What Is a Pension in The UK and How Does It Improve Retirement Prospects?

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You've probably heard of pensions if you work in the UK. Many investment providers and companies offer pension plans for employees. Even self-employed persons can create and contribute to pensions. However, despite their prevalence, it can sometimes be challenging to determine what a pension precisely is and how these plans fit into the broader scheme of providing financial security for your retirement.

Here's what you need to know about pensions and how they can improve your retirement prospects dramatically!

Pension UK: What Are the Three Categories of Pensions?

Colloquially, people refer to any plan that provides income during retirement as a “pension.” However, there are three different levels of pensions in the UK. And, even within those levels, there are sometimes different types of pension funds.

Broadly, the UK has three different pension categories: State, workplace, and individual.

State Pension

The State Pension is the regular payment from the government you will receive when you reach a certain age (currently 66, but that will start increasing in 2026). How much you get depends on your National Insurance record, including your average contributions during your working years. You'll see these deductions taken automatically from your paycheque if you're an employee. You'll typically need to make these contributions manually if you work for yourself.

While the State Pension is helpful in retirement, it often isn't enough to live on alone. For example, someone born in 1980, aiming to retire at 68 (the future State Pension age), making £50,000 a year, would only receive £179.60 per week for life. That comes out to a mere £9,339.20 annually.

That sum of money is better than nothing, obviously. Still, it certainly isn't going to replace the £50,000 a year the person is currently making!

This shortfall is why people need to contribute to other retirement vehicles outside the State Pension.

Workplace

The next most common pension plan is the workplace pension. Companies provide these plans as benefits to employees. These plans help employees save for retirement and typically feature some company match on contributions.

We'll cover more about these plans later, but there are two primary types of plans: defined benefit and defined contribution. Each type has pros and cons, but you must understand which pension type your employer has to get the most out of it!

Furthermore, workplace pensions are through the employer. When people used to work jobs for 20-30 years, this didn't matter so much. Now, people job hop quite a bit more. It's not uncommon for someone to work a year or two at a company and go elsewhere.

As such, many employees have different pensions scattered with various financial institutions. If you have lost track of your pensions, you can use a free service from the UK government to find your old pensions! You can consolidate them or, at least, actively manage them.

Individual

Lastly, workplace pensions assume that you are employed, of course. However, about 15% of the population is self-employed. As such, they don't have access to a workplace pension.

Fortunately, self-employed people are still eligible to access pensions. And you can even set up an individual pension if you don't have any other pension outside of the State one. You can contribute to these pensions even if you're taking time off work, and you can even save into one of these schemes for your children and grandchildren. Opening pensions for the little ones is one of the best ways to help them start life with a solid financial footing!

There are numerous ways to save for retirement and guarantee income between individual pensions, workplace ones, and the State Pension. Indeed, it's not too hard to have guaranteed income during retirement if you contribute regularly!

Pension UK: Workplace

As noted earlier, there are two types of workplace pensions, defined benefit and defined contribution. You don't choose which type of pension you receive from your employer – your employer will provide one of these two pension types to you, and you'll have the opportunity to contribute to it.

Defined benefit pensions tend to be most common in public sector jobs or older workplace pension schemes. With these “legacy” pensions, employees contribute a certain amount per paycheque and receive a defined benefit upon retirement. For example, a workplace might offer a pension that costs 10% per paycheque but offers 80% of your salary for life if you work with the company for 20 years. Or, a company might take some amount in exchange for providing £2,000 monthly during retirement, adjusted for inflation.

Conversely, a defined contribution pension is the more common scheme. With these plans, you contribute a bunch of money to your plan and build up a pot of money. That pot of money then provides your income when you retire. Naturally, the more money you have, the more income you can have when you retire!

There are typically matching contributions and tax breaks that help people save for retirement with defined contribution plans. The government adds 25% to every contribution, and, often, the employer will kick in another 75%. Therefore, for every £1 you contribute, you'll get an extra £0.25 from the government and an additional £0.75 from your employer, effectively doubling your contribution. Pension contributions are pre-tax, too, so you can lower your tax bill by contributing more.

If you have a workplace pension and you don't have any other pressing financial issues, please consider contributing to it. A workplace pension is arguably the best way to save for retirement!

Pension UK: Individual

If you do not have access to a workplace pension, you can still contribute to one yourself.

The most common self-directed pension is a SIPP (Self-Invested Personal Pension). Most financial institutions offer these accounts, including big-name share dealers like Hargreaves Lansdown and Freetrade.

As the name implies, these pension plans provide holders with the most flexibility regarding investments. These plans typically allow people to invest in UK shares, overseas shares, and numerous funds. Like most accounts, they often have a yearly charge for holding investments. Still, if you shop around, you can typically find dealers with relatively low fees overall.

Pensions have a £40,000 annual allowance (meaning that people can contribute up to £40,000 per year to these plans). However, if you make more than £240,000 annually, you may have an annual allowance as low as about 10% of that. Additionally, there's a lifetime allowance that currently sits at £1,073,100.

If you have no access to any workplace pension, you should open up a pension (probably a SIPP). You can still take advantage of the 25% top-up by the government, and you can make your contributions tax-deferred. Indeed, because of the government match, you should probably open this retirement account before opening any others!

An Example of How Your Pensions Will Make It Possible to Retire

To show the power of pensions, let's go back to the example of the person making £50,000 per year. As noted above, they will receive £9,339.20 from the State Pension annually at age 68.

However, let's suppose that this individual also contributes 10% pre-tax to their workplace plan. That comes out to £5,000 annually. The government will add 25% more, £1,250, and the employer will add another 75% for £3,750. As such, the employee has £10,000 annually going into their pension.

Further, suppose that the worker does this from age 25 to age 65 (40 years) with an average return of just 5% per year, not inconceivable with a reasonably well-invested pension plan!

With these hypothetical parameters, the person will have about £1.2 million in their pension fund by age 65. Please note that, while this amount currently exceeds the lifetime allowance, let's assume that the ceiling is above £1.2 million by the time this person wants to retire.

This person will then be able to take £39,600 per year and have enough money to last until at least 90 (100 with average market conditions, and 100+ with good market conditions).

Add in the State Pension amount, and the result is that this hypothetical worker is essentially back to their original salary of £50,000. This person will experience no lifestyle loss during retirement!

And all it took was a 10% contribution annually to ensure they would have money in their golden years for life!

Start Contributing to a UK Pension

No matter what type of pension plan you have access to – workplace or an individual one – the most important thing anyone can do is start investing now. The earlier you begin investing in a UK pension, the more you will have in retirement. Indeed, investing 10% of your paycheque for 40 years at a 5% ROI results in 2x the money as investing 10% for 20 years at a 10% ROI.

With matching contributions from the government and, if applicable, your employer, contributing to your pension plan is one of the best ways to have enough during retirement.

Indeed, no matter where you find yourself in your career – it's never too early or too late to start investing for your retirement!

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