How you fund your retirement is one of the biggest financial decisions you will ever make. That makes it essential to understand some of the jargon around pensions, so you can make the most of your free time when retired. 

To help, we’ve explained some of the key terminology around pensions across two articles, starting with the situation when you’re building up your pension savings. 

In our second article, we look at the options for people coming up to retirement and what they may need to be aware of. If you have questions around retirement, it may be worth speaking to a financial adviser.

Why might I need a pension?

Everyone needs a plan on how to fund retirement if they want more than the basic standard of living from the government-provided state pension. 

A pension can be one of the best ways to plan for retirement. The government offers generous tax breaks to encourage you to set one up, recognising that you’re giving up income now in order to support yourself later on in life. 

As well as growing free from income tax, capital gains tax and dividend tax, the government will top up contributions to a pension. If you’re a basic rate taxpayer, the government will top up your pension contributions by 25%. So, for every £0.80 you put in, you’ll get £0.20 from the government. 

If you’re a higher or additional rate taxpayer, you can claim back an extra 20% or 25% back through an annual self-assessment form. 

The maximum amount you can put into all your pensions each tax year and benefit from tax relief is the lower of your gross annual earnings or the annual allowance, which is set at £60,000 for 2023-24¹. 

What are the different types of pension?

In the UK, we generally think about pensions as coming in two forms. 

First, there’s the state pension, with the government promising to pay out an income for life when you reach state retirement age. This is currently 66, but due to rise to 67 for everyone by the end of 2028.

Provided you have 35 qualifying years of national insurance contributions, the government will currently pay you £203.85 per week, as of July 2023. You usually need at least ten 10 qualifying years on your national insurance record to get any new state pension. 

Second, there are private pensions, which you and/or your employer can pay into and which offer tax breaks, as outlined above. 

You can either have a private pension which your employer sets up for you (a workplace pension) or you can set up one yourself. A workplace pension can be one of two types: 

1. Defined benefit (DB) – where you receive a certain benefit for life once you retire. This is a guaranteed annual income, which may rise over time to help take inflation² into account. The certainty of an annual income for life should not be taken for granted, though, unlike with defined contribution schemes, you cannot generally pass on a DB scheme after death. 

While DB schemes are much rarer now, you may have one if you work in the public sector or have an older private-sector scheme. If in doubt, check with your pension provider or speak to a financial adviser.

2. Defined contribution (DC) – where how much you have at retirement depends on how much you put in and how well your investments perform. Most pensions which people contribute to are of this variety. 

Importantly, workplace pensions can come with additional benefits to help you save for retirement. It’s worth investigating whether your employer offers to match your contributions, as these can make a big difference to the final size of your pot. Take a look at our recent ‘Take control of your finances’ article to see just how big that difference can be.

What is auto-enrolment?

You will probably hear a lot about auto-enrolment. By law, your employer has to enrol you into a pension if you earn more than £10,000 a year. 8% of the value of your salary between £6,240 and £50,270 has to be paid in – comprising 3% from your employer, 4% from you and 1% tax relief from the government³. 

You should check whether you’re saving enough for the kind of retirement you want. 

What if I don’t have a workplace scheme?

If you don’t benefit from a workplace scheme or you don’t think you’re saving enough for retirement, this is where a self-invested personal pension (SIPP) might be able to help. A SIPP is a type of DC pension you set up and manage yourself. 

A SIPP is an example of a private pension, but there are a number of other options, including stakeholder pensions . These come with a default investment option and low minimum contributions. There is also a legal limit on charges though these can still be comparatively high. So, if you have a stakeholder pension and are comfortable managing your retirement finances, it may be worth exploring whether you can save money by transferring to a SIPP such as the Vanguard Personal Pension. If in doubt, speak to a financial adviser.  

What else should I consider when saving for retirement?

The cost of a DC scheme is an important factor, because the lower your costs, the more of your returns you hold onto. 

Imagine you have a pension worth £100,000, for example, with 25 years left until you retire. If you save 0.5% in investment costs each year, you end up with a pension that is almost £43,000 larger, assuming you don’t make any more contributions and your investments grow at 5.5% per annum. 

And what about as I move towards retirement?

As you get older, the term lifestyling might also crop up. This refers to an investment strategy that gradually moves your pension investments from shares, which have historically provided higher returns but are higher risk, into typically lower-risk, lower-returning bonds. 

Lifestyling is sometimes also called de-risking. Many investment managers offer target retirement or target date funds, which automatically de-risk your investment portfolio as you get closer to retirement. 

These funds will often have a year in their name. All you need to do is pick the fund closest to the year when you want to retire. For example, if you want to retire in 2055 or within 5 years after that, you could choose the Vanguard Target Retirement 2055 Fund. For more information, visit our Target Retirement funds webpage. 

Finally, it’s worth highlighting Pension Wise, the government-backed service that provides free, impartial guidance to the over-50s. Everyone 50 or over with a defined contribution pension is entitled to an appointment to discuss their retirement options.

We go through the terms you’re likely to encounter when thinking about how exactly to fund retirement in our next article. 

¹ Prior to 6 April 2023, you also had to pay a higher tax rate (the lifetime allowance charge) when withdrawing money from your pension if it exceeded the lifetime allowance (£1,073,100 for 2023-24). While the lifetime allowance still exists, the government abolished the lifetime allowance charge. 

² Inflation is the rise in cost of goods and services and resultant fall, over time, in the purchasing power of your money.

³ While you can opt out and choose not to make any contributions, that means you’ll miss out on the employer contribution and tax relief. You’d effectively be giving up free money. As at April 2021, 22.6 million people were enrolled in workplace pension schemes, according to the Office for National Statistics.