How do pensions work?

A pension is a retirement fund built up over the course of your working life. You make regular contributions and typically the money is invested, with the aim to grow your savings over time. In contrast to other types of long-term saving, pensions come with the added benefit of tax relief. 

Different types of pension

There are several types of pension within the UK, and how each type works differs slightly. There’s personal pensions, the State Pension and workplace pensions, as well as two sub categories within these – defined contribution and defined benefit pensions.

Confused yet? Don’t worry! Here’s an explanation of how each of these works.

How do personal pensions work?

A personal pension is set up solely by you, and what you’ll receive depends on what you’ve put in, as well as how well your investments perform over time. Typically, pension fund managers will invest your contributions into a mixture of shares, bonds, property and cash.

How does a workplace pension work?

A workplace pension is much like a personal pension, but differs in that it’s set up by your employer. Auto Enrolment legislation now means it’s compulsory for employers to set up a pension scheme for eligible staff, as well as make a minimum contribution to their employees’ pensions.

How does the State Pension work?

The State Pension is a government-backed pension that you can claim when you reach pension age. The amount you’ll receive depends upon your National Insurance Contributions, with the government determining your State Pension payments through the credits you’ve accrued during your working life.

So, now that we’ve covered these three, how do defined benefit and defined contribution pensions fit in within these?

How do defined benefit pensions work?

Defined benefit (DB) pensions are a type of workplace pension, which promise to pay you a retirement income based on a percentage of your salary. How much you get depends on how long you’ve spent working for your employer, and how much you were earning when you left work. These types of pensions are now pretty rare as many businesses can no longer afford them, so they’ve switched to more affordable defined contribution schemes. 

How do defined contribution pensions work?

Defined contribution (DC) pensions are a type of workplace and personal pension, which you pay contributions into – most commonly through your salary. What you put in is then invested by fund managers, typically in things like shares, property, cash and bonds. Once you reach 55 you can use your DC pension to buy an annuity, which will provide an income for the rest of your life. Alternatively, you can just take out your savings bit by bit.

Hopefully that’s helped clear up how pensions work. It’s important to bear in mind that pensions benefit from tax relief. 

Updated: 4th September 2020 

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