There are three main types of pension schemes – state, workplace and personal pensions. We take a look at how they work and what the differences are.
All pension schemes work in a fundamentally similar way. They’re long-term savings plans that aim to provide you with a suitable source of income when you retire.
But they all have different ways of getting you to your ultimate goal: having enough money to live off when you retire.
The state pension
The state pension is a regular payment from the government that you receive when you retire. In order to get it, you must meet the following criteria:
You’ve reached state pension age. At the moment, this is 65 years old for men and 63 years and 9 months old for women. However, the government plans to raise the age to 66 by 2020, to 67 by 2028 and to 68 years old by 2039.
You’ve paid National Insurance (NI) contributions for at least 10 years. You’ll also qualify if you weren’t paying NI but you received National Insurance credits.
How does it work?
In order to get your state pension, you have to claim it.
You should receive a letter with instructions on how to do this about four months before you reach retirement age. You can also file your claim online, by phone or by downloading and completing a claim form.
You should receive your first payment within 5 weeks of your birthday. Payments are made into a bank account of your choice every four weeks, for the rest of your life.
What do you get?
The size of your state pension depends on how many NI contributions you’ve made during your working life. You’ll need at least 10 years’ worth of contributions to qualify. However, the more you’ve contributed over the years, the larger your state pension will be. To get the maximum amount, you’ll need 35 years’ worth of contributions.
The maximum amount you can receive is currently £159.55 a week (£8,296.60 a year). For a lot of people, this won’t be enough to continue their current standard of living. That’s why it’s important to save for your retirement in other ways if you can.
Workplace pension schemes
A workplace pension scheme is a retirement savings plan arranged by your employer. This is in addition to your state pension.
How do they work?
By law, all employers in the UK have until 2018 to automatically enrol employees into a scheme.
To be eligible for a workplace pension, you must work in the UK, earn more than £10,000 a year and be between 22 and the state pension age.
Your employer doesn’t have to enrol you if you earn less than £10,000. However, you can ask to be enrolled if you earn at least £5,876.
Workplace pension schemes can take one of two forms:
- Defined benefit schemes
Also known as final salary schemes, these are usually taken care of entirely by your employer. These don't require you to contribute to the scheme. Instead, your employer will pay you a pension when you retire based on your salary and how long you’ve been employed with the company.
These types of schemes are getting more and more expensive for employers so they’re becoming rarer outside of the public sector.
- Defined contribution schemes
These are the most common types of workplace pension plans. Your retirement fund is built up from your own (regular) contributions and contributions from your employer (if you’re an eligible employee). The contributions are then invested, usually in stocks and shares, by people working for the pension scheme company. The aim is to grow your contributions enough to give you a suitable income when you retire.
When do I start receiving my workplace pension?
You can usually start getting your workplace pension at age 55 - ten years earlier than the current state pension age.
Check out our guide to workplace pensions for an in-depth look at how they work.
What do I get?
If your workplace pension is a defined benefit scheme, what you’ll get will depend on how long you’ve been in your employer’s service, the size of your salary and the scheme's 'accrual rate' (a percentage of your final salary that's set by the scheme)
If your workplace pension is a defined contribution scheme, what you get will depend on how much you and your employer contributed to the scheme, and how well the scheme’s investments did over time.
Here’s our in-depth guide on the ins and outs of workplace pensions.
Personal pension schemes
A personal pension scheme is a retirement savings plan which you arrange yourself. Anyone can start one, but it’s an especially good idea if you’re self-employed or ineligible for a workplace pension.
How do they work?
Personal pension schemes tend to either be defined contribution schemes or self-invested personal pensions (SIPPs).
Defined contribution schemes usually have pre-selected funds and employ professionals to oversee your investments. With SIPPs you’re in control.
You get a wider choice of investments and you have the potential to earn higher returns.
But they can be much riskier and more time consuming to manage. If you don’t have much experience with investing this might not be the route for you.
When can I start receiving my personal pension?
Just like a workplace pension scheme, you can take out your personal pension from your 55th birthday.
How much will I get?
Your retirement pot will depend on three factors:
- how long you’ve contributed
- how much you’ve contributed
- how well the scheme’s investments have done
Some defined contribution schemes have a minimum amount you must contribute each month. But if you only pay the minimum, you may not save enough to comfortably live off when you retire.
A rough rule of thumb is to save a percentage of your income equal to half your age. So, if you start saving when you're 24 you could put aside 12% of your income each year until you retire. If you start saving when you’re 40, then it would be 20% of your income each year.
Here’s a more in-depth look at personal pension schemes.
How do I take the money from my pension pot when I retire?
There are a few different options for accessing the money from your personal or workplace pension once you retire:
1. Use your pension pot to buy an annuity
One option when you want to retire is to buy an ‘annuity’. This is a type of insurance product that lets you convert your pension savings into a regular income for the rest of your life.
If you go for this option, the amount you get will depend on the size of your pension pot and the annuity rate you’re given. For example, if you have £50,000 saved up and get offered a rate of 5%, you'd receive £2,500 a year.
You can find out more about how to pick the right annuity for you here.
2. Enter income drawdown
With most pension plans, the money you save gets invested in order to help it grow further. With this option, your pension pot continues to get invested, but you can take out - or draw down – an income for your retirement.
This can be a more flexible option because you can decide the income you want each year. Although this obviously depends on how much you’re investing and how well your investments are doing. But, because your funds continue to be invested, it can be riskier and doesn’t offer you a guaranteed income.
You can read more about the different types of income drawdown here
3. Take out your pension in lump sums
This option lets you leave your money in your pension fund and take money out as and when you need it. 25% of each withdrawal you make will be tax free, and you’ll be charged tax on the rest.
4. Take out your whole pension in one go
You also have the option to take out your entire pension in one go. You can take out up to 25% of it tax-free. However, you’ll need to pay tax on the rest if you do this.
You can take out your pension using a combination of these different methods. So you could withdraw 25% of your pot tax-free and then purchase an annuity, or enter income drawdown using the rest of your savings.