Saving for your retirement is one of the most important things you’ll ever do, and there are various different types of pension to help you grow your nest egg.
Understanding how each pension type works can seem confusing, especially as there’s lots of jargon to get to grips with, but essentially, they all allow you to pay in during your working life with the aim of building a pot of money to live off in retirement. Your pension may come with other benefits too, such as employer contributions, or a guaranteed income in retirement, but this depends on what kind you’re contributing to.
There are broadly three types of pensions: defined benefit, defined contribution (the most common, and includes workplace and personal pensions) and the State Pension. Here, we walk you through what you need to know about each one, and how to make your money work as hard as possible towards a comfortable retirement.
If you’re considering getting professional financial advice, Unbiased is offering Rest Less members a free pension review. It’s a chance to have a qualified independent financial advisor (IFA) take a look at your pension arrangements and give an unbiased assessment of your retirement savings.
The review is free and without obligation, but if the IFA feels you’d benefit from paid financial advice, they’ll go over how that works and the charges involved.
Workplace pensions
All companies are now required by law to offer employees access to a workplace pension, under the government’s auto-enrolment scheme. You can learn more about this in our guide How does pension auto-enrolment work? If you are contributing to your workplace pension scheme, there are two main types:
Defined contribution (money purchase) pensions
A defined contribution, also known as a money purchase pension, is the most common type of workplace pension, where your contributions are invested and the amount you receive when you retire is based on underlying investment performance, in addition to employer contributions.
Unlike defined benefit pensions (see below), they don’t provide a guaranteed income in retirement, and are considered less expensive for employers to run. However, the hope is that, over decades, you can benefit from investment growth and build a substantial pot.
How defined contribution pensions work
If you have recently been enrolled in a workplace pension, or work in the private sector, chances are, you’ll be paying into a defined contribution pension scheme. You’ll be automatically signed up by your employer if you are aged 22 or over and earn at least £10,000, unless you actively opt out of your employer’s pension scheme.
You will contribute a certain percentage of your salary each month into a workplace defined contribution pension. The amount you pay in depends on how much you have chosen to contribute, but under auto-enrolment, there’s a minimum percentage you must pay in.
How much will you pay into your workplace defined contribution pension?
Under auto-enrolment, the minimum total contribution set by the government is currently 8% (with the employer contributing 3% and the employee contributing 5%, although your employer may contribute the entire amount). You may choose to pay in more than the minimum amount, depending on your company pension rules.
Some companies, and particularly larger employers, may promise to match your contributions. In this case, your employer pays in the same amount as you, beyond the minimum percentage. It can be wise to save extra money into your pension to benefit from extra employer money, and you could think of it as benefitting from a pay rise that’s delayed until you reach retirement. Ultimately, if it’s an option and you can afford it, increasing your contributions may be worth doing to increase your pension provision.
Your contributions are usually put directly into your pension each month, so they are taken from your salary before tax. The amount that is paid into the pension is then topped up with tax relief. Effectively, this gives you back the money you would have paid in tax if you had received the money as salary. For basic-rate taxpayers, this means you get tax relief on the pension contributions at 20%. If you’re a higher-rate taxpayer, this rises to 40% and reaches 45% if you’re an additional-rate taxpayer. You can find out more in our article How pensions tax relief works.
Your money is invested in the stock market, and you may be able to choose between a variety of funds, or stick to your workplace scheme’s default fund. It’s worth checking your options, and considering how long you have to go until retirement and your attitude to risk, though, instead of relying on the default option.
What you receive at retirement from a workplace defined contribution pension
Here is a rundown of what affects how much you receive from a defined contribution, or money purchase pension:
- How much your employer has contributed to your pension
- How long your pension has been invested
- How the underlying investments have performed over this time
You can find out more about how defined contribution pensions work in our article What is a defined contribution pension?
Defined benefit (final salary) pensions
Generous defined benefit pensions are considered ‘gold-plated’ workplace pension schemes, as they guarantee a fixed income in retirement, no matter how long you live. Sadly, they are few and far between these days, as they are expensive for companies to operate, particularly given rising life expectancy, and have gradually been phased out over the years in favour of defined contribution pensions.
However, if you are working in the public sector, or have done so in the past, you may have access to a defined benefit pension (although newer employees are typically enrolled into a defined contribution pension instead).
How defined benefit pensions work
The amount you receive at retirement is based on a particular calculation, which typically consists of a proportion of your final year’s pay, multiplied by the number of years you have been working for your employer and paying into the pension scheme.
Your money is invested in shares, bonds and funds, similarly to other types of pensions. But essentially, the reason this type of pension is considered the best is because it promises to pay you a fixed income at retirement, no matter how much you have paid in or how the pension scheme’s investments have performed. The risk therefore lies with your employer, rather than being dependent on investment performance.
However, each scheme has its own rules on what counts towards earnings and how benefits are built up over the years. Earnings may exclude, for example, overtime or bonuses and how much you receive may be based on your final salary or an average of your overall earnings. Check with your pension administrator exactly how your particular plan works, and how much you are likely to receive at retirement.
What you receive at retirement from a workplace defined benefit pension
Here is a rundown of what affects how much you receive from a defined benefit, or final salary pension:
- How many years you have worked and paid into the pension scheme.
- The rate at which you build up your pension benefits while part of the scheme, known as the ‘accrual rate’. Typically, this is a fraction of your salary, for example around 1/60 or 1/80.
- Your final salary when you retire, or an average of your salary over your working life.
You can find out more about how defined benefit pensions work in our article What is a defined benefit pension?
Private pensions (personal pensions)
If you aren’t able to contribute to a workplace pension, because you are self-employed and don’t have access to one, or not currently working, for example, you can pay into a private pension, also known as a personal pension.
These are simply another type of defined contribution pension, but the difference is that you won’t benefit from employer contributions on top of however much you choose to pay in. However, you will receive tax relief on your contributions, boosting your retirement pot and increasing the amount that’s invested to grow over time. Unlike most workplace pension schemes, there isn’t a set minimum contribution level into a personal pension (but there are some rules on maximum limits, which you’ll find below).
If you wish, you may also decide to set one up alongside your company pension, although you should always consider maximising your employer’s contributions before setting up a personal pension.
You can choose from several different types of private/personal pensions, depending on your personal preferences, and how much investment choice you want. Remember to always check the charges, too, as these can vary dramatically between providers and eat into your overall pension pot over time.
Here, we explain the main types of private, or personal pensions:
Stakeholder pensions
These were introduced in 2001 with the aim of simplifying pensions and reducing charges. Charges on stakeholder pensions are currently capped at 1.5% each year for the first 10 years and then 1% each year after that, and they usually offer a simple, default investment fund so you don’t need to choose where your money is invested.
You can make small contributions into a stakeholder, often from just £20 a month, so they can be an option if you cannot afford to save much each month, and you may be able to stop and start your contributions if necessary which may be useful if you are unsure about paying in a set amount each month.
Major pension providers such as Standard Life and Aviva are known for offering stakeholder pensions. You may also be part of a group stakeholder personal pension through your employer, but since the introduction of auto-enrolment in 2012, these have largely been replaced by standard workplace schemes.
Standard personal pensions
A personal pension offers a wider range of investment funds to pick from than a stakeholder. Charges can range from just 0.2% to more than 1%, so vary enormously, and often depend on how much you hold in your pension. You choose which funds are suitable for your pension savings, depending on how much risk you are prepared to take and how long you have until retirement. Providers usually offer guidance on which are generally higher risk, or may be suitable for more cautious investors.
You can also often choose from ready-made fund portfolio options from online investment platforms such as Nutmeg.com, Wealthify.com, and PensionBee.com, which may be a simple way to get started. Before you sign up, make sure you are comfortable with the charges you’ll pay, and overall investment choice on offer from your provider.
How much you end up with when you retire will depend, as with any defined contribution pension, on the amount you’ve paid in and your investment performance, after charges.
Find out more about the different types of pension that you can pay into if you don’t have access to a workplace scheme in our article Self-employed? Your pension options explained.
SIPPs (self-invested personal pensions)
SIPPs are defined contribution pensions that are essentially a ‘DIY’ option, enabling you to build your own portfolio and choose from a wide range of options when it comes to where your money is invested.
You may pay for a financial adviser to manage your SIPP, or manage the account yourself, depending on how experienced an investor you are, and how much time you have to keep an eye on your pension and choose/change investments.
How a SIPP works
A SIPP gives you access to a wide range of investments from different providers, rather than the pension funds of a single provider. You can choose your investments from, for example, thousands of shares, funds and bonds, gold and commercial property, and other more esoteric investment options such as forestry.
Any returns are protected from income tax, tax on dividends and capital gains tax. You’ll also receive tax relief on your contributions at your marginal rate.
There are a growing number of SIPP providers on the market. For example, Vanguard, Hargreaves Lansdown, AJ Bell and Interactive Investor are some of the options. Bear in mind that SIPP charges can be higher than personal pension charges, given the wider investment choice. But how much you pay will often depend how often you trade, and what investments you want access to.
The amount you eventually receive on retirement from a SIPP will depend on how much you’ve paid in over the years, and how your chosen underlying investments have performed.
You can find out more about how SIPPs work in our article Everything you need to know about SIPPs.
What are the pension allowance rules?
Whatever type of pension you have, you’ll be subject to certain rules on how much you can pay in per year, and over your lifetime:
- The limit on how much you can pay in per year and benefit from tax relief is £60,000 for most people, or 100% of earnings, whichever is lower. However, if you earn more than £200,000 a year, the limit is lower. This is known as the ‘annual allowance’.
- Bear in mind that if you’ve previously accessed a pension flexibly and taken any income from that, as opposed to just your tax-free cash, then the allowance drops to £10,000 a year. This is known as the Money Purchase Annual Allowance (MPAA).
- You can take 25% of your total pension pot as tax-free cash from age 55, with the remainder being subject to income tax at your personal rate.
Previously, the Lifetime Allowance would also have applied, which was a rule that limited the total amount you can build up in your pension over your lifetime before facing tax penalties. However, this was abolished from 6 April 2023, so no longer applies.
Find out more about the various pension allowances in our guide Understanding your pension allowances.
State Pension
The State Pension is the pension you receive from the government when you reach State Pension age, and often forms the foundation of your retirement income. The amount you receive is based on your National Insurance Contribution (NIC) record over your lifetime.
You need to have 35 ‘qualifying years’ of NICs to receive a full state pension, and 10 years to receive anything at all. These can be made up of NICs paid while you were employed, Class 2 NICs if you’re self-employed, national insurance credits if you are caring for a child aged under 12, or in receipt of Carer’s allowance. You can also pay voluntary NICs to make up for missing years in your record and increase the amount of State Pension you receive.
There are two types of State Pension, depending on when you were born.
- Basic State Pension: You receive this if you’re a man born before 6 April 1951, or a woman born before 6 April 1953.
- New State Pension: If you’re a man born on or after 6 April 1951, or a woman born on or after 6 April 1953, you’ll be subject to the new State Pension rules.
Find out more about the State Pension in our article How the State Pension works.
The new State Pension amounts to a maximum of £203.85 a week (about £10,600 a year) for the 2023/24 tax year. At present, State Pension age is 66, but it will rise to 67 by 2028, and is expected to increase to 68 between 2037 and 2039.
You can defer taking your State Pension to increase the amount you get. Find out more about how this works and the potential benefits and pitfalls in our article Deferring State Pension – How much can I get and is it worth it?
What is the ‘triple lock guarantee’?
The state pension has over previous years risen in line with one of three measures, depending on which is greater, known as the ‘triple lock’:
- Inflation, as measured by the consumer price index
- Earnings growth
- 2.5%
The triple lock was temporarily suspended in 2022 as wages soared disproportionately in the wake of the pandemic. It has however been reinstated this year and the State Pension rose by 10.1% (in line with September’s inflation figure) on 6 April 2023.
The new State Pension, which applies to those who reached retirement age on or after 6 April 2016, is £203.85 a week in the current 2023/24 tax year, up from £185.15 in the 2022/23 tax year. If you retired before 6 April 2016, the most you can get from the basic State Pension in the 2023/24 tax year is £156.20, up from £141.85 a week in the 2022/23 tax year.
This rise is likely to help ease the pressure many are feeling as a result of high inflation and the rising cost of living
What type of pension will you get?
This depends on your personal circumstances, but chances are, you’ll be able to sign up for at least one of the pension types detailed here.
However, remember that you aren’t limited to one pension. You may have several different types of pension over your working life that combine to make your retirement income, alongside other investments such as ISAs.
Where can you get help choosing a pension?
A good financial adviser can help you navigate your pension choices, and decide on the right type of pension for you, alongside which investments to hold in it, and specific recommendations based on your individual circumstances.
If you’re considering getting professional financial advice, Unbiased is offering Rest Less members a free pension review. It’s a chance to have a qualified independent financial advisor (IFA) take a look at your pension arrangements and give an unbiased assessment of your retirement savings.
The review is free and without obligation, but if the IFA feels you’d benefit from paid financial advice, they’ll go over how that works and the charges involved.
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