A guide to pensions

Pensions are a way of building up and investing a pot of money that you can use to supplement your state pension in retirement.


The tax advantages of pensions make them particularly attractive for this purpose compared to other savings products.

  • Income tax relief is given on contributions. So if you pay £800 into your pension it will be boosted by £200 tax relief to make a total of £1,000.  If you are a higher-rate taxpayer you can claim extra tax relief.
  • There is no UK income or capital gains tax to pay on the returns made by the investments in your pension.
  • Usually, up to 25% of your pension can be taken free of tax, while the remainder is subject to income tax. Benefits can be accessed from the age of 55.

Any UK resident under 75 can contribute to a pension and receive tax relief. As a general rule, you can contribute as much as you earn to your pension, subject to a £40,000 annual allowance.

You don’t even need to have any earnings to contribute and receive tax relief. However, in this case, your annual contributions are limited to £3,600, of which you pay £2,880 – the rest is made up of tax relief.

There are a variety of pensions and if you change jobs during your working life, the chances are you will contribute to more than one type of pension.

Employers’ pension schemes

If you work for an employer, you will normally be expected to contribute to a workplace pension scheme. Nowadays it is compulsory for larger employers to enrol all their employees in a pension under the Government’s Auto Enrolment scheme. The scheme is being rolled out to all companies. It started with the largest in October 2012 and ends with the smallest employers in 2017.

Although it is not compulsory for employees to join their employer’s pension scheme, the advantage is that your employer will also make contributions to your pension and you will lose this money if you don’t join.

There are two main types of employer schemes, salary-related and contribution-related schemes:

Salary-related (defined benefit) schemes

These are pension schemes, typically found in the public sector and also provided by large companies in the past, where the amount of pension you get is based on your pay and your years of employment. Originally they were related to ‘final’ salary – your earnings in the last three or so years before retirement.  Nowadays, this type of scheme has become relatively rare and where they are still available, they are more likely to be based on your average salary over the period you worked for your employer.

Public sector pensions are often paid for out of taxation. Private sector schemes are investment based and the responsibility for the pension fund investments is in the hands of the pension scheme trustees.

Contribution-related (defined contribution) schemes

In recent years, many employers have introduced contribution-based pension schemes where the amount of pension you get depends on how much you and your employer contribute to your pension fund during your working life and on the returns earned on the pension investments.

With these schemes your contributions will either go into a single fund where they are pooled with other employees’ contributions or, more likely nowadays, you will own an individual policy which is part of a group scheme. If the scheme is a pooled one, then the pension fund trustees are responsible for the investments. If it is a policy-based scheme, you will be given a limited choice of investment funds but there will be a ‘default’ fund available for those who prefer not to make their own choice.

Private pensions

If you are self-employed, or you have several pensions from past employment which you would like to consolidate in one place, you will need to set up your own private pension. In the past, most people took out personal pensions with insurance companies which offered them access to a limited number of investment funds. Today the most popular type of private pension is a Self Invested Personal Pension (SIPP) where you have more freedom to choose your own investments. SIPPs are particularly attractive for consolidation purposes but are equally good if you are starting out with a modest monthly contribution.

How SIPPs work

A SIPP can be opened with a lump sum of as little as £100 and regular savings of £25, although the minimum investment requirements vary between providers. You can also transfer into a SIPP the money you have built up in other pensions. Your SIPP provider will contact your previous pension companies to arrange the transfer. A fee will be charged for each transfer.

As their name suggests, SIPPs are designed for investors who want to choose their own investments. It is possible to include most types of investments in a SIPP such as shares, investment funds, bonds and cash. Direct property investment is also allowed, but it must normally be a commercial property such as shops or offices. Not all SIPP providers allow property investment. For most people, it is enough to be able to hold funds and investment trusts in a SIPP.  These can range from low-cost trackers to actively managed, highly specialist funds.

The cost of SIPPs varies enormously. Charges can include set-up fees, annual management fees, dealing charges, income drawdown fees and (worth looking into when you first set up your SIPP) exit fees. The lowest-cost SIPPs are usually offered by consumer-oriented fund platforms.