What is a pension and how does it work?

A pension is a tax-efficient way to put money aside for later in life, to provide income for when you retire.

Depending on the type of pension you have, you, your employer, and other people, like your spouse or children, can all pay into it. The government also ‘contributes’ to your pension in the form of tax relief. Then, once you turn 55 or you retire, you have a number of options for how you choose to take your pension income.

You can pay into as many pensions as you want, depending on how much you can – and want to – put aside for when you’re older. However, there are limits to how much you can contribute to your pensions each tax year, as well as over your lifetime. Find out how much you can pay into your pension.

It’s important to know that pensions are usually invested in stocks and shares, so the value of your pension can go down as well as up – and you may get back less than you put in. The tax treatment of your pension will depend on your individual circumstances and may change in the future.

How does a pension work?

How a pension works will depend on what kind of pension you have. However, in really simple terms, there are three key things to know about how a pension works:

• you (and others) contribute to it
• the government ‘tops it up’ through tax relief
• you have a pot of money to live from later in life

Is it worth paying into a pension?

It’s generally a good idea to pay into a pension if you can. Once you retire, or turn 55 and perhaps start working less, you’ll still need to receive an income on which to live. The sooner you start thinking about where that income is going to come from, the more prepared you’re likely to be and the better chance you’ll have of living the lifestyle you’d like to live in retirement.

While there may be other ways to save or invest, a pension provides great benefits when it comes to putting money aside for your retirement income.

• You’ll get tax relief on the payments you make to your pension pot: the government adds 25% to any contributions you put in up to a certain limit; and, if you’re a higher or additional rate taxpayer, you can claim even more via your tax return form. Find out more about pension tax relief.
• If you have a workplace pension, your employer is legally obliged to contribute to your pension on your behalf: not only do you receive contributions from the government in the form of tax relief, you also receive contributions from your employer. Ask your employer if you’re not sure how much they contribute to your workplace pension.

But there’s more. Pension investments are free from income tax and capital gains tax, so you won't pay tax on any dividends from shares and you won’t pay capital gains tax on any profits made from the investments within your pension pots. However, there are income tax implications when you start to withdraw from your pension.

Types of pension

There are three types of pension in the UK: the workplace pension, the personal pension and the state pension. The type of pension you have will depend on your personal circumstances.

Workplace pension

Workplace pensions, which are also known as company pensions and occupational pensions, are offered by employers. Nowadays, employers in the UK are required to have a pension scheme set up and they must automatically enrol their eligible employees.

Both the employer and the employee have to contribute a certain minimum amount to the employee’s pension each month. The specific scheme you’re in will have its own rules about contribution levels, however, the government introduced minimum auto-enrolment contribution levels that all schemes have to abide by. From 6th April 2019, your employer’s minimum contribution is 3% and you will need to contribute a minimum of 5%.

So, if you’re employed and meet the eligibility criteria, you’re most likely already enrolled in your employer’s pension scheme. Typically, you’ll contribute a percentage of your monthly salary into the pension and your employer will add money too, up to a certain amount. The government also contributes to your pension, through tax relief. It's worth checking to see what you and your employer’s auto-enrolment contributions are and if they'll be enough to build the pension pot you're hoping to achieve.

There are two main types of workplace pension schemes:

1. With a defined contribution pension scheme you pay in a percentage of your salary and your employer also contributes to it. The contributions are then invested by the pension provider. The income you get in retirement isn’t guaranteed – it depends on how much has been contributed and the performance of the investments. As with all investing, the value of your pension could go down as well as up and you may get back less than you put in.

2. Defined benefit pension schemes are also sometimes known as final salary pension schemes. With a defined benefit pension scheme, you’ll get a specified amount as income when you reach retirement age. Your pre-determined retirement income is based on how long you’ve worked for your employer and your salary when you retire. You may still have to pay contributions, and your employer usually will too.

If you’re not sure which type of workplace pension you have, check with your employer.

Personal pension

A personal pension, also known as a private pension, is a type of pension you can set up yourself. You can have a personal pension even if you already have a pension through your employer.

If you decide to open a personal pension, it’s up to you to choose your provider, how much you’re going to contribute (within the annual and lifetime limits), and how often you’re going to contribute to it. As with a workplace pension, the government will also contribute to your personal pension through tax relief.

Personal pensions are normally run as defined contribution pension schemes, so the value of your personal pension when you retire will depend on how much you’ve contributed to it and how the investments that it’s invested in have performed. As with all investing, the value of your pension could go down as well as up, so you could get back less than you put in.

There are three main types of personal pension:

1. With a ‘simple’ personal pension, you’re most likely to make regular contributions to your pension, which will be managed by a pension provider. The provider should offer various investment strategies for you to choose from depending on your personal circumstances and attitude to risk.

2. A stakeholder pension is similar to the basic version, except there are strict government rules about how they’re managed. Stakeholder pensions have low minimum contribution amounts, only a few investment options and caps on how much the provider can charge you.

3. A self-invested personal pension (SIPP) is a type of personal pension that lets you manage how your money is invested. You choose which investments to invest your money in and actively manage those investments. SIPPs are often more suitable for large contributions and, because you control how your money is invested, they might be better for experienced investors. They can also have higher charges.

If you open a Nutmeg personal pension, our expert investment team will proactively manage it on your behalf. For each payment into your pension pot, we’ll also automatically add the 20% government tax relief that you receive at source. You can start a Nutmeg personal pension with as little as £500 and then continue to put more money into it through regular contributions, ad hoc lump sums, or a bit of both.

State pension

The state pension is a pension you’ll receive from the government once you reach the state retirement age, provided you have at least ten years’ worth of qualifying national insurance contributions or credits and meet the other eligibility criteria laid out by the government. The amount you get will depend on the national insurance contributions you’ve made. The government will then pay you your state pension – a guaranteed income – for the rest of your life.

It’s unlikely that the state pension by itself will be enough to support the type of retirement you’d probably like to have, but it could be a useful supplementary income to other pensions. Find out more about the state pension.