Understanding pensions in 3 Simple Steps
Retirement might seem a long long way away and nobody wants to think about getting older, but thinking about retirement and your pension early is important to set yourself up for the future. So what is a pension and how do they work? We’re here to explain.
What is a pension?
A pension scheme is a long-term savings plan. It is a tax-efficient way to save money during your working life. Some pension schemes are run by employers, others you can set up yourself. You can save into more than one pension scheme if you want to.
How does a pension work?
The type of pension you have will change the way a pension works but there are a few key things to know about a pension that applies to most types of pensions:
- You and others contribute to a pension
- The government tops up a pension through tax relief
- You have a pot of money to live from later in life
What’s the difference between a workplace pension, a personal pension and a state pension?
A workplace pension is offered by employers. By law, all employers in the UK are required to have a pension scheme set up and they must automatically enrol their eligible employees.
In a workplace pension both the employee and employer contribute to the employee’s pension each month. The minimum contribution for an employee is 5% and for the employer, it’s 3%.
The government also contributes to your pension, through tax relief. This means that some of the money you would have paid in tax on your earnings goes into your pension pot rather than to the government.
There are two types of workplace pensions you need to know about:
- First up it’s the defined contribution pension scheme. This is where you pay a percentage of your salary and your employer also contributes to it. These contributions are then invested by the pension provider. Don’t forget, with investing the value of your pension could go down as well as up and you may get back less than you put in.
- The second type of workplace pension is called a defined benefit pension scheme, AKA final salary pension schemes. With a defined benefit pension scheme, you’ll get a specific amount as income when you reach retirement age. This is determined by how long you’ve worked for your employer and your salary when you retire.
A personal pension AKA a private pension is a type of pension you set up yourself. It’s up to you who you choose as your provider, how much you’re going to contribute and how often you’re going to contribute. Personal pensions are usually defined contribution schemes, which means the value of your pension will depend on how much you’ve invested and the value of these investments. The good news is that just like workplace pensions the government will give you tax relief on your personal pension.
When it comes to personal pensions there are three types:
- Simple personal pension
Managed by a pension provider, you’ll make small monthly contributions and you’ll be able to pick from a range of investment strategies so you can pick one that suits you, for example
- Stakeholder Pension
This is similar to a personal pension but the rules on how they’re managed are a bit more stringent. They have low minimum contribution amounts and only a few investment options and caps on how much the provider can charge you
- State Pension
Finally, a state pension is a pension you’ll receive from the government once you reach the state retirement age, provided you have at least ten years of qualifying national insurance contributions or credits and meet the other eligibility criteria laid out by the government.
The amount you get also depends on the national insurance contributions you’ve made. The government will then pay you your state pension for the rest of your life.
Pensions can be a bit confusing but we hope our breakdown has helped you understand the different pensions on offer and which one might be best for you.