Introduction to Pensions
What is a pension?
Simply put, a pension is a type of savings plan that helps you save money for retirement. It also has beneficial tax treatment compared to other forms of savings. There are three different types of pensions, and you can have more than one kind should you wish to.
Different types of pensions
The three different types of pensions in the UK are the following:
They vary somewhat in what they offer savers, so here’s a brief explanation of each.
What is the State Pension?
When they reach state pension age, the state pension is essentially a regular payout that people can claim. How much you get, depends upon your National Insurance Contributions, with the government determining your pension payments through the credits you’ve accrued throughout your life.
What is a workplace pension?
Exactly as it sounds, a workplace pension is organised through an employer. Thanks to the Automatic Enrolment Act, employers are now required to set up a pension scheme for eligible employees, either through their own scheme, a specialist pension provider or a government-backed scheme. An employer must put in a minimum contribution to a workplace pension, as must an employee. The government also contributes to your pension in the form of tax relief. You choose how much to pay into your pension and your pension provider claims tax relief from the government and adds it to your pot.
Click here to learn more about workplace pension laws.
What is a personal pension?
A personal or private pension is a defined contribution pension so the amount you get in retirement, depends on how much you have contributed into the pot and how well your investments have performed. You choose how much to pay into your personal pension and your pension provider claims tax relief and adds it to your pot.
These are the three types of pensions that you will encounter as a saver, but it is worth noting that pensions can also differ in terms of whether they are defined benefit or defined contribution pensions. Here’s a brief explanation of what these terms mean.
What are defined benefit pensions?
When you retire, a defined benefit (DB) pension scheme, sometimes called a final salary pension scheme, is one that promises to pay out an income based on how much you earn. Unlike defined contribution (DC) pensions, the amount you’ll get at retirement is guaranteed, and it will be paid directly to you so you won’t have to use your pension pot to decide your next move. Outside of the public sector, these type of pensions are quite rare nowadays.
What are defined contribution pensions?
Defined contribution (DC) schemes are workplace pension schemes where your own contributions and your employer’s contributions are both invested and the proceeds used to buy a pension and/or other benefits at retirement. The value of the ultimate benefits to be paid under the DC scheme depends on the amount of contributions paid in, the return on investment minus all charges and fees, and the cost of buying the benefits.
These contributions are usually invested in bonds or shares and the final size of the pension pot will depend on how well they perform over time. After the age of 55, you can use a defined contribution pot to buy an annuity, which will then pay you an income for the rest of your life, or you can simply take out your money as you wish (subject to tax).
What is a pension fund?
A pension fund is a product that invests the money you save for retirement. Tax relief and any employer contributions are also invested into the pension fund. Pension funds hold the savings of large numbers of investors and specific investment decisions are made by professional money managers.
Choosing a pension fund
When you start a workplace pension or a private pension, you may be given a choice of pension funds, so that you can make a broad decision about how your money is invested. Many people just opt for their pension provider’s default pension fund, which is designed to be suitable for a wide range of people.
Good pension funds invest in a range of assets to help manage your risk. Asset types include shares, bonds, property and cash.
You can choose a pension fund based on factors such as type of investment, risk and location profile, but all specific investment decisions are made by the pension fund’s experts.
The situation is somewhat different with defined benefit pension schemes. Since these pension plans promise a certain retirement income, investment decisions are made by the pension insurance trustees.