What is a pension, really? How does it grow? What happens to it when you die? These are the questions Jack gets asked constantly — and the answers are far simpler than the industry makes them sound.
Pensions are one of those subjects that should be simple and have somehow ended up surrounded by impenetrable language. Defined benefit, defined contribution, drawdown, crystallisation, annual allowance — the terminology alone is enough to make most people switch off.
That switching off is costly. A pension is likely to be one of the most significant financial assets you will ever have — and most people go through their entire working life with only a vague sense of how it actually works. This article is an attempt to fix that.
At its most basic, a pension is a tax-advantaged savings account that you cannot access until you reach a certain age (currently 57, rising to 57 in 2028, and linked to the state pension age in future). The money you put in gets tax relief — meaning the government tops up your contributions at your marginal rate of income tax. If you are a basic rate taxpayer, every £80 you contribute becomes £100 inside your pension. If you are a higher rate taxpayer, that £80 can become £100 with additional relief claimed through your tax return.
Inside the pension, your money is invested. It grows — or can shrink — depending on how it is invested and what the markets do. You do not pay income tax or capital gains tax on the growth while it is inside the pension wrapper. This sheltering effect, over many decades, makes pensions a uniquely powerful savings vehicle.
When you come to access your pension, usually in retirement, you can take 25% of it as a tax-free lump sum (up to a limit). The rest is taxed as income when you draw it — but by that point, many people are in a lower tax bracket than during their working years.
You may have heard of final salary pensions. These are a type of defined benefit (DB) pension, and they work differently from most modern pensions. With a defined benefit scheme, your employer promises to pay you a pension in retirement based on your salary and length of service. The risk of the investment sits with the employer, not with you. These schemes are increasingly rare in the private sector, though still common in public sector employment.
Most people today have a defined contribution (DC) pension — a pot of money that you and your employer contribute to, which is then invested on your behalf. What you get in retirement depends on how much went in, how the investments performed, and when you decide to access it. The investment risk is yours. This is more flexible, but also more complex — and requires more active engagement from you.
Inside a defined contribution pension, your contributions are invested in funds. Most workplace pensions put you in a default fund automatically, which is often a “lifestyling” fund that gradually reduces risk as you approach retirement.
To be honest, default funds are not always the best choice for everyone. They are designed to be appropriate for a broad range of people, which means they are not specifically designed for you. If you have decades until retirement, you may well be better served by a fund with more growth potential. If you are closer to retirement, you may need something more cautious. This is where advice adds real value — not picking funds speculatively, but aligning your pension strategy with your actual retirement timeline and objectives.
The contribution level matters enormously. The minimum under auto-enrolment is currently 8% of qualifying earnings (3% from your employer, 5% from you). That is a floor, not a target. Most people who run the numbers discover they need to be contributing significantly more than the minimum to retire comfortably — particularly if they started contributing late.
This is the question I get asked most often, and it has a surprisingly good answer: defined contribution pensions sit outside your estate for inheritance tax purposes. This means they do not automatically attract the 40% inheritance tax charge that applies to other assets above the threshold.
If you die before you have accessed your pension, the full pot can typically be passed on to your nominated beneficiaries free of inheritance tax. If you die before 75, your beneficiaries can usually receive it free of income tax too. If you die after 75, they pay income tax on withdrawals at their marginal rate — but they inherit the full pot, and can draw it down as they wish.
The key word in all of this is “nominated.” To pass your pension on in this way, you need to have completed an expression of wishes with your pension provider, nominating the people you want to receive it. It does not go through your will automatically. Many people have never done this — or have an out-of-date nomination that still names an ex-partner.
If you have had several jobs over the years, you probably have several old pension pots sitting with providers you have half-forgotten. This is extremely common. The government's own research suggests there are billions of pounds in lost or unclaimed pension pots across the UK.
Consolidating old pensions is not always the right answer — sometimes an old scheme has valuable benefits worth keeping. But tracking them down and understanding what you have is always the right starting point. If you have old pensions and are not sure where they are, the government's free Pension Tracing Service is a good place to begin.
A pension review is one of the most valuable things you can do. Jack can help you understand what you have, whether it is working as hard as it should be, and what you might need to do differently.