What is a pension, and how do pensions work?

Despite the importance of properly preparing for later in life, recent research by the Department for Work and Pensions found that 16% of 40–75-year-olds have not yet started saving for retirement.

If you’re in this age bracket, or perhaps even younger… Old age might feel like a long way off! But with life expectancies increasing, it’s becoming ever more crucial to start planning for retirement earlier in life.

Thankfully, help is at hand. Here’s our guide on everything you need to know about pensions.

What is a pension?

A pension is a financial product designed to provide a tax-efficient way to invest money so you have a retirement income to live on later in your life.

The key thing to know about pension plans is that, although you may hear talk of ‘saving for retirement' when you contribute to a pension that money is typically invested. This is an important distinction because it means the value of your pension investments can go down as well as up.

How do pensions work?

There are different types of pensions, but eligible UK citizens will receive a state pension once they reach the qualifying age (it’s currently possible to access your pension if you’re aged 67 or above, for people born after 1960).

The state pension is funded by your National Insurance contributions, so you’ll need to make NI contributions for 35 years to get the full rate or 10-34 years to claim partial payments.

Even the full state pension won’t be enough for most people to live on. But it can be a helpful way to top up the income from your other pension pots.

Pensions are considered to be a tax-efficient way to prepare for retirement over the long term because the UK government boosts your contributions by reimbursing income tax paid to HM Revenue & Customs (HMRC) on your earnings.

Depending on your retirement plans, you may wish to supplement your state pension and any workplace schemes with a Self-Invested Personal Pension (SIPP). There are limits to how much you can contribute in a given tax year, but your pension tax treatment will depend on your personal circumstances and may be subject to change in the future.

The benefits of a pension plan

If you’re trying to save money for your retirement, you may feel anxious about the sheer amount of money you need to try and ensure yourself a decent quality of life in your later years.

However, the UK government has put mechanisms in place to make the process more rewarding.

1. The government boosts your contributions with tax relief

As we mentioned previously, tax relief is applied to pension contributions in the form of reimbursement on the income tax initially paid to HMRC.

You’ll automatically get this tax relief through most workplace pensions and some SIPPs.

The Scheme Administrator claims this tax relief and invests it into your pension plan. For a basic rate taxpayer (paying 20% income tax), a contribution of £100 to your SIPP would only cost you £80 in real terms, because the Scheme Administrator reclaims the £20 income tax paid.

If you pay a higher rate of income tax, or if your pension isn’t set up for automatic relief, you’ll need to claim the extra tax relief by filing a self-assessment tax return with HMRC.

2. Your employer must contribute to your workplace pension

If you’re employed, the chances are you've been automatically enrolled into a workplace pension. It’s not compulsory for you to contribute, but if you do then your employer must also make contributions up to a limit, which can make this a valuable benefit (a bit like a pay rise that goes straight into your pension).

Employers are required to pay a minimum amount (calculated as 3% of your salary between £6,240 and £50,270 per year before tax). But some employers offer more as a way to reward employees and attract new hires.

This is worth considering when you’re job hunting!

3. Your money can make more money with compounding

When you put money in a pension, it’s normally invested in financial assets like stocks/shares (portions of a company), bonds (loaned money) and property. If these assets go up or down in value, so will your pension.

A return on investment is calculated as a percentage. So, in theory (if the right investments are selected), the more money you have to invest, the greater the potential for further earnings.

Compounding refers to the process of reinvesting any returns to hopefully earn a return on the principal amount plus those returns, in the future… And the effects can be surprising over time!

Although there’s no guarantee that your pension will increase in value, when any returns are reinvested, the value of your pot can start to snowball.

How to build a pension

Conventional wisdom says you should contribute as much to your pension as early as possible. And for good reason! The longer the time horizon for your investments, the more time it gives you to weather short-term volatility in the stock market and benefit from compound earnings.

But if you’re thinking “I barely have enough for bills and the bus”, you’re not alone 😬 Setting aside significant amounts early on in your career simply may not be possible, because this is naturally when your salary is at its lowest. And you may need to prioritise the cost of education, training, or living in a big city to advance your career and boost your earnings potential.

But this doesn’t mean your retirement plans are doomed. There is always a balance that can be struck, and it’s important to recognise the impact that making small, regular contributions can make. An app like Plum can help you automatically set money aside when you have a little extra to build the good habit and move closer to your long-term goals 🙌

How to find pensions from previous jobs

If you’ve held multiple jobs over the course of your working life, it’s likely that you have previous workplace pensions. As the years pass it’s easy to lose track of these schemes from previous employers, so it’s of little surprise that there are more than 2.8 million pension pots currently “lost” in the UK. And we’re not talking peanuts. The average value of a lost plan is £9,470 🤑

Pensions become “lost” when the provider can no longer contact you. This is often because you moved addresses and forgot to update them. But there’s also a possibility you have a pension without knowing it.

Employers are now legally required to auto-enrol you in their pension scheme once you’re 22 years old up to the State Pension age. And while they should give you the details, it’s easy to miss those communications when you’re tied up with your day-to-day job.

If you’re wondering how to track down a lost pension, the best place to start is by contacting your previous employers. It’s possible to find a lost pension with your NI number and the dates of your employment. Alternatively, the Pension Tracing Scheme is a free government service that can search for more than 200,000 pension schemes.

It can be tough to manage and keep track of multiple pensions. A SIPP lets you consolidate existing pension policies in one place and invest in a choice of risk-managed or diversified global funds. Remember, your capital is at risk if you invest because the value of your investments can go down or up.

How to create a personal pension with Plum

With Plum, creating a SIPP yourself is easy.

Regulated by the independent financial services regulator, the Financial Conduct Authority (FCA), Plum allows you to consolidate your previous pensions by transferring them all into one account.

SIPPS are offered by Plum Money. Quai Investment Services Limited ("Quai") acts as the Product Provider to the SIPP. Quai is regulated by the FCA.

Quai is required to supply important information to help you to decide whether this product is right for you. You should read this document carefully so that you understand what you are buying and keep it safe for reference.

It's easy to make additional contributions to your Plum SIPP through the app. You can do this via the Plum ‘brain’ in 3 ways:

1. One-off, contributing from your Plum Balance

2. One-off, contributing from your linked bank account

3. Regularly, by investing parts of your Plum Auto-savings

There is no minimum or maximum amount, though transfers from pension funds that are already in drawdown are not currently accepted.

We hope we’ve helped you find the right combination of pensions for you. Please remember that, as with all investing, your capital is at risk. You shouldn’t invest in or deal in any financial product unless you fully understand it and the inherent risks. If you automate and invest you should be satisfied your choices are suitable in light of your circumstances and position.

You can normally only access the money from age 55 (57 from 2028).

Take a look at our website to learn more about a Plum SIPP.

Plum Money is the trading name of Saveable Limited. Plum is not permitted to provide financial advice and this article should not be considered a replacement for a bespoke financial adviser. Visit the Money Helper site for free and impartial help.

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