What is a pension and how does it work?

Your pension is vital to your financial wellbeing during your retirement years. But learning about how pensions work, what their benefits are, and what choices you’ll have can be overwhelming. Which is why we’ve put together this guide.

What is a pension?

A pension is a tax-efficient way of investing money during your working life, which you can then use for an income in later life. The money you invest will accumulate and potentially grow in value over time.¹

When your income is over a certain level, the government applies tax to your earnings. If you put money into a pension scheme, it qualifies for tax relief. This means that in addition to the money you’re putting in, some of your money that would have gone to the government as tax now goes into your pension pot instead.

This is why pensions are particularly tax-efficient, and it's one of the key advantages of a pension over other savings accounts.

Additionally, if you’re auto-enrolled into a pension scheme by your employer, they’ll also contribute a minimum of 3% of your earnings to your pension.

When you retire, you can use your pension savings in several ways. You’ll be able to:


Take your pot as a lump sum, or as a series of lump sums. This may not be as tax efficient as other options.	Put your pot, or a part of it, into pension drawdown, which allows you to take an income and/or lump sums when you need.	Use your pot, or part of it, to purchase an annuity, which provides you a guaranteed income for life.

You needn’t stick to just one of these, as you can use portions of your savings for each. We discuss this in more detail below.

When can I access my pension savings?

Under normal circumstances, you can access your private pension at 55 (this will change to 57 from April 2028). However, this is a minimum age, and you may not want to take your income until later in life, for example when you stop working.

A pension scheme is designed to give you an income alongside the State Pension, which is provided by the Government. Most people can start claiming a State Pension at 66, but this is slowly changing to 67 and 68 for those born after 5 April 1960. You can check your State Pension age here.

State Pension versus private pension

State Pension

The State Pension is a regular payment, normally paid every 4 weeks from the Government to qualifying UK citizens, based on the number of years you’ve paid National Insurance (NI).

To qualify for the full State Pension, you’ll need to have paid NI on your earnings for 35 years. If you’ve paid NI for 10 years or more, you may be eligible for a partial State Pension. For the 2024/25 tax year, the full State Pension is £221.20 per week.

Most experts advise that you shouldn’t rely solely on the State Pension, and that to enjoy your retirement more fully, you’d want to save as much as you can into a private pension.

Many people aren’t saving enough to give them the standard of living they hope for when they retire. If this is the case, you may need to start saving more, lower your expectation of what you’ll be able to afford in retirement, or keep working later in life.

Private pension

All pensions outside of the State Pension are known as private pensions. You may have a private pension through your employer or directly with a pension provider like Canada Life. There are lots of types of private pensions, and it’s best to set aside time to understand how it all works. This is important as each decision you make can have long-lasting effects.

Private pensions can be divided into two basic types of saving:


1. Defined benefit pension schemes	2. Defined contribution pension schemes

Comparing defined benefit with defined contribution

Defined benefit

Defined benefit pensions, also known as final salary schemes, pay out a guaranteed income for life.

The basic idea is that your employer will pay you a portion of your salary throughout your retirement based on how long you worked for that employer.

This may increase each year to account for the effect of rising prices. Nowadays, these are quite rare and are usually only available if you work in the public sector, although some people may have one if they worked for a large company in the past.

The amount of income from a defined benefit scheme will primarily depend on your salary, how long you spent with your employer, and how much they have said they will pay you (e.g., 1/60th of your salary for each year).

They are often referred to as DB schemes.

Defined contribution

Here, you contribute a portion of your income to build up a pot of money that you can use for an income in retirement.

The income you might get from a defined contribution scheme depends on a number of factors, including:

How much you pay in, alongside any payment your employer makes
How well your investments perform
The choices you make when you access your money

Pension contributions into the scheme can come from you, a third party, and/or your employer.

You’ll get pension tax relief from the government on the amount you pay in, but there are limits to this

There are different types of defined contribution schemes:

1. Workplace pension

If you are employed and earn more than £10,000 a year, your employer is required to auto-enrol you into a pension scheme. However, you can opt-out if you wish, although if you do so your employer will re-enrol you every three years.

They’re obligated to contribute a minimum of 3% of your earnings to your pension, and you need to pay a minimum of 4%. An additional 1% will come from the government in the form of pension tax relief.

You can choose to pay more, and your employer will often match your additional contributions, up to certain levels. Some employers are willing to redirect this into a personal pension scheme of your choice.

2. Personal pension and self-invested personal pension (SIPP)

If you’re self-employed or have unpredictable income, a personal pension gives you flexibility to contribute regularly or add lump sums on an ad-hoc basis. You’ll open a personal pension with a provider, who’ll administer the pension on your behalf.

It’s very common for personal pensions to be self-invested personal pensions (or SIPPs). As you get to choose where to put your money with a SIPP, it’ll give you greater control over how your savings are invested. However, this could also increase your risk if you’re not experienced in making important investment decisions.

3. Stakeholder pension

This is another type of personal pension with low minimum investment amounts and a cap on its fees.

Learn more about the different types of pensions.

Why save into a pension?

Up to certain limits, any money that you save into a pension scheme qualifies for tax relief. This means that in addition to the money you’re putting in, some of your money that would have gone to the government as tax now goes into your pension pot instead. This makes pensions particularly tax-efficient, and it’s a key advantage they enjoy over other savings accounts.

What are the benefits of pension tax relief?

Simply, tax relief on your pension contributions allows you to invest more money into your pension. To illustrate how much of an effect this can have, compare saving £250 per month over 25 years without tax relief to the same contribution, but with tax relief added.

	Without tax relief	With tax relief
Your monthly contribution	£250	£250
Tax relief at 20%	£0	£62.50
Monthly total	£250	£312.50
Total invested into your pension over 25 years	£75,000	£93,750
Potential pot value after 25 years**	£128,960	£161,200

**Potential pension investment growth over 25 years, at an assumed average annualised return of 4%

Please bear in mind that because investments can fall as well as rise, the future value of your pension can never be guaranteed, and the above comparison isn’t based on any product.

Another advantage is that when you start accessing your pension, you can take up to 25% of your pot tax free.

Find out more about tax relief.

How are pensions invested?

It’s important to know that whereas people often speak of pension ‘savings’, pensions are actually invested, which has several implications.

Typically, pension funds invest in assets like company stocks, bonds, and property, as well as cash.

Stock

Stocks (often called equities) represent a share of ownership in a company. If a company does well, the value of its shares can rise, too. Additionally, companies may pay a part of their profit to shareholders in the form of a ‘dividend’. This can be reinvested within a pension plan.

Bonds

Bonds are a type of loan made by investors to companies and governments. UK government bonds are called ‘gilts’, and company bonds are called ‘corporate bonds’. These may grow (or fall in value) but also pay an income known as a ‘yield’.

Property

Pension funds can either invest in physical property or buy shares in property funds. Property earns rent, and the physical assets can increase in value, too.

With equities, bonds, and property, investments can fall in value as well as rise, which means the value of your pension pot can fluctuate over time. Cash savings have lower risk, but won’t have the opportunity to grow as much.

When saving, people often invest in cash. These savings won’t fall in value – although inflation can mean the buying power reduces.

If your savings deposit doesn’t keep up with inflation, you’ll actually lose money in ‘real’ terms. This is because your purchasing power will have decreased. Put another way, £100 would have bought you more ten years ago than it’d buy today.

Your pension options at retirement

You can take your entire pension savings pot as a lump sum or as a series of lump sums when you reach retirement age.

As a pension benefit, HM Revenue and Customs (HMRC) allows you to access up to 25% of your pot tax free, although this amount is limited to a lifetime total of £268,275.

If you take a lump sum of £100,000, for example, you don’t need to pay tax on up to £25,000. The balance, however, is subject to Income Tax. This means that, in this example, the remaining £75,000 will be added to any other income for the year and taxed at your marginal tax rate.

This is called an Uncrystallised Funds Pension Lump Sum (or UFPLS, pronounced ‘uf-plus’).

The name is intimidating, but the basic idea is quite straightforward. Your pension savings are ‘uncrystallised’ until you decide to either take a lump sum, buy an annuity, or enter into drawdown (see below). The portion of your savings you use for these becomes ‘crystallised’.

You can keep taking lump sums until your savings are depleted. But, because an UFPLS can result in you paying significant tax, another option to consider is pension drawdown, which is more flexible.
Pension drawdown is a way to draw an income from your pension fund while still leaving your pot invested. You’re given the flexibility to choose when, and how much, to withdraw.

Additionally, because HM Revenue and Customs allows you to access up to 25% of your pension savings tax free (up to a limit of £268,275), you can take a tax-free lump sum from your pension savings when you move money into drawdown.

The tax-free lump sum you’re entitled to is known as a Pension Commencement Lump Sum (PCLS) – otherwise referred to as ‘tax-free cash’.

An important advantage of pension drawdown is that you can access this tax-free cash while avoiding withdrawing taxable income at the same time. We’ll use an example to explain this:

Let’s assume that your savings pot is £100,000. You could take £25,000 as a tax-free lump sum when you put the other £75,000 into drawdown. You’d then draw on this £75,000 at a later date, either regularly or when needed. These later withdrawals are treated as income and taxed at your marginal rate.
A lifetime annuity is a regular income that you purchase using your pension savings. For example, you might elect to use your pension savings (or a part of it) to buy a monthly income from a provider like us. These annuity payments will last for life and are guaranteed.

Income payments can be paid to you monthly, quarterly, half- yearly or yearly.

To help cope with inflation, you can choose to increase your initial income by a set amount on an annual basis, or have it vary in line with the Retail Price Index. If you choose this, the starting income will be lower compared to an annuity which doesn’t increase.

Your annuity income would depend on your pension savings, your age, and the annuity rates at the time, any attaching death benefits you choose, as well as your health and lifestyle.

A lifetime annuity can also be used to provide an income for your chosen beneficiaries, like a spouse or partner. If you include death benefits, an income or lump sum can be passed on to loved ones when you die.

Once you’ve set up your policy, you can’t normally revise or cancel it, so we recommend that you seek professional advice before you apply.

As you can access up to 25% of your pension savings tax free – up to a limit of £268,275 – you can take a tax-free lump sum from your pot when you purchase an annuity. This is known as a Pension Commencement Lump Sum (PCLS) and is sometimes referred to as ‘tax-free cash’.

What happens to my pension savings when I die?

This depends on what you have chosen to do with your pension savings and at what age you pass away.

If you’re invested in a private defined contribution pension and pass away before age 75, your savings will be paid to your chosen beneficiary who will (usually) pay no income or Inheritance Tax. Normally, schemes allow people to take the money as a lump sum, or retain it within the tax- efficient pension scheme to invest and take an income or lump sums when needed.

If you pass after age 75, your pension savings will be paid to your beneficiary; but they will pay Income Tax at their marginal rate if they decide to access those benefits. Alternatively, they can decide to keep the money in the pension wrapper – and pay no Income Tax until it is withdrawn. Inheritance Tax won’t normally apply.
When you buy an annuity, you’re given different options for what happens to your money when you die.

For example, you might choose to guarantee that income continues to be paid to your beneficiary if you die within 10 years of starting the annuity, or you might choose to pay your spouse 50% of the income when you die.

If you don’t select any of the available ‘death benefit’ options, your income payments will stop when you die, and any remaining savings will be lost. So, it is very important to consider how you want to support your family should you die.

Learn more about annuity death benefits.