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How do pensions work?

by Marko Florentino
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It is important to make sure that you are getting the most out of your state pension when you are planning your retirement, as some extra help will put less strain on your other pensions. 

Now read our guides on how to claim National Insurance credits, and how to pay voluntary National Insurance contributions to help boost your state pension

Workplace pensions – defined contribution vs defined benefit

Your employer decides which type of pension scheme to offer and which pension provider they use.

The most common workplace pension is a defined contribution (DC) pension. In this scheme, your money is invested over the course of your working life, and the value of your pot will fluctuate according to stock and bond market moves. 

Defined benefit pensions (in some cases known as “final salary” pensions) are now very rare outside the public sector. They promise a guaranteed income in retirement, regardless of stock market moves. 

For those of us outside the public sector, long-gone are the days of final salary pensions complete with a generous income that rises with inflation. 


Employer contributions

If you’re contributing to a workplace pension, your employer must contribute at least 3pc of your monthly salary, and often they will offer more. This is in addition to your salary, so it costs you nothing.

Tax relief

You get tax relief on pension contributions. If you’re a basic-rate taxpayer earning up to £50,270, the Government will provide 20pc tax relief on your pension contributions. So, if you put in £100 a month, it will actually only cost you £80, since the Government adds the other £20. 

If you are in a higher tax bracket, you can claim tax relief up to the amount of income tax you pay. You’ll automatically get 20pc, but you can claim the additional relief either via your tax return, or by contacting HMRC.

Tax-free lump sum

When you decide to draw your pension, you can usually take a tax-free lump sum from the age of 55. For most pensions, this is 25pc of your pot.

Your fund grows over time

As you save towards retirement, the money is invested by your pension provider. This is important as without it, the money you put away now would be worth a lot less when you retire decades later due to inflation. You can usually set which level of risk you’d like your provider to take, which will impact your returns.

A guaranteed income in retirement

Almost everyone will need an income when they give up work. For most people, this comes from their pensions. 

When you retire, you might choose to buy an annuity with some or all of your pension pot. There are a number of different types, but it usually means buying a guaranteed annual income for a set number of years or for life.

Other considerations

Pensions are widely regarded as an important investment for the future, but there are drawbacks. You have to decide how much you can afford, what your future needs might be and how much risk you’re willing to take with your fund. This can be difficult, particularly if retirement is decades away.

There are also major mistakes you can make if you take your pension without carefully considering your options.

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