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For many of us, our pension will be the main, if not only, source of income at retirement, with many contributing to this for 40+ years, so it's pretty useful to know a thing or two about how it works.

In simple terms, a pension is a type of savings plan designed to help you save money and prepare for later life. It also offers favourable tax treatments compared to other forms of savings meaning that the money within your pension is protected from any tax charges on its growth.

Explore the range of topics below to find out more about your pension - the main types of pension,  how a pension works and when you can access it.  

There are three main types of pension:

  • The State Pension

  • Defined contribution pensions

  • Defined benefit pensions

 

The State Pension

Most people get some State Pension. It’s paid by the government and is a secure income for life which increases each year. 

You build up your entitlement by making National Insurance contributions during your working life. In some cases, you may even build this when you’re not working, such as when you’re bringing up children or claiming certain benefits.

 

Defined contribution pensions

With this type of scheme, you build up a pension pot which you can draw an income from in the future (post age 55).  With this type of pension scheme, you can usually withdraw at least 25 per cent (a quarter) of your pot tax-free.

The amount that builds up depends on:

  • the level of charges you pay

  • how well your investment performs, and

  • how much you and your employer (if you are employed) pay into the scheme

Defined contribution (DC) pensions include workplace, personal and stakeholder pension schemes.

 

Defined benefit pensions

You’re most likely to have a defined benefit (DB) pension if you work in the public sector or for a large company. This is a salary-related pension which pays out a secure income for life and increases each year.

The pension you get is based on how long you’ve been a part of the scheme and how much you earn.

You might have a final salary scheme where your pension is based on your pay when you retire or leave the scheme, or alternatively a career-average scheme where your pension is based on the average of your pay while you were a member of the scheme.

If you are part of your employer's DC arrangement, you will pay into this each month, along with your employer and the Government (via tax-relief).

When paying in to your workplace pension, often, there will be a minimum amount that you will be required to pay into to get your employer's contribution. 

The amount that you and your employer pay into the arrangement will often be a percentage of your salary i.e. 5%. The amount your employer pays will often be dependent on your role within the company. Alternatively, your employer may opt for salary exchange meaning that you basically sacrifice a part of your salary, and instead of making any direct contributions into your pot, your employer makes this on your behalf (using the salary you gave up).

When this money is paid into your pension each month, it is invested in the stock market via a fund, or range of funds. You may also have some of your pot in cash if you opt for a low risk investment or are nearing retirement and expect to need access to your funds in the very near future. If you do not opt to select a particular fund or funds to be invested in, you will automatically be invested into the default fund arrangement.

There are a range of considerations to bare in mind when selecting your investment, for example, you may wish to consider ethical considerations, as well as the fund charges. If you are invested in your employer's scheme default fund, the charges are likely to be relatively low as the fund is designed to provide moderate returns. Alternative funds that may offer higher returns may include higher fund charges.

Under current tax arrangements all personal contributions into defined contribution pensions receive tax relief at the tax payers marginal tax rate.

When making payments into a personal pension plan, taxpayers will receive basic rate tax-relief at a rate of  20%.This means that when a  tax payer makes a net payment of £80 into their pension, this will automatically be increased to £100, with the government paying the £20 via tax-relief.

Higher rate tax payers can obtain relief up to their highest marginal rate but this must be reclaimed via HMRC directly. 

You can make payments into your pension and receive tax-relief at your marginal tax rate up to age 75. Please note, individuals who are part of a salary sacrifice scheme will automatically receive tax relief as their contributions are taken from their pre-tax salary. This means they will not receive any further tax-relief on their contributions. 

This rule applies even if you do not have relevant UK earnings tax as HMRC allow anyone to contribute up to £3,600 to most types of pension in any tax year without any evidence of earnings (subject to the eligibility criteria). This means that if you have a partner with no relevant UK earnings/ unemployed, you may still wish to open a pension for them. They will be able to contribute a max of £2,880 each year, and receive the Government tax-relief of 20%, making their total contribution for the year £3,600.

Tax-relief can be particuarly beneficial for individuals who are higher-rate or additional-rate taxpayers when making contributions, then drop to basic-rate taxpayers at retirement. Careful tax planning may be required. 

However, it is important to note that there are limitations on how much you can pay into your pension and receive tax-relief. 

Your annual allowance is the total amount of contributions that can be paid into pension(s) for tax relief purposes. Any contributions above your allowance will trigger an annual allowance charge.

The total that you can pay into your pension each year is £2,880 or 100% of UK earnings if this is higher. However, there is a basic total annual allowance of £40,000 (tax year 2021-22) that you must also consider.  This will be restricted further if you have an adjusted income greater than £240,000 pa - known as the tapered allowance, or have already started taking an income from your pension pot - known as the money purchase annual allowance. 

If you exceed the annual allowance in a tax year, you won't receive tax relief on any contributions you pay that exceed the limit and you will be faced with an annual allowance charge.

Benefits will ultimately be tested against the Lifetime Allowance which stands at £1.073 million for 2021/2022.

Tapered Annual Allowance

Since 6 April 2020, people with a taxable income over £240,000 will have their annual allowance for that tax year restricted. This means that for every £2 of income they have over £240,000, their annual allowance is reduced by £1. Their reduced annual allowance is rounded down to the nearest whole pound. The maximum reduction is £36,000. So anyone with an income of £312,000 or more has an annual allowance of £4,000. People with high income caught by the restriction may have to reduce the contributions paid by them and/or their employer or an annual allowance charge will apply. However, the tapered reduction doesn't apply to anyone with 'threshold income' of no more than £200,000. 

Money Purchase Annual Allowance

If you start to take money from a defined contribution pension, the amount you can pay into a pension and still get tax relief reduces. This is known as the Money Purchase Annual Allowance or MPAA.

As a basic guide, the main situations when you’ll trigger the MPAA are:

  1. If you take your entire pension pot as a lump sum or start to take ad-hoc lump sums from your pension pot.

  2. If you put your pension pot money into a flexi-access drawdown scheme and start to take an income.

  3. If you buy an investment-linked or flexible annuity where your income could go down

  4. If you have a pre-April 2015 capped drawdown plan and start to take payments that exceed the cap

The MPAA won’t normally be triggered if:

  1. You take a tax-free cash lump sum and buy a lifetime annuity that provides a guaranteed income for life that either stays level or increases

  2. You take a tax-free cash lump sum and put your pension pot into a flexi-access drawdown scheme but don’t take any income from it

  3. You cash in small pension pots valued at less than £10,000

The MPAA only applies to contributions to defined contribution pensions and not defined benefit pension schemes.

If you have a standard defined contribution pension, you will typically have access to this from age 55. Normally, this will consist of 25% tax-free cash with the remainder being taxed at your marginal rate of income tax.  Some pension schemes differ, for example, offer higher amounts of protected tax-free cash so you should check with your specific scheme administrator. 

There are also some circumstances when you may be able to take money from your pension even earlier than 55, such as if you’re in poor health or in a profession where your normal retirement age is earlier than normal, for example if you are a professional athlete. You may also have a protected pension age lower than 55 under the rules of the scheme.  

The government has confirmed plans to increase the minimum pension age from 55 to 57 from 2028, alongside planned increases in the State Pension age to 67. From then on, the minimum pension age will remain ten years below State Pension age.

However, it is important to note that if you start taking an income from your pension whilst still working, this significantly limits how much you can continue to pay in on an ongoing basis.

Whether you plan to retire fully, to cut back your hours gradually or to carry on working for longer, you can now tailor when and how you use your pension – and when you stop saving into it – to fit with your particular retirement journey.

There’s a lot to weigh up when working out which option or combination will provide you and any dependants with a reliable and tax-efficient income throughout your retirement.

With most defined contribution pension schemes, individuals will have access to 25% tax-free cash at retirement, with the remainder taxed at your marginal tax rate. You do not have to take the 25% tax-free cash a single lump sum and taking your tax-free cash does NOT trigger the money purchase annual allowance. However, as soon as you take an income from your pension (i.e. anything over and above the tax-free cash) this will trigger the money purchase annual allowance, meaning the amount that you can pay into your pension and receive tax-relief will be limited to £4,000 per anum.

Flexi-access drawdown

With this option you can set the income you want, and withdraw this on a regular basis, with the rest remaining invested. However, the investment risk with this option does mean that your funds may run out, and therefore the amount you withdraw may have to be adjusted periodically depending on the performance of your investments.

As you can normally take 25% of your pension tax-free, you may choose to take this as a lump sum or simply take 25% of each withdrawal tax-free. For exmaple, if you withdraw £1,000 per month, £250 of this would be tax-free with the remainder taxed at your marginal tax rate. Alternatively, you may take the full 25% in lump sum withdrawals and then get taxed on the full £1,000 each month.

Purchasing an annuity

You can normally withdraw up to a quarter (25%) of your pot as a one-off tax-free lump sum then convert the rest into a taxable income for life called an annuity. This guarantees a regular retirement income for life. Lifetime annuity options and features vary – what is suitable for you will depend on your personal circumstances, your life expectancy and your attitude to risk. Visit the Money Helper site for further information.

Important Considerations

There are a range of alternative options available, such as lifting your whole pension pot, however this carries a range of implications that must be fully considered first. Visit Money Helper for further information on this. You don’t have to choose one option when deciding how to access your pension – you can mix and match as you like, and take cash and income at different times to suit your needs. You can also keep saving into a pension if you wish, and get tax relief up to age 75.

You may have muultiple defined contribution pensions that you have accumulated over the years, and are keen to amalgamate these into your current workplace pension, a personal pension, stakeholder pension, or self-invested personal pension (SIPP).

However, whether a transfer is suitable or not will very much depend on your individual circumstances and objectives and we would always recommend seeking financial advice or guidance before making this decision. 

Some of the most important considerations to factor in before transferring pensions include charges, investment performance and whether you will loose any safeguarded benefits - it’s possible that your current pension could have valuable benefits that you’d lose if you were to transfer out of it, such as additional death benefits, a higher tax-free lump sum, a pension for your partner after you die, or a Guaranteed Annuity Rate (GAR) option. It is crucial that you factor this in to your decision as these benefits will likely be lost on transfer.

The state pension is a regular payment from the government that most people can claim when they reach State Pension age.

The amount of State Pension you’ll get depends on how many ‘qualifying’ years of National Insurance payments you have.

This includes National Insurance contributions that you pay when you are working and contributions that are credited to you when you are unable to work. You’ll usually need at least 10 qualifying years on your National Insurance record to get any State Pension. They do not have to be 10 qualifying years in a row.

Your State Pension age depends on when you were born. You can find out your State Pension age by using the calculator on the GOV.UK website. 

You’ll be able to claim the new State Pension if you’re:

- a man born on or after 6 April 1951

- a woman born on or after 6 April 1953

If you reached State Pension age before 6 April 2016, you’ll get the State Pension under the old rules instead.