How Do Pensions Work?

After a life of working hard, retirement is a time to enjoy life. Having a pension for a regular income after you stop working means you’ll be able to enjoy your golden years without too much financial stress.

Sounds great, but how do you get a pension? There are a few different types of pension, so it can start to get confusing. We’re here to cut through the complicated language and answer your questions like:

  • How do I get a pension?
  • Who decides how much pension I get?
  • How safe is my pension?

What Are My Pension Options?

A pension is a pot of money that you save for a particular purpose – to give you a stable income when you’re ready to retire. The government wants to encourage people to save for their future so provides tax benefits on a range of choices.

State Pension

As of April 2019, the state pension in the UK changed. Men born after 6th April 1951 and women after 6th April 1953 will receive a government pension based on their national insurance (NI) contributions.

How much you receive will be based on government policy over the coming years. It’s a secure option, but it’s unlikely that you’ll be able to live a pleasant life with holidays and regular treats.

Workplace Pension

Your employer has to contribute to your retirement savings at a rate of at least 3% of your salary per month, and they can choose to pay more. You also need to add money to your savings pot. A minimum of 8% of your salary has to be saved each month between you and your employer. The money comes out of your salary before you’re taxed, so you’ll pay less tax each month. It’s worth noting that you can opt-out of taking a workplace pension if you wish.

This type of pension is called a Defined Contribution Scheme.  When you come to retire, you’ll receive a pot of money based on how much you and your employer have saved for you over the years. You can use this money however you want, and we’ll look at some options in a moment.

Another, much less common workplace pension is a Final Salary, or Defined Benefit Scheme. You can contribute to your savings, but the income you get once you retire is based on how much you were earning in your job. Your employer guarantees to cover any difference between what you’ve saved and what you receive.

Private Pension

Being self-employed has some perks, but it also means there’s no employer to pay into your pension scheme. It’s your responsibility alone to save for your retirement. You can still pay into a pension and get some tax benefits.

To make sure you choose a pension that matches the level of risk that you’re prepared for and will be as tax efficient as possible, seek advice from an independent financial advisor (IFA).

Personal Savings

You can use lots of other types of savings as a nest egg for your future. Options like ISAs, property investment, and investing in the stock market can all build up a pot of money that you can use to buy a pension when you retire. You can even consider downsizing your home and using the leftover money to purchase an annuity.

How Is A Pension Calculated?

As you head towards retirement, it’s time to start looking at what your income might be. The money that you’ve been saving in a pension scheme can be accessed as soon as you turn 55. You can take it as cash and have 25% paid out as tax-free, or choose to buy an annuity.

An annuity is a policy that you take with an insurance company. It gives you an income that either:

  • Is fixed or increases annually.
  • For your whole life or a defined term.
  • Continues to pay a spouse or finishes when you die.
  • Pays out a lump sum when you die or finishes.

These factors will feed into how much income you’ll get from your annuity.

A pension calculation isn’t just about the type of pay out that you want. Your circumstances affect your monthly income, such as your age when you buy the annuity and health factors like if you smoke or have any medical conditions.

Instead of buying an annuity, you can consider using your savings pot to invest in a buy-to-let property. If you choose to go down this route, your pension income will be based on the rentable value of the house that you buy.

Can I Lose My Pension?

There have been horror stories about pension pots being lost in the past. Over the years, governments have worked to make pension savings more secure. It’s not a perfect system, though, and there is some risk.

The good news is that the first £85,000 of your pension savings are protected by the Financial Services Compensation Scheme (FSCS). This means if the company holding your pension fund goes bust, the FSCS will cover your losses and try to move your pension to another provider.

Your pension provider will use your money to invest in the stock market. This should increase the value of your savings, but it’s not guaranteed. If you come to retire and there’s been a stock market crash, you might get less money out than you put in. The FSCS doesn’t cover losses because of stock market performance. You could choose to delay taking your money if that’s the case.

The Take Home

Before you retire, think of your pension as a tax-free savings pot that is waiting for you when you choose to stop working. You and your employer, if you have one, add money each month and it gets invested to help preserve its value. It’s a way of building up some cash for your retirement that you can’t dip into.

Once you’re ready to retire, a pension becomes something else – the money you get each month to cover your living costs. You can use the cash you’ve been saving to buy an annuity, buy property to rent out, or invest elsewhere. Seek financial advice if you want to know about more sophisticated investment options.

The content on pensiontimes.co.uk is for informational and educational purposes only and should not be construed as professional financial advice. Should you need such advice, consult a licensed financial advisor. Any references to products, offers, rates and services from third parties advertised are served by those third parties and are subject to change. We may have financial relationships with some of the companies mentioned on this website. We strive to write accurate and genuine reviews and articles, and all views and opinions expressed are solely those of the authors.

Joanne Rushton
Joanne Rushton
After working at the Co-operative Bank for five years, Joanne left to discover the world before returning to work helping customers understand their finances and get the most out of the banking. A career shift came after two more years, and she found herself working as a teacher in Hanoi, Vietnam before turning to her childhood of passion for writing.

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