How do pensions work?



Pensions are an incredibly important aspect of our finances, responsible for ensuring a good standard of living when we're older. Unfortunately though the options available, rules present and general nature of the pension system are, on the whole, rather complex. As a result, many people can forget, or downright refuse, to engage at all. 

But pensions matter, and it's important not to let their nature detract from the need to understand and invest in them while you have time. Not sure how the pensions game is played? Here's all of the information you need to understand their basics, and how to use them in a way that works for you

The basics

What is a pension?

First things first, pensions are financial products that are paid into while you're working, with the aim of providing them money when they retire. Pensions can be created via the workplace, be bought and operated via a provider, or managed personally. 

Pension pots grow through the years as more money is invested in them, as interest is paid on the sum, or as stocks, shares and other investments grow in value. Most people in the UK can also receive a State Pension when they're older, which grows according to how many years a person has paid National Insurance (NI) contributions. 

When you reach pensionable age (the age at which you can begin drawing from your pension) then you will have the option to take out the money. This is usually around the age of 55, although the State Pension is given to those who are older. 

Laws require all employers to enrol their workers on a workplace pension scheme if they're aged between 22 and State Pension age, work in the UK, and earn more than £10,000 each year. Also, tax relief is paid on pension contributions, meaning that each contribution is topped up by the government. 

The varieties

There are a number of different types of pension that you can invest in, with the variety informing how much you will receive when you reach retirement age.

The State Pension

The State Pension is divided into two categories. If you reached pension age before April 6th 2016, you'll receive the old State Pension, with the amount given being dependant on how many years you paid NI, up to a maximum of 30 years' worth.

You may be entitled to the Additional State Pension depending on your National Insurance contributions. There’s no set amount, but the money you receive will depend on the benefits you claimed and how much you earned whilst working. 

The new State Pension is for those reaching pension age on or after April 6th 2016. The amount paid again depends on the number of years that you contributed to NI, but the maximum is 35 years' worth. If you have less than ten years of contributions, you won't be eligible.

The Additional State Pension is not available if you reached State Pension age on or after 6 April 2016.  In effect, the New State Pension is a combination of the State Pension and Additional State Pension.  

Both varieties of State Pension increase per year in line with either UK earnings growth, prices growth, or an interest rate of 2.5% - whichever is highest. This is called the triple lock.

Defined benefit pensions

An older type of pension scheme that has fallen out of favour among employers due to its high cost, defined benefit pensions – also known as final salary schemes – see employees pay a portion of their salary into a pension pot while they work. 

Depending on the agreement with the company, if you have a defined benefit pension and retire, you'll receive a portion of your final salary annually until you die. This amount is worked out depending on how many years you worked at the company. 

So, for instance, if your employer pledged to pay one sixtieth of your final salary for each year you worked there, and you had 20 years of service, when you retired, you'd be paid a third of your final salary each year until you died.

Defined contribution pensions

The most popular form of pension scheme, and that which the government's new workplace pension rules are built around, defined contribution schemes see employees pay a portion of their pay into a scheme, which is then matched by their employer and topped up by pension tax relief.

This money is then invested by the operators of the scheme in things like bonds, stocks and shares, with the returns from these investments being added to the pension amount over time.

Personal pensions

If you have a knowledge of investing, then a personal pension could be a good choice. With these, you set up a pension account with a provider and either choose the investments you'd like to make with your money or pick from a selection of investments chosen by the fund's operator.

The longer you have a pension set up and pay into it, the more money you'll have when you retire. This is because the investments in your pension are designed to grow in value over the long term.

When you retire

You can choose to receive a pension when you reach a pensionable age, the earliest of which is 55. You will usually have the option of delaying your pension, in return for higher payments later on. Otherwise, it's either decided when you sign up to a pension provider or when you pass State Pension age. The latter is more difficult to work out, as the government reserves the right to change this age, given that the UK's population is living far longer than it once did. 

To check your State Pension age, click here to use the government's tool.

When you retire, you can do a number of things with your pension pots. You can firstly take up to 25% of your money out tax-free. You can use some or all of your money to:

  • re-invest into funds that allow you to take a regular income (not guaranteed), take ad-hoc lump sums as required or simply leave your money invested for potential growth. This is called drawdown.

or

  • Buy an annuity with some or all of the money which will provide you with a regular guaranteed income for life.

Any money taken from the drawdown or annuity elements will be subject to income tax based on your total income each tax year.

Pensions can take a little time to get your head around, but after you do so, you'll have a far better understanding of your finances during retirement, allowing you to do the things you want to do once you stop working.

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