How A Pension Works
A pension is arguably the most tax-efficient way of saving money for your retirement.
Simply put, a pension is a pot of cash that you, and your employer, can pay into - and which you get tax relief on - as a way of saving up for your retirement.
At retirement, you can draw money from your pension pot or exchange the cash with an insurance company for a regular income until death, called an annuity.
How Does a Pension Grow?
Pensions grow in multiple ways -
Your contributions. A portion of your salary will be automatically put into a workplace pension, if you have one. You can also choose to put extra money into your pension, either monthly or as one-off payments.
Employer contributions. Almost all employers (with very few exceptions) must contribute at least 3% of your salary into your pension.
Tax relief from qualifying contributions.
All contributions within your annual allowance threshold will receive tax relief. This means that if you pay the money into your pension yourself, or if it is taken by your employer from your pay packet, you automatically get 20% tax back from the Government as an additional deposit into your pension pot. (If you are a higher taxpayer, you’ll have a different annual allowance threshold and a different tax rate.)
Getting 20% tax relief doesn't mean you get 20% back of what you contribute. Instead, the 20% is calculated on your pre-tax earnings. So, when a basic rate (20%) taxpayer invests £80 of their take-home pay in a pension, they'd have actually earned £100 before tax. The tax relief is 20% of the £100 is £20 added to your pension pot.
- Investment growth. A portion of your pension is typically invested in financial products such as stocks, which can increase and decrease in value over time. Investments can grow faster than interest rates rise, which means that your spending power won’t deplete over the years.
A pension plan is modelled after a traditional long-term retirement savings plan, where a company sets aside a fixed percentage of the employee's salary in a retirement savings account and invests the account proceeds on the employee’s behalf.
Over the years, those assets (usually invested in stocks, bonds and funds) grow, providing the employee (hopefully) an ample income source during retirement.
Upon retirement, the employee can choose to receive those pension benefits as a lump sum or in a series of regular payments.