What is a pension and how does it work?

A pension is a tax-efficient way to put money aside for later in life, giving you an income for when you retire or cut back on your working hours.

Depending on the type of pension you have, you, your employer, and third party contributors, like your spouse or children, can all pay into it. The government also provides tax relief on your contributions. Then, once you reach the Normal Minimum Pension Age (NMPA) or you retire, you'll have a few options for how you take your pension income.

You can pay into as many pensions as you want, depending on how much you want to put aside for when you’re older. However, there are limits to how much you can contribute to your pensions each tax year. Find out how much you can pay into your pension.

It’s important to know that most pensions are invested in stocks and shares, typically through defined contribution schemes. This means your pension value can go down as well as up, and you may get back less than you put in. However some pensions work differently, such as defined benefit schemes, which promise a set amount when you retire (more on that later). Tax rules also apply to your pensions, which vary by individual status and may change.

Is it worth paying into a pension?

It’s generally a good idea to pay into a pension if you can. Once you retire, or reach the NMPA and decide to reduce your working hours, you’ll still need to receive an income to support yourself. Planning early for that income can help you feel prepared and give you more flexibility when it comes to life after work. You can find out what it could take to reach your desired income in retirement using our pension calculator.

While there may be other ways to save or invest, a pension provides great benefits when it comes to putting money aside for your retirement income.

• You get 20% tax relief on the payments you make to your pension pot: in some schemes, the government tops up your contributions if you make them from your take-home pay. In others, tax relief is automatic, which means your contributions come out of your pay before it's taxed. If you’re a higher or additional rate taxpayer, you could get even more tax relief, which you may have to claim through your tax return form. Find out more about pension tax relief.
• If you have a workplace pension and meet the requirements, your employer has to contribute to your pension on your behalf: not only do you get tax relief on your contributions, your employer will contribute to your pension too. If you're not sure how much they contribute to your workplace pension, ask your employer.
• Pension investments are free from dividend and capital gains tax: you won't pay tax on any dividends from shares, and you won’t pay tax on any profits made from the investments within your pension pots. However, there are income tax implications to keep in mind when you start to withdraw from your pension, if you transfer to an overseas pension, or for your beneficiaries when you die.

Types of pension

There are three types of pension in the UK: the workplace pension, the personal pension and the state pension. The type you have will depend on your personal circumstances.

Workplace pension

Workplace pensions, also known as company or occupational pensions, are offered by employers. Employers in the UK are required to have a pension scheme set up, and they must automatically enrol their eligible employees.

Both the employer and the employee have to contribute a minimum amount to the employee’s pension each month. The specific scheme you’re in will have its own rules about contribution levels, however the government introduced minimum auto-enrolment contribution levels that all schemes have to follow. From 6 April 2019, your employer’s minimum contribution is 3% and you’ll need to contribute a minimum of 5%.

So, if you’re employed and meet the criteria, you’re most likely already enrolled in your current employer’s pension scheme. Typically, you’ll contribute a percentage of your monthly salary into the pension and your employer will add money too, up to a certain amount. You’ll also get 20% tax relief on your contributions. If you're a higher or additional rate taxpayer, you may be entitled to more tax relief, but whether you need to claim it yourself depends on how your employer's scheme is set up. It's worth checking with your employer to understand what applies to you, and whether your and your employer's contributions will be enough to build the pension pot you're hoping to achieve. 

There are two main types of workplace pension scheme:

1. With a defined contribution pension scheme (also known as a money purchase pension scheme), you pay in a percentage of your salary and your employer also contributes to it. The contributions are then invested by the pension provider based on your chosen investment style. The income you get in retirement isn’t guaranteed – it depends on how much has been contributed and the performance of the investments. As with all investing, the value of your pension could go down as well as up and you may get back less than you put in.

2. With a defined benefit pension scheme (also known as a final salary pension scheme), you’ll get a specified amount as income when you reach retirement age. Your pre-determined retirement income is based on how long you’ve worked for your employer and your salary throughout your employment. You may still have to pay contributions, and your employer usually will too.

If you’re not sure which type of workplace pension you have, check with your employer.

Personal pension

A personal pension, also known as a private pension, is a type of pension you can set up yourself. You can have a personal pension even if you already have a workplace pension.

If you decide to open a personal pension, it’s up to you to choose your provider, and decide how much and how often you’re going to contribute to it. As with a workplace pension, the government will also contribute to your personal pension through tax relief (higher and additional rate taxpayers with a personal pension will need to claim this through their tax return form).

Personal pensions are normally run as defined contribution pension schemes, so the value of your personal pension when you retire will depend on how much you’ve contributed and how the investments have performed. 

There are three main types of personal pension:

1. With a ‘simple’ personal pension, you’re most likely to make regular contributions to your pension, which will be managed by a pension provider. The provider should offer various investment strategies for you to choose from depending on your personal circumstances and attitude to risk.

2. A stakeholder pension is similar to the basic version, except there are strict government rules about how they’re managed. Stakeholder pensions have low minimum contribution amounts, only a few investment options and caps on how much the provider can charge you.

3. A self-invested personal pension (SIPP) is a type of personal pension where you choose which investments to put your money in and actively manage those investments. SIPPs are often more suitable for large contributions and, because you control how your money is invested, they might be better for experienced investors. They can also have higher charges.

With a Nutmeg personal pension, our expert investment team will proactively manage it for you. Every time you pay into your pension pot, we’ll automatically add the 20% government tax relief you're entitled to. You can open our Nutmeg personal pension with a minimum contribution of £500 and then continue to put more money into it through regular contributions, one-off lump sums, or a bit of both. You can also transfer other pensions you’ve built up elsewhere, like those from previous employers.

State pension

The state pension is a regular payment from the government that you receive once you reach the state pension age, as long as you've paid or been credited with a specified number of qualifying national insurance contributions, and meet the other eligibility criteria laid out by the government. The amount you get will depend on the national insurance contributions you’ve made. The government will then pay you your state pension – a guaranteed income – for the rest of your life.