What is the definition of a pension and how does it work?

 Pensions are a source of income in later life, usually, after you've left the workforce. There are various sorts of pensions, each of which works in a somewhat different way. You can also get a pension from a variety of sources.

This article describes each type of pension and how it works so you can make more informed pension decisions - whether you're approaching retirement or just starting out in your career.

What are the many types of pension plans?

Pensions are available from three separate sources: the government, previous employers, and personal pensions (i.e. products you set up yourself). Here's a basic rundown of each type of pension.

Pension from the state

Once a citizen reaches a particular age, the UK government gives a state pension to all qualified individuals. For most people, this age is currently 65, although it is expected to rise in the future. You don't 'build up' a pot of money because the pension is paid with current taxes. To be eligible for it, however, you must accumulate 'qualifying years,' which are normally achieved by making National Insurance (NI) contributions from your earnings.

Payments on your state pension are guaranteed for the remainder of your life once you begin receiving them. In the tax year 2019/20, the maximum state pension is £168.60 per week. To learn more about the state pension, go here.

Pensions at work

Employees must be enrolled in a pension plan by their employers. Your employer and you both contribute to the plan, and the government matches your contributions with tax breaks (see below). You can freely opt-out of a workplace pension plan, but no one can force you to do so.

There are two types of workplace pensions:

  • Contribution with a defined amount (also known as a money buy')
  • Defined benefit (also known as 'final salary' or 'average salary') is a type of compensation that is set by the employer.

Defined contribution pensions are by far the most popular these days, however, defined benefit pensions remain popular in the public sector. You may learn more about each type by reading the descriptions below.

Find out if you can cash in a pension from a prior employer if you don't contribute to it any longer.

Pensions for individuals

If you're self-employed, for example, you can set up your own personal pension plan. Personal pensions come in a variety of shapes and sizes, but they have always defined contribution ('money purchase') plans.

A personal pension is comparable to a defined contribution employment pension, however, there are some major differences:

  • You don't get any contributions from your company (obviously!).
  • You can take 'contribution holidays,' when you don't pay towards your pension for a period of time.
  • If you have a SIPP, you can choose the assets in which your pension is invested (self-invested personal pension).

Just like with a working pension, you get tax savings on your contributions from the government. To learn more about personal pensions, go here.

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