benefits, you will also be building up entitlement to the state pension.

However, even with the state pension, if you are paying only the minimum amount into your pension, you could face a shortfall in the income that you need for a comfortable retirement. This makes it vital to engage with your pension as early as possible and to make a plan.

In our NerdWallet survey, 29% of young adults aged between 18 and 24 years old said that they do not plan on starting a workplace or personal pension as they think that the state pension will be enough to support them in retirement.

However, even saving a small amount regularly into a pension from an early age can make a significant difference later on. In contrast, if you wait till much later in life, you’ll have to save much more to make up for the lost time.

» COMPARE: Personal pension providers

It’s always worth checking the rules on your workplace scheme to ensure you’re maximising any benefits you could get, such as matched contributions from your employer.

You should also consider taking financial advice to help with pension planning, ideally from an independent financial adviser.

Once your pension is set up, you should keep track of how your pension pot is progressing. It is wise to have an annual review to check whether the approach you’re taking is on course to deliver enough income for a comfortable retirement. This is even more important the closer you get to retiring.

» MORE: Tips to maximise your pension savings

How much pension do I need?

Working out how much pension you need to live on in retirement isn’t easy, particularly as much can depend on what is hopefully the open-ended question of how long you will live. Whether you’re likely to be mortgage or debt-free when you retire will be important, as will the kind of lifestyle you want in retirement. For instance, are you planning to run a car, travel the world, pursue hobbies, eat out regularly, or take the grandkids on day trips?

Our NerdWallet research found that 83% of adults in the UK have not considered the size of pension they might need to live comfortably in retirement, yet it is something everyone should think about.

Some pension calculators may give you an idea of the size of pension pot you might need to live well in retirement, and show how much you need to save each month to hit that target. You should also get a state pension forecast to see how much income you’re in line to receive from the government, and regularly check your pension statements to see what your own personal and workplace pensions are on track to provide.

Alternatively, you might want to talk to a financial adviser, who should be able to help you work out your retirement needs and a plan for meeting them.

» MORE: Learn about pension advice

Could I use my property as a pension?

Our NerdWallet research revealed that 37% of 18- to 24-year-olds plan on releasing equity from their home to give them a retirement income. But while property often plays a part in many people’s plans to fund retirement, it might not be sensible to rely on bricks and mortar entirely.

The intention to downsize your home to raise funds for retirement may work out for some. However, there’s always the risk that property prices will fall or you’ll have difficulty selling. Finding a new home that ticks enough boxes and can sleep the grandchildren may also not be straightforward. Some people also become so emotionally attached to their homes that when the time comes they realise they don’t want to leave.

If you’re a landlord with additional property that you rent out, the income you receive from tenants could potentially supplement or even replace income from a pension. You might also be able to sell your buy-to-let property to raise funds for your retirement. However, it’s important to consider how you would replace the rental income if you had no tenants for a sustained period of time. And as with any property, the value of your buy to let could fall, as well as the income you receive from it.

Even if you have one or more rental properties, it may not be as reliable as a pension. Taxes on landlords have increased in recent years, maintaining property can be expensive, and you will be liable for capital gains tax if you sell up.

In comparison, both the government and your employer will pay into your pension, two perks that are difficult to ignore. So while property could potentially be your pension, you need to strongly consider the pros and cons of going down this route.

» MORE: Is property better than a pension?

When can you access your pension?

A pension can usually be accessed from age 55, at which point there are various options for how you use the money built up in your pension pot.

Buying an annuity is one way of ensuring that you’ll have a certain level of income coming in for the rest of your life. On the other hand, a carefully managed drawdown plan can offer flexibility over how you take your pension and allow you to draw an income, but without the guarantee that this will continue until you die. Alternatively, you can mix these options.

» MORE: Your options for cashing in a pension

WARNING: We cannot tell you if any form of investing is right for you. Depending on your choice of investment, your capital can be at risk and you may get back less than originally paid in.

Research methodology: The research was carried out in September 2021 for NerdWallet by market research company OnePoll. Ten questions were posed to a sample of 2,000 nationally representative UK adults about their thoughts on pensions. The results were broken down by age, gender, region and whether respondents had a pension.

Image source: Getty Images

About the authors:

Hannah is an award-winning journalist with a background in the trade press. She writes about finance, asset management and business for Shares, Citywire, FE Trustnet, and interactive investor. Read more

Tim draws on 20 years’ experience at Moneyfacts, Virgin Money and Future to pen articles that always put consumers’ interests first. He has particular expertise in mortgages, pensions and savings. Read more

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