What is a pension?

What is a pension?

A pension is a way of saving money to ensure an income when you retire that is additional to what you get from the state. You can get a pension via an employer or by building up your own savings in a plan. You will normally have to contribute part of your earnings to an employer scheme.

How good an income that will be can depend, for most people, on how much you save, how you invest it, the age you are when you want to take your pension and how much an insurance company will give you each month for the rest of your life in return for the pension pot lump sum you have built up (this is called an annuity).

A minority – the lucky minority – have secure workplace pensions where the payments depend on how long you have been in the job and how much you earned when you retired.

Whatever sort of pension plan you have, it has major UK tax benefits. You get tax relief on the contributions you pay in (although this will be restricted for those earning £150,000 plus from 2011) and, except for the super-rich, you can take 25 per cent of your pension investment as a tax free lump sum when you retire.

The pension is usually regarded as the best type of retirement plan for the vast majority of people, who, unless they’re very rich, really do need to save for old age. (The state pension is too little for most to rely on alone).

While there are alternative ways of saving these usually come with their own risks. The pension is generally seen as the best option for most people – not least because of the extra money you get to put in because of the tax benefits. (See how it works below).

There are three major pension routes – you will certainly have one, probably two and perhaps all three.

These are:

  • Occupational “final salary” pension plans from your employer
  • The money purchase pension scheme – either from your employer or from other earnings such as self-employment – these are often called personal pensions
  • The state pension – you may have entitlement to a top-up plan as well as the basic state pension. If you are not well off, your retirement earnings could be boosted by a pension credit.
  • The Stakeholder Pension is a form of personal pension that has limits on charges. These are 1.5 per cent for the first 10 years and 1 per cent thereafter. There are no entry or exit fees. Older plans have a 1 per cent charge. Many pension providers undercut these limits, especially for larger pension pots. Firms employing five or more people have to offer a stakeholder plan to the staff but they are under no obligation to invest anything in it on behalf of their workforce. So the offer can be a pointless gesture. Anyone can apply for a stakeholder.

The SIPP or self invested personal pension is also a variant on the personal pension plan. The big difference is that instead of relying on a management firm to decide how to invest, you do it yourself.

There are sections on each of these you can look at or you can read more about the basics