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Intro to Pensions - How do Pensions Work?

Updated On:
Feb 20, 2021
An alarm clock
· 3 min read
How do Pensions Work - Two older people holding up a sign

We all know that pensions are important. No one needs to tell us that someday when we are too old to work, we will need a steady stream of cash to keep us going. 


For most Koody readers, retirement might seem ridiculously far away. Still, it's important to remember that if you want to live comfortably and enjoy life when you are much older, it pays to start planning now.


This post aims to steer you to relevant parts of the website and help you understand on a high level how pensions work here in the UK.

So, without further ado, here's what we have lined up for you:

What is a Pension

A pension is a savings pot that you contribute to throughout your working life and spend from when you retire.

The money saved in a pension is usually invested in stocks and shares by your pension provider, and you normally won't be able to access this money until you are at least 55 years old (increases to 57 in 2028).

Types of Pensions

There are two types of pensions - defined benefit and defined contribution pensions. 


For our generation, the relevant pension type is the defined contribution pension. With a defined contribution pension, the onus is on us to build our own pension pots, which will then serve as an income source in retirement. 


Unlike a defined benefit scheme, which promises a specific income at retirement, the amount we might get from a defined contribution pension depends on how much we contribute throughout our lifetime, how our investments perform, and the lifestyle we choose at retirement.

Pension Annual Allowance

You can save as much as you like into your pension each year, but you will be taxed if you:

  1. Contribute more than £40,000 in one year - this is your annual allowance, and you can usually carry forward any unused allowance for up to three years.
  2. Contribute more than 100% of your earnings in one year.
  3. Exceed your lifetime allowance - £1,073,100 in your lifetime.


Tax Relief on Pension Contributions

The government will add money to your pension contributions in the form of tax relief (free money).


For every £80 you put into your pension, the government adds £20 - and you can claim an extra £20 if you're a higher earner.


You can think of tax relief as a refund of the tax you originally paid on your pension contribution, at your usual rate of income tax - 20%, 40%, or 45%. 


It's your pension provider who claims this tax relief at the basic rate and adds it to your pension. If you're a higher rate taxpayer, you'll need to claim the additional rebate through your tax return.

How to Contribute to Your Pension

  1. Workplace pension and auto-enrolment
  2. Personal pension
  3. State pension
  4. Lifetime ISA
  5. Pension for the self-employed


1. Workplace pension and auto-enrolment

A workplace pension is a way of saving for your retirement and is usually arranged by your employer. When you join a new company, your employer must enrol you into their workplace pension scheme if you meet the minimum requirement.

Once you are enrolled, both you and your employer must contribute a percentage of your salary into a workplace pension scheme.

The minimum your employer must contribute to your pension is 3% of your salary. And the minimum total contribution (you and your employer) must make is 8%.

See, Workplace Pension Scheme - Auto Enrolment

2. Personal pension

Personal pensions are private pensions that you arrange yourself.

If you don't have a workplace pension, a personal pension could be a great way to save for retirement. And even if you have a workplace pension, a personal pension in addition to your workplace pension could be a great way to grow your retirement savings faster.

There two types of personal pensions - Self-invested Personal Pensions (SIPPs) and stakeholder pensions.

See, Best Pension Providers - Personal Pensions
Also see, Stakeholder Pension - Best Stakeholder Pension

3. State pension

In addition to the personal and workplace pensions, you are entitled to something called the State Pension. This is free money from the government, and the amount you get is based entirely on your National Insurance record.

The earliest you can get the State Pension is when you reach the State Pension age. If you're currently aged between 20 and 39, your State Pension age will likely be 68. You can double-check that number here.

4. Lifetime ISA

Another way to save into a pension is with a Lifetime ISA. A Lifetime ISA is open to adults aged 39 or younger and lets you save up to £4,000 a year towards your first home or retirement. The government will add a 25% bonus to your savings every year up to a maximum of £1,000 per year.

5. Pension for the self-employed

If you are self-employed, a solo-founder, or the sole director of a company with no other employees, you will not be automatically enrolled into a pension when you start working for yourself. 

It is up to you to sort out your pensions. This shouldn't scare you. It's pretty easy to open a pension pot, and saving into one is just as simple as transferring money from one account to another.

See, Self-employed Pension - Best Pension for Self-employed People

Credits 


AJ Bell Youinvest
Product
SIPP
Account Type
Self-select & Ready-made
Minimum Contribution
£1,000 lump-sum. No minimum for a regular payment
Annual Platform Fee
0.25% - 0% (capped at £10 per month for shares)

If you are confident about picking your investments, AJ Bell Youinvest has thousands of investments for you to choose from, including shares, funds, investment trusts, and ETFs. And you can manage them online or with its mobile app. If you need help choosing, it has four ready-made portfolios and other investment ideas. AJ Bell Youinvest does not offer advice. Capital at risk. Pension rules apply.

LEARN MORE
Interactive Investor
Product
SIPP
Account Type
Self-select & Ready-made
Minimum Contribution
£0
Annual Platform Fee
 £240 (£19.99 per month)

Interactive Investor has more than 40,000 investments to choose from, including UK and overseas shares, funds, investment trusts, and ETFs. You get a free trade every month, which you can use to buy or sell any investment. It also has several ready-made funds and expert ideas to make it easy to choose investments. Finally, Interactive Investor charges a flat fee of £19.99 per month, so you know exactly how much you will be paying each month.

LEARN MORE
Legal & General's Logo
Product
SIPP
Account Type
Ready-made
Minimum Contribution
£100
Annual Platform Fee
0.25%

Legal & General have five multi-index low-cost ready-made funds, each with a different level of risk that may suit your needs. You’ll also benefit from an easy-to-use online account.

LEARN MORE
Vanguard Investor'
Product
SIPP
Account Type
Self-select & Ready-made
Minimum Contribution
£500 lump sum or £100 per month
Annual Platform Fee
0.15% (capped at £375 per year)

Vanguard is a popular low-cost investment platform with over 70 funds. Vanguard gives you the flexibility to choose a ready-made portfolio or build your own. Each ready-made fund portfolio gives you access to thousands of bonds and shares in a single investment.

LEARN MORE
Aviva's Logo
Product
Stakeholder Pension
Account Type
Ready-made
Minimum Contribution
£20 per month
Annual Fund Management Cost
Capped at 1%

Aviva lets you start your Stakeholder Pension with as little as £20 a month. And you can change that amount or stop and start payments when you need to.

LEARN MORE
Standard Life
Product
Stakeholder Pension
Account Type
Self-select & Ready-made
Minimum Contribution
£16
Annual Fund Management Cost
Capped at 1%

Standard Life offers straightforward investment options for you to choose from. You can choose from two strategic lifestyle profiles, which invest your money in funds and moves them as you get closer to retirement. If you don't want to choose a fund, that's fine too. Standard Life will automatically invest your money into a Lifestyle Profile.

LEARN MORE
Aviva's Logo
Product
Stakeholder Pension
Account Type
Ready-made
Minimum Contribution
£20 per month
Annual Fund Management Cost
Capped at 1%

Aviva lets you start your Stakeholder Pension with as little as £20 a month. And you can change that amount or stop and start payments when you need to.

LEARN MORE
Standard Life
Product
Stakeholder Pension
Account Type
Self-select & Ready-made
Minimum Contribution
£16
Annual Fund Management Cost
Capped at 1%

Standard Life offers straightforward investment options for you to choose from. You can choose from two strategic lifestyle profiles, which invest your money in funds and moves them as you get closer to retirement. If you don't want to choose a fund, that's fine too. Standard Life will automatically invest your money into a Lifestyle Profile.

LEARN MORE
AJ Bell Youinvest
Product
SIPP
Account Type
Self-select & Ready-made
Minimum Contribution
£1,000 lump-sum. No minimum for a regular payment
Annual Platform Fee
0.25% - 0% (capped at £10 per month for shares)

If you are confident about picking your investments, AJ Bell Youinvest has thousands of investments for you to choose from, including shares, funds, investment trusts, and ETFs. And you can manage them online or with its mobile app. If you need help choosing, it has four ready-made portfolios and other investment ideas. AJ Bell Youinvest does not offer advice. Capital at risk. Pension rules apply.

LEARN MORE
Interactive Investor
Product
SIPP
Account Type
Self-select & Ready-made
Minimum Contribution
£0
Annual Platform Fee
 £240 (£19.99 per month)

Interactive Investor has more than 40,000 investments to choose from, including UK and overseas shares, funds, investment trusts, and ETFs. You get a free trade every month, which you can use to buy or sell any investment. It also has several ready-made funds and expert ideas to make it easy to choose investments. Finally, Interactive Investor charges a flat fee of £19.99 per month, so you know exactly how much you will be paying each month.

LEARN MORE
Legal & General's Logo
Product
SIPP
Account Type
Ready-made
Minimum Contribution
£100
Annual Platform Fee
0.25%

Legal & General have five multi-index low-cost ready-made funds, each with a different level of risk that may suit your needs. You’ll also benefit from an easy-to-use online account.

LEARN MORE
Vanguard Investor'
Product
SIPP
Account Type
Self-select & Ready-made
Minimum Contribution
£500 lump sum or £100 per month
Annual Platform Fee
0.15% (capped at £375 per year)

Vanguard is a popular low-cost investment platform with over 70 funds. Vanguard gives you the flexibility to choose a ready-made portfolio or build your own. Each ready-made fund portfolio gives you access to thousands of bonds and shares in a single investment.

LEARN MORE
Aviva's Logo
Product
Stakeholder Pension
Account Type
Ready-made
Minimum Contribution
£20 per month
Annual Fund Management Cost
Capped at 1%

Aviva lets you start your Stakeholder Pension with as little as £20 a month. And you can change that amount or stop and start payments when you need to.

LEARN MORE
Standard Life
Product
Stakeholder Pension
Account Type
Self-select & Ready-made
Minimum Contribution
£16
Annual Fund Management Cost
Capped at 1%

Standard Life offers straightforward investment options for you to choose from. You can choose from two strategic lifestyle profiles, which invest your money in funds and moves them as you get closer to retirement. If you don't want to choose a fund, that's fine too. Standard Life will automatically invest your money into a Lifestyle Profile.

LEARN MORE
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