Introduction to pensions
What is a pension?
A pension is a tax-efficient way of saving for retirement. Money is paid in by you, your employer and the government (in the form of tax relief), and invested with the aim of generating returns to provide you with a retirement income. The actual investments held in your pension can be made up of any combination of assets – the pension is simply the “wrapper”. The investments are managed by a pension provider, who will take a charge as a percentage of the money in your pension fund.
Because pensions are designed to help you save for retirement, you can't access the money in your pension pot until you reach the age of 55.
Tax benefits of pensions
The main reason to use a pension for your retirement savings is the special tax treatment, which comes in two main forms:
- Any gains made on your investments are tax-free
- Your contributions are effectively topped up by the government
When you pay into a pension, you receive tax relief on the money you contribute at the highest rate of Income Tax you pay (so 20% for a basic rate taxpayer). This is essentially "free money" paid into your pension by the government.
If you're a basic rate taxpayer, the tax relief will be added automatically when you contribute to a personal or workplace pension. If you're a higher or additional rate taxpayer, you'll need to claim the extra tax relief through a self-assessment tax return.
How much should you put into your pension?
Everyone's circumstances are different, and exactly how much you can afford to save will depend on your income and your financial obligations. A good rule of thumb is to aim to contribute half your age as a percentage of your salary each year. For example if you're 30, you should aim to save 15% of your salary into your pension – including contributions from your employer.
Saving enough for retirement?
Check whether your contributions are keeping you on course with our pension pot calculator.
Although in theory there's no such thing as "too much money" in your pension pot, there are certain limits you'll need to stick to in order to keep the tax benefits of a pension:
- Lifetime allowance (LTA): This is the maximum amount you can have in your pension pot without paying tax on it. As of April 2016 the lifetime allowance is £1 million. If your pension pot is worth more than this amount, you will pay extra tax on anything above the threshold when you withdraw it. The amount of tax you pay will depend on how you withdraw the money – visit the government's website for more information.
- Annual allowance: This is the total amount you can contribute to your pension each year and still receive tax relief. It is currently set at £40,000 (although a limit of £10,000 may apply if you've already started drawing from a pension). If you contribute more than this amount in a year – across all your pensions, not per scheme – you won't get tax relief on any contributions above the threshold. You'll also have to pay an annual allowance charge.
Why should you pay into a pension?
Ultimately, paying into a pension means sacrificing some of your income now for a greater chance of a good income in retirement.
Even more important than how much you contribute is when you start. The infographic below shows how, thanks to compound interest, an extra few years can really boost your pension savings.
For most people, the simplest way to save for retirement is through a workplace pension. Auto-enrolment legislation means that it's now compulsory for employers to enrol their eligible workers into a pension scheme – and employers must also pay pension contributions.
The minimum contribution amounts are set to increase gradually until 2019:
Your employer may offer you the option of salary sacrifice, which is a tax-efficient way of making pension contributions. This involves giving up part of your salary, which your employer then pays into your pension, along with their own contribution. Because your contribution is taken out of your salary before tax, this effectively means that your salary is lower. This means that both you and your employer pay lower National Insurance Contributions (NICs). Some employers choose to add the money they save on NICs to your pension too.
However, having a lower salary could have other implications. For example, it might affect the amount you can borrow on a mortgage. If your employer provides you with life cover, the payout is usually worked out as a percentage of your salary – so having a lower salary could mean your life cover is reduced. If your salary falls below the level at which you pay NICs, your entitlement to other benefits such as Statutory Maternity Pay could also be affected.
If you're self-employed or not eligible for your employer's workplace pension scheme, another way to save for retirement is a personal pension. You benefit from government tax relief on your contributions, and you can access the money once you reach the age of 55.
Three kinds of personal pension you could consider are:
1. Ordinary personal pension schemes are offered by financial service providers, typically insurance companies such as Aviva, Legal & General or Standard Life. Usually the money you pay in is either invested in the company's default multi-asset fund or you can make your own choice from a limited range of other funds.
2. Stakeholder pensions are similar to personal pensions but are intended to be simpler and lower-cost. They have to meet the following conditions:
- Charges can't be more than 1.5% of the fund's value for the first 10 years, and 1% from then on
- Minimum contributions are just £20 per month, although you can pay in more
- You aren't obliged to contribute regularly, and there are no penalties for missing or stopping payments
- You can switch your fund to another stakeholder scheme or other pension at any time without penalties
3. SIPPs (self-invested personal pensions) are a type of personal pension that lets you choose your own investments. Many investment platforms offer a SIPP. You can typically choose from a much wider range of funds and also shares from UK and overseas stock markets. Find out more about SIPPs.
Where is your money invested?
When you pay into your pension, the pension provider invests it on your behalf with the aim of generating returns. The pension provider controls which underlying assets are held in the fund, and manages them to make sure the fund's aims are being met.
What risks are you comfortable with?
For more information on investment risk and reward, and how to determine your risk tolerance, read our guide.
Most providers will offer you a range of funds to choose from, with different aims, risk levels and other features – for example some funds will only invest in "ethical" industries. There will also usually be a "default fund" option, which will aim to provide balanced and stable returns. The fund managers will adjust your fund over time, in order to decrease the risk as you approach retirement age.
Choosing your own investments
If you feel confident in making your own investment decisions and want to have full control over where your pension fund is invested, another option is a self-invested personal pension (SIPP). A SIPP is essentially a wrapper for your investments (like an ISA) which protects your gains from tax and gives you the benefits of pension tax relief. You can invest in whatever assets you choose, but you'll need to manage them yourself.
Accessing your pension fund
You cannot legally access your pension before the age of 55. Any adverts claiming to offer this service are illegal, have hefty charges and are scams.
In 2015, new rules came into effect giving everyone greater flexibility when it comes to accessing their pension. From the age of 55 you can withdraw as much or little of your pension as you want, subject to tax. When it comes to using your pension pot to fund your retirement, there are two main options:
- Buying an annuity: this means exchanging your pension fund for a guaranteed income for life.
- Drawdown: this involves taking some of the money in your pension pot as an income, while leaving the rest invested. This option won't be suitable for everyone – visit our drawdown guide for more details.
Last updated: 14 June 2016