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Pensions Explained UK: Ultimate Guide For Beginners – Updated October 2022
Do you find all things pensions somewhat confusing or complicated?
Today we’re here to walk you through our ultimate guide to pensions in the UK.
Think of this as a complete beginner’s or dummy’s guide to pensions.
Table of Contents
Pensions Explained UK
We’ve put together the top questions that we usually receive and we’re going to answer them all in an easily understandable and actionable Q&A style.
Our goal is for you to walk away after reading this post and feel confident about your Pensions.
1. What is a Pension Plan?
This is simply a pot of cash that you (and your employer) can pay into and invest for your retirement.
Most people qualify for tax relief when they pay that money in meaning that you don’t pay tax on it now.
However, you’ll have to pay tax on a portion of it later, when you come to withdraw that pension as income at retirement.
To get a pension, most people will automatically get one via their workplace pension given new rules.
To get employer contributions, you’ll need to be part of an employer scheme and not Opt Out.
If you want to choose your own Personal Pension outside of your employer's workplace pension, that’s also an option.
We’ll cover more on this below.
Recommended: Super Simple Investing course
2. What Are The Different Types of Pensions?
The pensions we’ll be talking about today are Defined Contribution pensions, which are what most modern workplace and personal pensions are.
There’s also another kind, called Defined Benefit or ‘final salary’, which are less common so we won’t be covering those today.
In the UK, there are 3 different types of pension:
i) State Pension
This is a regular payment paid to you by the government when you retire.
The current State Pension age is 66, rising to 67 by 2028.
How much of it you receive depends on you having paid a certain amount of National Insurance Contributions during your working life.
To get a state pension at all, you need to have made at least 10 years’ worth of contributions.
To receive the full state pension (currently at £185.15 per week), you need at least 35 years’ qualifying National Insurance contributions.
You can check how far off you are from those 35 years of National Insurance contributions by visiting the government website.
We did this for ourselves and here are our results.
I’ve contributed about 19 years of those required 35 years so far:
ii) Workplace Pension
This is a scheme usually organised by your employer for you and your employer to make contributions towards your retirement.
With Auto Enrollment, employers are now required to offer pensions to their employees.
They automatically enroll you onto their scheme and contribute money to your pension if you’re aged over 22, and earn more than £10,000.
The current rules are that you should contribute at least 5% of your qualifying earnings and your employer contributes 3%.
iii) Personal Pension
A personal pension is also known as a private pension or Self-Invested Personal Pension (SIPP).
It is a savings product that you can set up yourself to save and invest for your retirement.
The amount that you get on retirement will depend on:
- The amount you have paid in,
- How well your investments perform.
Once you’ve opened a personal pension, you’ll be given a choice of pension funds.
You can choose where your money is invested by choosing various pension funds or stocks for your money to be invested into.
3. What Are The Advantages of Saving Into a Pension?
Pension contributions attract tax relief.
This means that for every £1 that you pay into a pension, the government will add a 25% top-up to your balance automatically.
For example, if you add £80 to your pension, you’ll get £20 topped up automatically, giving you a total of £100.
If you’re a Higher Rate Taxpayer, you can claim an additional 25% via your tax returns.
And if you’re an Additional Rate Taxpayer, you can claim an additional 31%.
For 2022/23 you get this tax relief up to 100% of your salary or £40,000, depending on which is lower.
Another important advantage of pensions is for Inheritance Tax.
If you die before the age of 75, personal and workplace pensions usually let you pass on your pension to beneficiaries, tax-free.
Also, if you die after the age of 75, your beneficiaries may pay Income Tax on anything they take out of the pension.
4. What Is Salary Sacrifice? How Does It Help With Pensions?
Salary Sacrifice is where you give up some of your monthly Pre-Tax income and your employer puts it towards your pension for you.
Doing this has some interesting advantages:
i) You pay less National Insurance, and your employer also pays less Employer’s National Insurance.
ii) Some employers take these additional savings and make an additional contribution to their employees’ pensions.
iii) You see an increase in your take-home pay as a result of paying less National insurance and less tax due to being taxed on a lower Taxable Income.
iv) If you’re a Higher or Additional Rate taxpayer, Salary Sacrifice means that you won’t need to claim back the extra tax relief yourself.
Also, if you’re a higher rate taxpayer earning just over £50,000 (e.g. £55,000) and you have a child that you’re claiming Child benefit for…
…salary sacrifice helps you get tax relief at 40% tax into your pension.
It also reduces your taxable income to below £50K and you get to keep your full Child Benefit and avoid the High Income Child Benefit Tax.
v) If you’re earning between £100K and £125K, you start losing your personal allowances i.e. you lose £1 for every £2 above £100K and lose it all at around £125K.
Salary Sacrifice lets you sacrifice some of your gross income into your pension.
By doing that, it reduces your Taxable Income to get you below £100K and gives you back your full Personal Allowances.
5. Should You Consolidate Your Pensions?
If you have several pensions from previous employers, consolidating your pension can be a great way to stay on top of things.
Benefits of consolidating your pension include:
- Easier to manage – Having your pension in one place takes out the stress and makes it easier to manage.
- Lower fees – You can better monitor and reduce the Admin fees and Management fees of your pension.
- Better Performing Funds – By combining your pensions into one, you can choose a pension plan that better matches your risk appetite. By moving your pensions, you can potentially find a plan that offers a better return.
But note that consolidating your pension does not guarantee better performance.
PensionBee helps you to combine your old pensions and invest them into a brand new online plan for free.
You can combine your Pensions with them in 3 simple steps.
- Sign up in minutes, for free
- Tell them about your pensions
- Leave the rest to them
They’ll start contacting your old pension providers.
As always with investments, your capital is at risk.
6. What Is Your Pension Personal Allowance?
Technically, there is no limit as to how much you can put into a pension.
However, there are limits on how much Tax Relief you’ll get for doing so.
There are 3 limits to be aware of tax relief purposes:
i) Earnings Limit
You’ll get tax relief on contributions up to your annual earnings.
E.g. If you earned £25K and had £35K in savings and decided to put all £35K into your pension, you can, but will only get tax relief on the first £25K.
ii) Annual Limit
This limit is aimed at higher earners.
You can only get tax relief up to the current annual allowance.
Current Annual Allowance = £40,000 + Any Unused Allowances In The Previous 3 Tax Years
This is very important as an investor.
Let’s say that you have been investing £10K per year into a pension in the last few years.
This means that you carry forward 3 X £30K (i.e. £40K less £10K) = £90K in addition to the current year’s £40K.
So you could make a total contribution of £130K (£90K + £40K) into your pension.
The annual allowance of £40K begins to taper (i.e. reduce) for annual earnings over £240,000.
For every £2 of ‘adjusted income’ over £240K, you’d lose £1.
This means that if someone earns £300K or more, that £40K annual allowance becomes £4K for tax relief purposes.
iii) Lifetime Limit
The current “Lifetime Allowance” is £1,073,100 and it has been frozen until 2026.
This lifetime allowance means that if your total pension savings (including gains and interest) exceed this amount, you’ll pay a tax charge.
Note that this amount of £1,073,100 also includes contributions paid by others such as your employer.
You can of course contribute more than the lifetime allowance to your pension, but you’ll only get tax breaks up to this maximum limit.
7. How Much Should You Put Into Your Pension?
Given Auto Enrolment, there are now minimum contributions into pensions as mentioned before.
We’d suggest contributing as much as you can to your pension.
Make sure that you prioritise paying off high-interest debts first before paying any excess into your pension.
Note also that a pension is not the only way to save for retirement, so you might need to combine it with other accounts.
e.g. a Stocks and Shares ISA or Life Time ISA.
A general rule of thumb of what percentage to contribute to your pension is to take half of the age that you started your pension.
Then put this percentage of your Pre-Tax income into a pension.
Let’s assume that you started a pension at age 30. Half of 30 is 15.
According to this rule of thumb, take 15% of your Pre-Tax Income and put this into your pension.
Note that this 15% includes your employer’s contribution.
So if your employer is contributing say, 5%, then according to this example, you’d contribute the rest, being 10%.
Remember: This is a rule of thumb.
8. How Is a Pension Invested?
Your pension is invested in your choice of pension funds, depending on the selection of funds offered by your chosen pension provider.
The goal here is that the funds you choose should help your pension grow over time.
Therefore, helping you to maximise the value of your pension so that you can get the highest income for your retirement.
The funds that you choose can vary depending on your:
- savings needs,
- risk appetite
- or even your values.
Whichever provider you choose, you should be able to choose funds to invest in to suit your attitude to risk, values or goals.
Recommended: Super Simple Investing course
9. When Can You Access Your Pension?
Under current rules, you can’t access the money in your pension until your 55th birthday.
Note that this minimum age will be increasing to 57 by 2028, which may affect your retirement plans.
10. Why Should You Open a Personal Pension?
Unfortunately, for many people, a combination of the state pension and the savings from a workplace pension will not be enough for retirement.
Especially as the cost of living continues to increase year on year.
Opening a Personal pension and getting tax relief on your contributions can help to boost your future retirement income.
Obviously, opening a personal pension is quite a big leap for some.
So it should be done after considering your personal circumstances to make sure that you can afford to make contributions to one.
Focus on getting your finances in shape first (like paying off high-interest debt and living within your means).
That should help to free up cash to contribute to a personal pension.
Recommended for Pensions Explained UK:
11. Is a Personal Pension Worth It When You’re Self-Employed?
Even if you earn less than £10K or have spare cash that you can put towards saving for retirement monthly…
Opening a personal pension can help to boost your retirement savings.
You should ideally save as much as you can into your retirement funds.
But even a small amount saved consistently can help to boost your retirement income.
If you can only save £50 a month over the 30 years, that’s an extra £18,000 (£50 x 12 months x 30 years) in your pension pot.
That's before factoring in investment gains and tax relief you may have qualified for in that period.
Every little helps!
PensionBee has an option for self-employed people wanting to open a brand new pension with no existing pension(s) to transfer.
There are no minimum savings amounts which means you can contribute to your pension flexibly, whenever your business allows.
Another provider worth exploring is Vanguard. They are known for their low-cost products.
12. What Should You Look For With A Personal Pension Provider?
It’s important to do your research and look for a personal pension provider that suits your needs.
When making a comparison, here are some things to look out for:
a) Choice of Funds
You shouldn’t necessarily just go with a provider that offers the most choice of funds.
Consider a provider that has the type of funds that you need.
For example, if ethical investing is important to you, make sure that this option is offered by the providers that you consider.
b) Fees and Charges
A few providers charge you an Annual Management Fee, and if you invest in certain funds, you may pay more fees.
Other providers just charge you one single fee per annum, so research what works best for you and think long term.
Some providers also charge you for transfers to other providers.
You should find out what those fees are before applying for a pension and compare them to other providers.
Always read the small print, as the headline fee being advertised may not be the total amount you’ll pay.
Recommended: Investment Fees Explained: Complete Beginner Guide
c) Minimum Monthly Contributions
Watch out for minimums.
Some providers may require a minimum annual or monthly pension contribution.
If you don’t meet that, you may get charged a penalty fee.
It might help to consider the past investment performance of two funds in order to decide which to choose.
If you’re looking at this, do make sure that you look at a wide enough range of at least 5 years of performance data.
It’s worth mentioning that past performance is not a reliable indicator of future performance.
Investments can go down and up over time.
If you’re unsure which fund or pension to invest in, please seek independent financial advice to make the right choices to suit your personal situation.
13. How Safe Is Your Pension?
The Financial Services Compensation Scheme (FSCS) does not protect Defined Benefit (DB) pensions if they fail.
Such pensions may be protected by the Pension Protection Fund (PPF).
If your investments are in Defined Contribution (DC) pensions and the UK-regulated provider of the investment fails…
The FSCS may pay compensation of up to £85,000 per pension scheme member.
Different schemes may come with different levels of protection, so you should read through any policy documentation carefully.
What if you were given bad advice?
If they’re a UK-regulated adviser and gave bad advice about your pension (such as transferring it), you could be eligible to claim compensation.
The FSCS may pay compensation of up to £85,000.
If that adviser is still trading, you can complain to the Financial Ombudsman Service.
Generally, the Financial Services Compensation Scheme (FSCS) can protect pensions that are provided by UK-regulated insurers.
As long as they qualify as ‘contracts of long-term insurance’.
A common example is an annuity, where you exchange the cash in your pension for a regular income from an insurance company.
Where the FSCS can pay compensation, they will cover the pension at 100% with no upper cap.
14. What About Saving In A Pension vs A Lifetime ISA?
In the ideal world, you can save into both to max out retirement savings.
However, note that both are quite different.
If you’re employed, then it would make complete sense to prioritise your workplace pension and max that out given employer contributions.
Doing this is worth more than the bonus that you’d get with a Lifetime ISA.
This makes even more sense if you’re a higher rate taxpayer as you get more in tax rebates given tax relief at 40%.
If you’re self-employed, or you want more flexibility in your retirement savings than you have with a regular pension, then a Lifetime ISA could be a good alternative.
Although note that you have a penalty for early withdrawals from a Lifetime ISA for retirement purposes.
If you’re completely new to LifeTime ISAs, please watch our video below where we covered a Complete Guide to Lifetime ISAs:
15. What Happens to Your Pension When You Retire?
When you retire, you can take 25% of your pension fund value as a Tax-Free cash lump sum.
The remainder of your pension pot can then be used to take an income either as:
- An annuity
- Drawdown i.e. taking cash directly as and when you need it, while the rest stays invested
The level of income that your pension will provide you in retirement will vary.
Key drivers for this level of income will include:
- The investment choices you made over the years
- How the pension funds you chose performed
- How much you put in in terms of contributions
- And what costs you were charged by the pension provider over the years.
Conclusion on Pensions Explained UK
Saving for retirement can seem daunting and uncertain.
I hope that this pensions explained UK guide has helped you to better understand pensions and improve your confidence in investing in them.
If you plan to retire early, prioritise investing in your Stocks and Shares ISA first, followed by your pension.
This gives you more flexibility and access to your money.
Note that if you’re ever approached by anyone or a company that promises to help you access your pension before the age of 55, it is a scam and you should avoid contact.
This type of scam is known as Pension Unlocking or Pension Liberation and has led to many people losing their money.
So please be scam smart and protect your pension savings.
Happy saving and investing!
To gain confidence about investing from a UK perspective, check out the Super Simple Investing course
Frequently Asked Questions on Pensions Explained UK
1. What is a good pension amount UK?
A good pension amount for retirement is to save around 25 times your annual living expenses.
For example, if you spend £24,000 a year, then a good pension amount to aim for is £600,000.
Some advisers also recommend saving 10 times your average salary during your working life by the time you retire.
For example, if your average salary was £35,000, then you should save a pension pot of £350,000 as a minimum.
Another popular metric is that you should save and invest at least 12.5% of your monthly salary.
For example, if you earn £40,000, then you should be saving £5,000 per annum (£416.67 per month).
Generally, the more you save in a pension, the more income you'll have available for retirement.
2. What are the 3 main types of pensions?
The three main types of pensions are:
- Defined Benefit or Final Salary Pensions – This type of pension is no longer popular as employers switch to Defined Contribution pensions.
- State Pension – This is a pension you received at state retirement aged based on your National Insurance contributions.
- Defined Contribution Pension – This is the most common type of pension and requires ongoing contributions from an employee and employer.
3. How do pensions work in the UK?
Pensions work by a percentage of your gross (pre-tax) income being saved aside for retirement.
Employers in the UK are required to contribute a minimum of 3% whilst the employee contributes a minimum of 5%.
The amounts saved receive tax relief and can then be invested in the stock market in order to grow and provide an income at retirement.
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