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Personal pension need-to-knows

Key points for retirement saving

Personal pensions
Guy Anker
Guy Anker | Edited by Martin Lewis
Updated 21 January 2019

Fancy an easy pay rise? Start a pension and you've got one. Not only will the Government top up your pension pot, but if you're employed, your employer may also HAVE to help.

This guide lists the 17 key things you NEED to know about pensions, including the rules which mean, over time, every employee will be auto-enrolled into a workplace scheme.

17 key pension need to knows

Note: This guide doesn't apply to final salary schemes where your wage and length of company service determine your retirement income - for basic info go to the Different pension types section. Nor does it cover the humble state pension - always check if you can boost it.

  1. What is a pension?

    A pension is not necessarily what people think it is, and it most certainly isn't only for old people.

    A personal pension is fundamentally a simple product:

    It is just a tax-free pot of cash you, your employer (and sometimes the Government) pays into, as a way of saving up for your retirement.

    At retirement, you can draw money from your pension pot or sell the cash to an insurance company in return for a regular income until death, called an annuity.

    Since the 2014 Budget you've been able to access your pension once you turn 55, taking as much or as little as you like, whenever you like.

    But it's important to understand how a pension affects your income. Effectively you're losing disposable income now in exchange for a future pay rise (in the form of pension income). As you'll be getting less in your pay packet, consider this carefully when budgeting. See our free Budget Planner tool.

  2. Is a pension REALLY worth it?

    The killer boost of a pension is the tax relief, which comes in two forms depending on whether you're a basic-rate or higher-rate taxpayer.

    You get some tax back on the money you put into a pension, while gains from the investments you make with that cash are largely tax-free.

    Tax relief on contributions

    You get the tax back you've paid on all contributions, if you're under 75, subject to an annual allowance. This usually goes straight into your pension pot.

    What tax relief do I get? 
    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-rate taxpayer you can claim an additional 20%, while top-rate taxpayers can claim an additional 25%. If you are part of a workplace pension, you may not need to reclaim any tax if your employer simply deducts less tax from your pay packet.

    However if you don't reclaim, it won't be paid. Therefore it is important to check if you are in a higher tax bracket. For more information on how to reclaim tax see HMRC.

    If your employer puts the money straight in from your pre-tax pay then it's never taxed in the first place, so you still win.

    How does the tax relief work?
    If you get 20% tax relief, it doesn't mean you get 20% back of what you contribute.

    Instead, the taxman works out your earnings on your contribution amount before tax was deducted. You then get back the difference between your contribution and your pre-tax earnings.

    So when a basic 20% rate taxpayer invests £80 of their take-home pay in a pension, they'd have actually earned £100 before tax to come out with £80 (20% of £100 is £20, leaving £80). In that example, the tax relief is £20.

    The graph below illustrates the tax boost.

  3. How much should I put in a pension?

    While this guide has already dealt with the minimum you have to put in under auto-enrolment, often, you really should be contributing more - if you can.

    Before starting, it's worth noting those in debt, especially at high rates of interest, should consider whether it'd be better to get rid of that before starting a pension. Plus, a pension's only one form of retirement planning. Combining it with other methods is often a good plan.

    If you opt for a pension, the simple answer of how much to put in is as much as possible, as early as possible. There's a very rough rule of thumb for what to contribute for a comfortable retirement...

    Take the age you start your pension and halve it. Put this % of your pre-tax salary aside each year until you retire.

    Make sure you include your employer's contribution in that percentage.

    So someone starting aged 32 requires 16% of their salary for the rest of their working life. This huge sum will scare the pants off anyone, but the rule helps us set some aims:

    • Don't delay. The sooner you contribute, the longer your money has to grow. The compounding effect - where the cash your investment earns can, itself, attract additional earnings - makes a massive difference.

    • Increase payments. It's important to put away a constant proportion of your earnings. As your pay increases, make sure your contributions increase proportionately, or you'll fall behind.

    • Use the 'pay rise trick'. Most people will be unable to contribute enough at the beginning. So start with whatever you can, but each time you get a pay rise, put a quarter of it each month into your pension. Then you'll be basking in the glory of more money, without getting used to spending the cash destined for your pension.

    For a more accurate way of calculating how much you need to retire, try using the Money Advice Service's pension calculator. It'll ask for information including when you want to retire, how much you and your employer are contributing, and whether you want your pension to be inflation-proof.

  4. How much can I put in a pension?

    There's technically no limit as to how much you can put in a pension. But, there are limits on how much tax relief you'll get for doing so, and there are three different limits you need to be aware of:

    • An earnings limit. You get tax relief on contributions up to your annual earnings. Imagine you earned £20,000 each year, but had £30,000 in savings, and decided one day to put all your savings into a pension. In this situation, you would only earn tax relief on the first £20,000 of your contributions.
       

    • An annual limit. This limit only applies to higher earners. You can only get tax relief up to your current annual allowance, made up of the current year's allowance (currently £40,000) and any unused allowance from the previous three tax years.

      Since April 2016, anyone whose total income, pension contributions and employer pension contributions is over £150,000 in a year will get a reduced allowance, with the very highest earners allowed just £4,000 of tax relief for £2018/19. For every £2 earned over £150,000, the allowance tapers down by £1, meaning anyone earning a total income of £210,000 or more will only get £10,000 tax relief annually.

      Those whose income (excluding pension contributions) is under £110,000 will be unaffected by these changes, even if pension contributions take them over.
       

    • A lifetime limit. Again, this is only relevant to the highest earners. In the 2018/19 tax year, this is £1,030,000 (£1,055,000 in 2019/20). What this basically means is that if your total pension savings (including gains/interest) are over this amount, you won't receive tax relief on further contributions.

    This example shows how the annual limits can be used and carried over...

    Current annual allowance = £40,000 (£4,000 in £2018/19 if you've started taking money from your pension). But...

    You can top up your allowance for the current tax year with any allowance you didn’t use from the previous three tax years. That's £50,000 for one of the years and £40,000 for the last two tax years.

    Say you invested £10,000 in a pension in each of the previous three tax years. You'd then have one lot of £40,000 and two lots of £30,000 - the unused parts of the previous three years' allowances - you could carry forward. This sum would total £100,000.

    Your current allowance would be £140,000 (£100,000 from the previous three years, plus £40,000 from this year).

    Money paid by someone else, such as your employer, counts towards those allowances. You can still save more into a pension but you will only get the tax breaks up to the stated maximums above.

  5. What's auto-enrolment?

    For many years, your company may have set up and contributed to a workplace pension. Not all companies offer workplace pension schemes and currently fewer than one in three UK adults are contributing to a pension, auto-enrolment is designed to address this.

    The auto-enrolment rules mean that if you're an employee, your employer will be forced to offer you a pension scheme. From 2018 all employers by law had to contribute to their employees' pensions.

    You have the option to say ‘no’ to auto-enrolment if you don't want to join. But it's an opt-out rather than an opt-in scheme, so if you do nothing, you'll be opted in.

    We've got a full guide on auto-enrolment, which will tell you everything you need to know.

  6. What's 'salary sacrifice'?

    Paying into a pension gets all taxpayers a tax break. But for an extra and easy bonus, salary sacrifice is worth considering.

    Salary sacrifice applies to a number of workplace benefits such as childcare vouchers or cycle-to-work schemes, not just pensions.

    It's where you give up some of your monthly earnings while your employer puts it towards something else - in this case, personal pension contributions.

    As it comes out of your PRE-TAX salary and straight into your pension, you pay a reduced rate of employees national insurance (NI). Your employer will also pay a reduced rate of employer's NI which gives them incentive to operate the scheme.

    • Basic-rate taxpayers: Because your pension contribution comes out of your pre-tax salary, you'll pay less income tax at 20%. You'll also avoid your 12% NI contributions on the amount you sacrifice. This means for every £68 you sacrifice from your pay packet, £100 goes into your pension pot.

    • Higher or top-rate taxpayers: If you pay tax at the higher 40% or 45% rates, salary sacrifice means you don't have to claim back the extra tax relief yourself - as you are never taxed on those contributions in the first place - and you don't have the 2% NI deducted on those contributions either. To deposit £100 in your pension pot, you only have to give up £58 from your pay packet, as no tax or NI is deducted as a higher rate payer. For a top-rate payer, you only give up £53.

    One thing to take into consideration is that you'll take less money home, albeit to get a great benefit back in the future. However, having a lower upfront salary may hit you — for example, it could reduce your earnings so that you'd no longer qualify for Statutory Maternity Pay.

    At current rates, this means that if your salary sacrifice takes your salary below £116 per week, £503 per month or £6,032 per year, you'll be affected. If that's you — think twice before sacrificing.

    It could also affect mortgage applications, state pensions and benefits, such as Jobseeker's Allowance and Employment and Support Allowance.

  7. Should I take my employer's pension?

    If you're employed, your employer may top up your pension as part of your benefits package, so absolutely consider it.

    This is effectively a pay rise, so don't give that away, plus there's no tax to pay on that contribution (subject to annual allowances, above). It may not be going into your pay packet, but it is cash going towards your future.

    Of course, you may not have the cash to afford the compulsory contributions, and there's no point getting into costly debt if that's the case. See our free Budget Planner tool to help you decide.

    You also need to check if you have primary, enhanced or fixed protection. This is where you will have fixed your lifetime pension allowance (currently it's £1 million for anyone without protection). If you have protection you will lose it if you take your employer's pension so weigh up the benefits.

    But before you do, check out our Pensions Calculator to work out what's actually going into your pension from your contributions, to show the boost a pension can give, factoring in any employer boost, plus tax relief.

  8. Aren't pensions a load of rubbish?

    Confused? Ignore whatever you've heard. This all stems from a fundamental misunderstanding of what a private pension is. It's simply a tax-free wrapper to save money for retirement. Their bad rap comes from investments that don't pay off or high charges (see Martin's blog: The one word that caused the pension crisis).

    Pension saving is a tax-efficient option that isn't implicitly risky. The risk comes from the investment choice. Safer investments, such as putting your money in cash rather than exposing it to the risks of the stock market, are available.

  9. The different types of pension

    Pensions come in all shapes and sizes. The first distinction is whether the pension is a final salary or a money purchase pension.

    Final salary pensions

    These pensions, sometimes referred to as defined benefit schemes or Career Average Revalued Earnings (CARE) schemes, are largely funded by employers, though staff sometimes have to pay into them. With one, you get a percentage of your final salary before retirement, or when leaving that firm, as an annual income.

    What that percentage is depends on how long you worked for that particular firm. There is normally an 'accrual rate' set by your employer as a fraction of your final salary.

    Say the rate is 1/60th, you get 1/60th of your final salary as a retirement income for each year you worked for that firm. So if you worked for 30 years, you'd get 30/60ths, or half your final salary with that firm.

    Money purchase pensions

    Money purchase pensions, also known as defined contribution schemes, save into your pension pot under a 'money purchase arrangement'. After years of saving, this cash can then be withdrawn thanks to new pension freedoms or can often be swapped for an annuity - an income for life.

    Most personal pensions are saved for with this method. How they differ is the way the money is invested and/or the level of charges.

    Personal pensions fall into the following categories:

    • Workplace pension scheme. This is where you and/or your employer make regular monthly payments, with that money invested by a pension company until you hit retirement. There are two types of workplace pensions: trust-based and contract-based pensions. 

    • Trust-based pensions - A board of trustees manage investments on your behalf. You and possibly your employer pay into the pot, and it's invested. The trust fund is kept at an arms length principle, separate from the company. What's more it allows benefits to be handed to your partner or other dependant members.

    • Group personal pensions - This type of pension is between you and a third party insurance provider. The provider isn't required to act in your best interests. The snag is that your employer chooses the provider, but these arrangements usually offer you a choice of investments.

    • Stakeholder pensions. These are similar to workplace pensions, but have low and flexible minimum contributions, capped charges and a default investment choice. You won't have to decide where to put your cash.

    • Self-invested personal pensions (Sipps). These work in the same way but are DIY pensions, allowing you to choose your investment. Investors prepared to do the legwork themselves can run a Sipp on the cheap, if they use the right provider. Read a full guide to Sipps.

    Don't forget the state pension. This is where you get a small pension from the Government when you hit state retirement age. The basic state pension is currently £125.95 a week (with £129.20 proposed for 2019/20) . Or under the new state pension - for people who reach retirement age on or after April 2016 - it's £164.35 for 2018/18 (with £168.60 proposed for 2019/20). You build up entitlement to the state pension by paying national insurance (NI) throughout your working life (see the State Pensions guide).

    The table below shows how the different pensions differ:

    PENSION Can you contribute? Can your employer contribute? Do you invest the cash?
    Workplace pension Yes Yes Yes
    Stakeholder pension Yes Yes Yes
    Sipp Yes Yes Yes
    Trust-based Yes Possibly Yes
    Group Yes Yes Yes
    Final salary Yes Yes No
    State pension Yes, by paying NI No No

  10. Who's holding my money?

    If your employer chooses which company manages your investments, you can decide the type of risks you want to take with them.

    The Government has set up its own scheme, called the National Employment Savings Trust (Nest), which many employers, who have yet to start a workplace plan, are expected to join.

    In a workplace pension (not a final salary scheme), where the money is managed by a third party, the fund manager may choose the particular investments, but you can let it know the type of risk you want.

    If you start your own pension, you choose the manager. If you opt for a Sipp, it will also be managed by another firm but you make the investment decisions (see the Cheapest Sipps guide).

    While the National Employment Savings Trust (Nest) arrangement by the government is a great scheme to encourage employers to provide employees, some who have not started a pension, with contributions, it isn't necessarily the only option.

    For some, sticking to pension contributions could reduce take-home salary, which could affect existing repayment arrangements and squeeze finances.

    Nest has been around since 2013, and has now clocked more than 2 million members. But if it's not for you, there are alternatives such as the not-for-profit People's Pension, the for-profit NOW which collaborates with one of the largest pensions funds in Europe, or Smart Pension.

  11. How do I get a pension?

    Under the new rules, many people will end up in a company pension so all they need to do is go ahead with what their employer offers. To pocket any contributions your employer makes, you need to agree to be part of its scheme.

    If you opt for your own pension (where only you contribute) then you will need to scour the market for the best deals.

    Unless you are financially savvy, it's usually best to get advice from an independent financial adviser (IFA), given there are a whole host of charges to watch out for. Since January 2013, IFAs can no longer be paid in commission, so you'll have to pay a fee for advice.

    See our Financial Advice guide for how to pick an IFA, including what getting advice will cost you.

  12. How do I get a cheap pension?

    If you don't get a workplace pension, it's time to do your homework. You can claw back the cash (if you know what you're doing).

    If your pension is straightforward, or you have the financial savvy to know what you want to invest in, you can head straight to the pension company and set that up.

    However be aware that this may not necessarily be the cheapest option as group plans (such as with your employer) can be cheaper.

    There are a number of specialist pension discount brokers. Here, you just tell them the pension you want and they arrange it without giving you advice. This means they rebate some or all of the charges back into your fund, effectively reducing the charges compared to going direct. 

    Even though we're only talking about fractions of a percentage point, the compounding effect means your fund could be £1,000s better off.

    Using this route means you get no advice, which may not be a problem. But if you're confused, unsure, or have complex circumstances, it's best to be safe and see an IFA. It's better to pay a few hundred pounds upfront so you don't end up losing thousands over your lifetime, if you've no idea what to do. Unbiased.co.uk and VouchedFor list local advisers.

    Important! Even if you pay a low set-up fee and/or get some charges rebated, you may still pay what's called an annual management fee charged by the fund manager that looks after your investments, so there are additional costs to consider.

  13. Some of the cheapest firms

    Some companies give you information/brochures on their pension funds, though this is not technically advice, so you don't pay for it. There's no set-up fee, although there will be other ongoing charges.

    These companies are Cavendish Online, BestInvest,  Commshare, Close Brothers, Chelsea Financial Services, Fidelity, Hargreaves Lansdown* and TQ Invest.

    If you do want to take financial advice it'll cost you, so check out our guide on choosing Financial Advisers first.

    Note: The firms mentioned above all offer decent deals, though it may be possible to beat them - it's not a definitive list.

  14. What happens when I retire?

    Once the money is in a pension, it can't be withdrawn willy-nilly. It must stay there until you're at least 55. (There are some extenuating circumstances where you can withdraw the money before 55). At that point, you can take 25% of it as a tax-free lump sum, with the rest ideally providing an income for the rest of your life...

    If you get approached before you're 55, it's a scam known as pension liberation. These scams are so damaging the government  banned cold calling about pensions in January 2019.  Firms ignoring this could be fined £500,000.

    For full details of how to release money from your pension legitimately and how to avoid scams, read our Pension Liberation guide.

    When your regular income stops... it's decision time. Ideally, start preparing a few years beforehand.

    Provided you're over 55, you'll be able to take as much as you like, when you like - though drawdowns above the tax-free 25% will be taxed at your marginal rate - so 20% if you're a basic-rate taxpayer, 40% or 45% if you're a higher or additional-rate payer, or the amount you've taken from your pension pushes you into that rate.

  15. You can do anything you like with your cash (you don't have to buy an annuity)

    You can still use your retirement cash to buy an annuity if you want to, but you no longer have to. The pension freedoms that were introduced in April 2015 mean that anyone who's aged 55 or over can take their pension money however they want, whenever they want, from the age of 55 - there's now complete freedom.

    For most people, accessing pension cash at 55 will be too early, so it can just be left where it is. Yet, if you want to, you can also access all your pension cash at once - the first 25% is tax-free and the remaining 75% will be taxed as income at your marginal rate (so, 20% if you pay basic-rate tax, though watch pension cash doesn't take your income over the 40% tax threshold).

    Assuming you've not taken all your pension out, the remaining options are:

    Option 1: Leave it invested in your pension for when you need it. Do this and it’s important to understand when you withdraw cash you get 25% of each lump sum you withdraw tax free. Eg, if you had £100,000 and took £20,000 out you’d get £5,000 of it tax-free, the rest would be taxed at your current rate.

    Option 2: Take 25% tax free, then buy a flexible income drawdown product.     This is a product you buy that keeps the rest invested so it can still hopefully grow, but you can also use it to take income when needed. 

    The tax here is different, you get the first 25% you withdraw tax free and then the rest is taxed when you take it – which could be useful if you’re likely to be in a lower-tax bracket once you’re older. 

    Option 3: Take 25% tax free, then buy an annuity.     This gives you a guaranteed income each year for the rest of your life.

    There are different charges on all of these, and it’s important to check them out and always compare different providers. For a quick briefing on all this see Martin's 5 minute pension freedom briefing, or for the full low-down read our Guide to Taking Your Pension 2015.

  16. How safe is my pension?

    With normal savings accounts, the simple rule is that up to £85,000 per person per institution is fully protected should your bank go bust. This protection's provided by the UK's Financial Services Compensation Scheme (FSCS, see the Savings Safety guide).

    If you put money in stocks and shares or funds that invest in them, then you've got a 'risk-based' investment, NOT savings, and a totally different FSCS protection applies. Critically...

    FSCS protection for pensions is very complex, and can vary with each product's structure. This is just a general guide, always check with your provider.

    The FSCS does not protect performance losses, say if the companies you invest in go bust, that's the investment risk you take. Protection with investments only applies if you lose money due to the product provider of the investment going bust, in this case the fund manager you've bought into through the pension.

    What protection do I get?

    Usually with pensions, the broker you buy it through doesn't hold any of the cash, it simply acts as a conduit for you to put the money into whatever funds or investments you want. Therefore in the unlikely event it goes bust, your money should be OK, and still held by the fund manager or bank it resides with. The protection applies should any of those go into default.

    If protection kicks in, the FSCS will first try to transfer your funds from the failed company to another company. If that's not possible, you get 90% of whatever you have saved in a pension back.

    For failed IFAs or brokers that mis-sold or provided dodgy pension advice, there may be a claim against the firm for mis-selling via the FSCS. This would be up to the investment limit of £50,000.

    If you've got a defined benefit (final salary) pension, there's a risk of your employer going bust, leaving you with no pension income. However, the Government set up the Pension Protection Fund (PPF) which may pay compension, subject to limits.

    • Stakeholder pensions

      If you invest using a stakeholder pension, this is usually covered under the 'long-term insurance' FSCS coverage. This means only 90% of everything in the pension (with no upper limit) is covered. For details of previous limits, see the FSCS website.
       

    • Cash

      If you have a Sipp and decide to hold the money as cash, you are normally covered under the standard £85,000 cover per person per institution, the same as normal savings get.

      Ask your Individual Sipp provider which bank the cash is held in (often they spread it around up to five). Then check whether any other savings you may have are in institutions linked to those used for the Sipp cash, as cumulatively you'll only get up to £85,000 protection in each. See What Counts As A Financial Institution?.

  17. Can I also save into a Lifetime ISA?

    In the 2016 Budget the Chancellor announced the creation of a Lifetime ISA, which started in April 2017. If you’ll be under 40 then, you’ll be able to use it to save for your first home or your later years, and the state will add 25% on top – that’s £1 for every £4 saved.

    The Lifetime ISA is designed as a boost to retirement savings, not a replacement. You can access the money in your Lifetime ISA tax-free from age 60.

    How does it compare to saving into a pension?

    Ideally, you'll be able to save into both to maximise your retirement savings.

    But, pensions and ISA savings are two different beasts. Both have their advantages, but if you're making a choice there are some things you need to consider.

    If you're employed, it's a no brainer to save into your workplace pension. With auto-enrolment, your employer must contribute towards your pension, plus you get tax relief of at least 20% (tax relief means that for every £4 you put into your pension, you get tax relief of £1 - the same boost as with the Lifetime ISA). Both of these together are worth more than the Lifetime ISA bonus. This is especially true if you're a higher-rate taxpayer, as the tax relief provided will be then at 40%.

    But, if you're self-employed, or you want retirement savings you can access more flexibly than a pension (albeit with a penalty), then the Lifetime ISA's definitely a good alternative.

    There are other advantages to pensions, though. If you lose your job, and need to then claim benefits, pension pots aren't counted as part of your wealth. However, ISA savings are and would be, so you may have to use a decent proportion of the savings before you'd be eligible for means-tested benefits. Similarly, Lifetime ISAs could be forfeit to creditors in bankruptcy, whereas pensions are protected.

    For full details, plus to get Martin's view, take a look at the Lifetime ISAs guide.

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