Published on 6th April 2024

Pensions are something we have all likely come across, but often there is a lack of understanding about what a pension actually is, how they work, and why bother?

With that in mind, in this blog I thought it would be worthwhile trying to answer some of these questions.

So here we go…

What is a Pension?

Most people in the UK nowadays have what are known as ‘Defined Contribution’ pensions.

These pensions are like a 'piggy bank' that you fill up with money during your working life, so that it can be used later, usually when you stop working.

A lot of people contribute every month (often directly through their payslip), and if you’re employed, your employer can also chip in - as well as the Government (more details on this below)!

This doesn’t mean however that they are reserved for the employed – in fact, it could be argued that those who are self-employed should be placing even more emphasis on pension planning as they don’t have an employer who is also paying in.

Once the money is paid into your pension, it is then invested into different things - such as shares (all around the World), Bonds, or Property, with the idea being for it to grow over time.

You also have a number of options when you reach retirement in terms of how you draw on the funds you’ve built up - whether that's a guaranteed income for life, a flexible income, or a bit of both.

The other main type of pension is a Defined Benefit pension.

A defined benefit pension promises to pay you a certain amount of income when you retire – usually based on your salary and how long you’ve worked for your employer. They are also sometimes known as final salary or career average pensions. These pensions are mostly provided by public sector employers, such as the government, the NHS, or local councils. However, some private sector employers do also offer them - although this is less common than it once was due to the high cost and risk.

They differ from defined contribution pensions in that you don’t have to worry about how your pension money is invested as your employer, and the pension provider, are responsible for managing the fund. You also don’t decide how to use your pension pot when you retire as you will be provided with a set regular income for life (often also linked to inflation) – i.e. a ‘defined benefit’.

How does state pension work?

As well as the above, we should all also be aware of the State Pension.

The state pension is a regular payment that you get from the government when you reach a certain age. How much you get depends on how long you have worked, or more accurately, how many years’ worth of National Insurance credits you’ve achieved. Importantly, this does not necessarily mean you need to have worked throughout your adult life – you can achieve NI credits through other means such as being a carer, or whilst bringing up young children.

Currently, the state pension benefits from the ‘triple lock’ which means that it is increased annually by the higher of CPI, 2.5% or average earnings growth. A political hot potato at the minute given the significant increase in inflation and then wage growth over the last few years which has led to higher than anticipated increases year on year!

The age at which you can draw state pension depends on your age, or more accurately, your date of birth. Previously this was age 60 for Women and age 65 for Men. However, this has been equalised and the minimum age you can draw your state pension is at least age 66, with those who have longer before they reach state pension age not able to draw on their pension until they are older (age 67 or 68 as things stand).

The current full state pension stands at £221.20 per week, or £11,502 per annum. In order to achieve this the equivalent of 35 years NI credits is required, and in order to achieve any state pension at all, there is a requirement of 10 years of NI credits.

How does tax relief work?

Pension tax relief is a way of rewarding you for saving for your retirement – an incentive/bonus for saving for the long-term, rather than spending in the short-term.

It means that some of the money that you would have paid in tax on your earnings goes into your pension pot instead of to the tax-man. The amount of tax relief you get depends on the type of pension scheme you are in and the rate of income tax you pay.

There are two main ways to get this relief (or bonus):

Relief at source: This is used by most personal and workplace pensions, and is when your pension company claims the bonus on your behalf directly from the government and adds it to your pension. For example, if you put £80 into your pension, your pension company will claim £20 extra from the government and add it to your pension. So you end up with £100 in your pension. This is not to mention the payment that your employer makes as well on top of this – if you have one.

If you pay income tax at a higher rate, you can claim additional tax relief by filling in a tax form or contacting HMRC.

Net pay: This is when your employer takes the money out of your pay before taking the tax so you get tax relief at your highest rate of income tax automatically. For example, if you pay income tax at 40% and put £100 into your pension, it will only reduce your take-home pay by £60. So you save £40 in tax, with this £40 instead being paid into your pension.

You can get tax relief on up to 100% of what you earn in a year, or £3,600 if that’s more. But there is also a limit on how much you can save into your pension each year without paying extra tax. The limit for 2024/25 is £60,000 for most people, but it might be lower if you earn a lot or have already taken some money out of your pension. You can also carry forward any unused allowances for the previous three years and therefore may be able to pay significantly more than the usual limit (provided your earnings allow for this).

When should I start?

The bottom line is that it is never too early to start a pension. In fact, the longer you save and the longer your monies are able to be invested and grow over time, the bigger your pension pot will be.

To illustrate this, let’s take someone who starts at age 25 versus someone who starts at age 35 – and let’s assume that they both earn £30,000 per annum, and both pay in 8% of their salary (with their employer matching this). Let’s also assume they both plan on retiring at age 65 and the pension grows at 5% per annum (net of any costs).

The person who starts at 25 would have contributed £96,000 and would achieve £610,400 by age 65. Whereas the person who started at age 35 would have contributed £72,000 and would achieve £332,900 by age 65.

By starting 10 years earlier, the 25 year old has actually only paid approximately 33% more, but would achieve over 80% more in terms of value by the time they reach retirement!

Another reason for starting earlier, and building more of a pot up earlier, is the ability to retire earlier!

State pension isn’t paid until (at least) age 66, whereas personal pensions can be drawn upon from age 55, rising to age 57 from 2028. With that being the case, many people use their personal or workplace pensions as a ‘bridge’ between retirement and state pension age, or draw more from their pensions earlier to make up for the shortfall in income versus when they are able to obtain state pension.

Please note that a pension is a long-term investment not normally accessible until 55 (57 from April 2028). Your capital is at risk. The value of your investment (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.

If you want to have a chat about pensions, and how you can maximise your own provision, then please don’t hesitate to get in touch either via the contact form on our website, by calling us on 01909 498 578, or by emailing us on hello@aspirionwealth.co.uk

By Nameer Al-Asadi; APFS; Cert CII(MP) – Chartered Financial Planner