The basics – What is a pension and how does it work?

 

What is a pension

It’s a tax-efficient way of saving while you work.

It gives you money to live off when you stop working.

There are three main types of pension schemes:

  • Workplace Pension – set up by an employer to help you save for your retirement. Both you and your employer pay contributions to this type of pension plan.
  • Private or Personal Pension – set up by you. You pay regular contributions into it.
  • State Pension – This is a regular payment from the government once you reach State Pension Age. Whether you are entitled to receive the full amount of state pension depends on your national insurance contributions.

Workplace Pensions schemes have two distinct types?

  • Defined Benefit (also called ‘final salary’, and sometimes ‘average salary’)
  • Defined Contribution (also called ‘money purchase’)

Defined Benefit:

  • Benefits are defined by a calculation in the scheme rules and because of this your benefit (or pension) is a known figure.
  • Your income will depend on; the size of your salary when you leave employment; how long you have worked there as a member of the pension scheme; and the schemes ‘accrual rate’.
  • Contributions are paid into a pool of assets for all members – not individual accounts.

Defined Contribution:

  • You and your employer pay into an individual personal retirement account (or a pot).
  • The amount you pay in to the pot is known when you start to pay.
  • You choose how your pot is invested, and the goal is to grow your pot of money over time. The value of your pot may go up or down depending on how your investments perform.
  • Benefits are not guaranteed and depend on the size of your pot at retirement.
  • You can use your pot in several ways when you retire (such as buying an annuity or drawdown scheme).

IMAGE CREDITS

Photo by Windows on Unsplash

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