Pension basics – what you need to know
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When it comes to saving for retirement you’ll often hear people talking about their pension, but what exactly are they referring to, and what do you need to know?
As it’s not the easiest concept to understand, we’ll go through some of the key questions people ask about how a pension works, and why it's worth considering using one as part of your retirement planning.
The information in this article is based on our understanding of current taxation law and HMRC practice, which may change. The value of an investment can fall as well as rise and isn’t guaranteed. The final value of your pension pot when you come to take benefits may be less than has been paid in. If you’re in any doubt as to what to do, or decisions to make having read this article, please speak to a financial adviser.
What is a pension plan?
A pension plan is a tax-efficient way of saving for your retirement, that provides you with an income when you retire.
There are a few different types of pension plans.
Workplace pension – this is a pension plan that’s provided via your employer. By law, if you meet certain age and earnings criteria, your employer must enrol you into a pension plan, and together, you’ll both pay a proportion of your salary into the plan. In addition, you’ll usually get tax relief from the Government on your own contributions.
Individual or personal pension – you can arrange this yourself, or with the help of a financial adviser. This type of pension plan is usually used by someone who’s self-employed.
State Pension – this is an income provided by the UK Government, where the value is based on how many years you’ve paid National Insurance while working. While the State Pension probably won’t be enough to support you on its own, it can be a useful addition to your retirement income.
How does a typical workplace pension work?
You and your employer make regular payments, usually monthly, into your pension plan which are then invested into the stock market. In some cases, you can choose where you want the payments to be invested, but sometimes your employer has what’s known as a ‘default investment fund’ that’s been chosen specially for your workplace scheme.
The objective is for your pension savings to grow over the long-term, perhaps 20, 30, or 40 years depending on when you start saving into it. The earlier you start paying into your pension, the longer you’ll have to help your investments grow and help towards putting yourself in a better position when you come to retire1.
Remember that the value of an investment can fall as well as rise and isn’t guaranteed. The final value of your pension pot when you come to take benefits may be less than has been paid in.
To make sure you're saving enough for the retirement you want, you should think about what a comfortable retirement looks like for you. Think about what you might want to do in retirement and how much that lifestyle might cost you.
Why pay into a workplace pension?
One of the key benefits is that you’ll usually get tax relief on your pension contributions. The money you put into a pension is given tax relief by the Government to encourage pension saving. The value of any tax relief will depend on your individual circumstances.
There are three different ways of contributing to your pension savings, depending on how the plan is set up:
- If the pension plan is set up on the ‘relief at source’ basis, the government will add an extra £20 tax relief for every £80 you personally put into your plan. If you’re a higher rate or additional rate taxpayer, you get extra tax relief but you’d need to reclaim this money yourself through an HMRC self-assessment tax return, or directly from the taxman.
- If the plan is set up using the ‘net pay arrangement’ you don’t have to do anything to get tax relief. Your pension contributions are deducted from your salary by your employer before income tax is calculated on it. So you get relief on the amount immediately at your highest rate of tax.
- The third way of paying into your pension is through ‘salary sacrifice’. This is where your own contributions are paid by ‘exchanging’ part of your salary, before tax, for a higher employer pension contribution. It saves you and your employer tax and National Insurance on these contributions because the money is paid into your pension plan, rather than directly to you.
Salary sacrifice isn’t always suitable for everyone and may not be an option under your plan. You should think about other things linked to your level of salary such as statutory maternity and paternity pay, or the amount of mortgage you can borrow. The value of the reduction in tax and National Insurance will depend on your individual circumstances and could change.
Your employer will be able to tell you which method of obtaining tax relief applies to your plan, and whether or not salary sacrifice is an option.
Auto-enrolment requires employers to make pension contributions for those employees who meet certain criteria, but an employer may be willing to contribute more than the legislation requires. So, if you’re an eligible employee as a result of auto-enrolment, you can ask your employer exactly how much they pay into your pension for you.
When can I access my pension?
Workplace and personal pensions generally can’t be accessed until you’re at least age 55 – this is expected to rise to 57 from 6 April 2028.
The age at which the State Pension is paid is rising from 66 to 67 between 2026 and 2028, and then to 68 between 2044 and 2046.
Taking your pension benefits
There are a variety of ways you can access the money you’ve saved into your pension plan.
- Flexi-access pension drawdown – this is an option where your pension savings continue to be invested and you can take money out as and when you need it. Your pension savings are to last the whole of your retirement so you should be mindful of this when deciding how much you withdraw.
The value of an investment, and any income you take from it, can fall as well as rise and isn’t guaranteed. You could get back less than has been paid in. The level of income is not guaranteed.
Drawing income will reduce the value of your pension savings. You might need to reduce your drawdown income in the future, in particular if investment performance is lower than expected, or you live to a greater age than originally anticipated. The level of income you take will need to be reviewed regularly. The income you receive may be lower or higher than you could receive from an annuity, depending on the performance of your investments. The rules governing how much income you can take may change. This could mean income drawdown no longer meets your requirements.
- Annuity – an annuity guarantees to pay you an income for the rest of your life or for a fixed term, depending on which you choose. Certain things will increase the amount of money you can get from an annuity, including how old you are and if you’ve any pre-existing health conditions.
You can buy a single-life annuity that expires at the end of your life or a joint-life annuity which will continue to provide an income for someone who’s dependent on you after you’ve died. Some annuities will increase the value of payments made each year based on inflation, but the trade-off is that, to start with, you’ll get paid less than from an annuity that doesn’t rise with inflation.
As annuity rates can change substantially and rapidly, there is no guarantee that when you do purchase an annuity the rates will be favourable. This could mean that your pension might be less than you hoped for.
- Pension freedoms – these rules mean you can take your pension savings in one go, or as a series of lump sums or regular payments but be aware that if you do this there are income tax implications. If you’re not sure what to do, we’d recommend you speak to a financial adviser.
Taking your pension
There’s no easy answer as to when you should take your pension, as it’ll depend on your own financial position at the time and working out if you'll have enough money to last for your whole retirement. But remember that just because you can take your pension at 55 currently, rising to 57 from 6 April 2028, you don’t have to stop working – you could continue to work and take pension benefits at the same time.
When you do take money from your pension pot, 25% is tax free – you’ll pay income tax on the other 75%. The amount of tax you pay depends on your total income for the year and your tax rate.
This is based on our understanding of current taxation law and HMRC practice, which could change.
Getting financial advice
You might not have the experience, interest, and time to look after your own retirement planning. If this is you, then one of the best ways to help you plan for the future and help reach your retirement goals is to speak to a financial adviser who specialises in pensions.
Working with a highly qualified adviser will bring peace of mind over your pension planning. By working together, you can create a road map to get you to where you want to be, as well as helping to keep your plans on track along the way.
You can search for a financial adviser by visiting the Money Advice Service
1 Nick Green – Why start your pension early? Data source: Unbiased.co.uk – 3 December 2020