What is a pension and how do pensions work?

A pocket guide to pensions. What are they and how do they work?
What is a pension and how do pensions work?
Updated
November 30, 2021

Table of contents

Let's start at the beginning...with a definition

Pension plan, pension pot, pension scheme. The list of alter egos goes on. 

The good news is, what you really need to know about pensions is actually quite simple. 

A pension is an investment account designed to help you save and invest for retirement. 

Before diving in it’s important to know that pension and tax rules can change and depend on your personal circumstances. So before making any decisions, check how anything mentioned below will apply to you. Before you invest you also need to be comfortable that the value of your portfolio can go down as well as up and you may get back less than you invest.

Pension basics

‘Pension meaning’ is one of the most Googled questions out there. 

So we’ll start there. 

Here are a few simple things to help break down the pension basics:

  • The aim is to build a  pot of retirement savings you can live off later on in life
  • The government tops up your contributions through tax relief
  • The earlier you start investing even small sums regularly the longer your investments will have to grow
  • In a pension your investments grow free from UK tax

How do pensions work? 

There are a few types of pension in the UK: workplace pensions, personal pensions and the State Pension. You’ll likely have all of them over your life but how they work, what you get and when you get it, differs slightly. 

Types of pension

Here’s a brief summary of the main types of pensions. For each type we break it down to how it works, what you get and when you get it. 

Workplace pension 

Workplace pensions are set up by your employer. 

And while a workplace pension was once seen as work perk, since 2012 UK employers have legally been required to enrol you into a workplace pension scheme.  And that’s the rule whether you work full or part-time. 

This means that each new job likely brings with it a new pension. So it’s more than likely you’ve already got a few pensions knocking around.

Check our top tips on finding old pensions

Personal pension

A personal pension is a pension that you set up and contribute to yourself. 

The big thing to know about a personal pension is that you can have one in addition to a workplace and your state pension. 

Why have a personal pension?

  • To save more and supplement a workplace or state pension 
  • To save for retirement if you are self-employed 

There are a few types of personal pension and one of the options is a self-invested personal pension or SIPP.

Why have a SIPP?

  • To make your own investment decisions 
  • To combine old pensions and keep pensions under one roof
  • To see exactly how your pension pot is performing 

State Pension

The State Pension is provided by the UK government and kicks in later in life. 

How much you get and when you are allowed to get it (i.e. State Pension Age), is defined by the government. 

What age do you get the State Pension in the UK?

This is an expensive game for the government, so the state pension age has been creeping later and later. It’s currently 66 but that’s set to rise to 67 by 2028 and to 68 by 2039). 

How much is the new State Pension?

The amount of state pension you get depends on a few things like personal income and circumstance but one of the main determinants is your history of paying national insurance.

To be entitled to the new state pension you’ll need at least 10 qualifying years on your National Insurance record. This means 10 years in which one or more of the following applies: 

  • You were working and paid National Insurance contributions
  • You were getting National Insurance credits if you were unemployed, ill or a parent or carer
  • You were paying voluntary National Insurance contributions‍

Things to think about

We’re all going to have to fend for ourselves a lot more in retirement and the earlier we prepare for this, the better. Take a look at our latest guide to investing in your 30s

Why pay into a pension? 

Pensions have a few benefits to boast about:

  • Aim for a comfortable retirement 
  • Tax-efficient investing 

Aim for a comfortable retirement 

Having enough money in later life is not guaranteed by the state or even a workplace pension. So making sure you are paying enough into a workplace and a personal pension is an important step in saving enough for retirement.

Tax-efficient investing 

The main benefits of personal pensions and workplace pensions are the tax benefits. 

Firstly, there’s tax relief. 

Tax relief is the government’s way of topping up or adding to your pension contribution, to encourage us all to save more into a pension. 

There are different limits around this in terms of how much money you can add and how much money the government will add. But for most of us, the government will add at least 20% in tax relief. 

For example, if you pay £80 into a pension, the government will add an extra £20 to the pot, making your total pension contribution £100. 

Basic tax relief example.
Find out more about tax relief in our guide SIPPs explained.  

Secondly, pensions are a tax wrapper. 

This means inside a pension, your investments grow free from UK tax. So that’s dividends free from dividend income tax and investment gains free from capital gains tax. 

Find out more about how your investments are taxed

Pension FAQs

Is it ever too late to start a pension?

It’s never too late to start a pension (unless you decide to start after 75 years old, then it is too late). 

But the later you leave it to start a pension, the higher the risk is of not having enough to live on later in life.

Making regular and consistent contributions over your lifetime can be the key to a comfortable retirement. The sooner you start, the more time you give your investments to grow and for compound interest to work its magic. 

The question you need to keep in mind is how much will you need to retire? Whether you're starting a pension in your 20s and 30s or you need guidance for starting a pension in your 40s and 50s our guides offer clear and jargon-free guidance.

Can I manage my own pension?

Yes, you can. 

Personal pensions are designed for you to manage. You control what you invest in and how much. SIPPs are a type of personal pension that give you the most control. 

With workplace pensions, you often have more control than you think. 

While your employer will set the workplace pension up, you might be able to increase your contributions if you’d like to and you should be able to choose what your pension is invested in. 

To find more about both of these a good place is your employer or pension provider directly. 

What is a pension fund? And is it different from a pension plan? 

A pension fund tends to mean what your pension is invested in. Remember, the pension is just the outer wrapping, the actual fund might refer to a readymade basket of stocks you can put in that wrapper.

While lots of pensions like the state or workplace pensions are still invested in funds, with personal pensions like SIPPs the investment opportunities are much broader. You can invest in stocks, ETFs, REITs, fractional shares and more.

A pension scheme or pension plan is the type of savings and investment plan you have set up. So it really refers to the type of account rather than what the money is invested in.


Learn more about the Freetrade Pension

Take control of your retirement savings with a Freetrade SIPP (self-invested personal pension).  Start a SIPP today and contribute regularly or transfer old pensions to one single pot you can grow and manage yourself. 


Important information on SIPPs

SIPPs are a pension product designed for people who want to make their own investment decisions. You can normally only access the money from age 55 (set to rise to 57 from 6 April 2028).

This article is based on current rules, which can change, and tax relief depends on your personal circumstances. When you invest, your capital is at risk.

The value of your portfolio can go down as well as up and you may get back less than you invest.

Before transferring a pension you should ensure you will not lose valuable guarantees or incur excessive transfer penalties. Pensions are usually transferred as cash so you will be out of the market for a period.

Freetrade does not currently offer drawdown products for our SIPP.

Important information

This should not be read as personal investment advice and individual investors should make their own decisions or seek independent advice.

When you invest, your capital is at risk. The value of your portfolio can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future results.

Eligibility to invest into an ISA and the value of tax savings depends on personal circumstances and all tax rules may change.

Freetrade is a trading name of Freetrade Limited, which is a member firm of the London Stock Exchange and is authorised and regulated by the Financial Conduct Authority. Registered in England and Wales (no. 09797821).

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