Pensions Demystified

A pension is money you put aside now so future-you has income when you stop working. That's it. Everything else—the tax relief, the employer contributions, the investment growth—is detail that makes pensions attractive, but the core is simple: you're paying your future self.

Most people find pensions confusing because they're a promise about the far future, wrapped in tax rules and investment jargon. But strip away the complexity and it's just deferred income. You earn money now. You set some aside. It grows. You use it when you're 60-something and no longer working.

How Workplace Pensions Work

If you're employed, you're likely in a workplace pension. Your employer deducts a percentage of your salary and pays it into your pension pot. The employer also contributes—legally they must contribute at least 3% if you're contributing 5%, though many contribute more. (Check your payslip to see exactly what's being deducted—see Understanding Your Payslip for detail.)

That money gets invested. Usually in a mix of stocks, bonds, and other assets. Over decades, it grows through both continued contributions and investment returns. When you reach retirement age (currently 55, rising to 57 in 2028), you can access it.

You don't pay tax on pension contributions. If you earn £40,000 and contribute £2,000 to your pension, you only pay tax on £38,000. For a basic rate taxpayer (20%), that £2,000 contribution only costs £1,600 of take-home pay. Higher rate taxpayers (40%) see even better relief—£2,000 contribution costs them £1,200 net.

This is the government incentivising retirement saving. They're saying "We'll top up your pension contribution with tax relief because we'd rather you fund your own retirement than rely entirely on state support."

The Power of Compounding

Pensions work because of time. Money invested in your 20s has 40+ years to grow. Money invested in your 50s has maybe 10-15 years. The difference is exponential, not linear.

Here's an example that shows why starting early matters:

Person A: Contributes £200 monthly from age 25 to 35 (10 years), then stops. Total contributed: £24,000.

Person B: Contributes £200 monthly from age 35 to 65 (30 years). Total contributed: £72,000.

Assuming 5% annual growth, Person A ends up with more money despite contributing a third as much. Why? Because their money had more time to compound. Each pound they invested had 30-40 years to grow. Person B's pounds only had 1-30 years.

This isn't about being clever. It's pure mathematics. Start early, and time does most of the work. Start late, and you have to contribute far more to catch up.

What If I've Started Late?

Not having started early doesn't mean don't start now. Starting at 40 is better than starting at 50. Starting at 50 is better than not starting at all. You've lost the compounding benefit of early years, which means you need to contribute more—but you still need to do it.

If you're in your 40s or 50s and haven't built pension savings, this needs to be a priority. You might need to contribute 15-20% of salary to build adequate retirement income. That's uncomfortable, but the alternative—reaching retirement with insufficient income—is worse.

How Much Do You Need?

The rule of thumb: aim to replace 50-70% of your pre-retirement income. If you're earning £50,000 before retirement, you probably need £25,000-35,000 annually in retirement to maintain a similar lifestyle.

Why less than your working income? Because certain costs disappear. You're not commuting. Not buying work clothes. Not paying into a pension anymore. Mortgage is often paid off by retirement. But other costs might increase—healthcare, travel if you're using your time to explore.

The Pension and Lifetime Savings Association suggests three retirement standards:

Minimum: £14,400 annually for a single person. Covers essentials but not much else.

Moderate: £31,300 annually. Comfortable lifestyle with some luxuries.

Comfortable: £43,100 annually. Financial freedom and flexibility.

These assume no housing costs. If you're renting in retirement, add your rent to these numbers.

Where Does the Money Actually Go?

Your pension contributions get invested, usually in funds that hold a mix of stocks, bonds, property, and other assets. When you're young, the mix is usually more weighted to stocks (higher risk, higher potential returns). As you approach retirement, it shifts toward bonds and cash (lower risk, more stability).

You don't pick individual stocks. Your pension provider offers a selection of funds—usually a default fund that most people use, plus alternatives if you want more or less risk, or specific ethical preferences.

For most people, the default fund is fine. It's designed by professionals to be appropriate for your age and time to retirement. If you want to be more involved, you can choose different funds, but don't assume you'll do better than the default without genuine investment knowledge.

Can You Access Your Pension Early?

Currently you can access pensions from age 55 (rising to 57 in 2028). But just because you can doesn't mean you should. Taking money out early reduces what's left to grow, which means less income later when you actually need it.

When you do access your pension, you have options:

Take 25% as a tax-free lump sum: The rest stays invested and you draw income from it as needed.

Buy an annuity: Exchange your pot for guaranteed income for life. You lose flexibility but gain certainty.

Drawdown: Leave the money invested and withdraw amounts as needed. Flexible but requires managing the investments and withdrawal rate.

Most people use a combination. Take some tax-free cash, leave the rest invested in drawdown, maybe buy a small annuity for guaranteed baseline income. This is complex enough that you should talk to a financial adviser before making decisions—these choices affect your income for decades.

What About the State Pension?

The state pension currently pays about £11,500 annually (full rate) if you've made 35 years of National Insurance contributions. Less than 35 years means proportionally less. You can check your state pension forecast online through your Government Gateway account. (See National Insurance & State Pension for complete detail on building entitlement.)

Don't build your retirement plan around state pension alone. It's not enough. Treat it as a baseline that other income sits on top of. Your workplace and private pensions need to provide the bulk of your retirement income.

Multiple Pensions from Different Jobs

If you've changed jobs multiple times, you probably have several small pension pots scattered across different providers. This isn't necessarily a problem, but it makes tracking harder and you might be paying multiple sets of fees.

Consider consolidating them into one pot. This gives you a clearer picture of your total pension savings and potentially reduces fees. But check before transferring—some older pensions have valuable guarantees you'd lose by moving them. Get advice if you're unsure.

The Pension Annual Allowance

You can contribute up to £60,000 annually into pensions and get tax relief (including employer contributions). For most people, this limit is irrelevant—they're nowhere near contributing £60,000 yearly. But if you're high-earning or get a large bonus you want to put into your pension, be aware the limit exists. (For more on tax year timing and allowances, see Tax Year Timing.)

Once your income exceeds £260,000, this allowance starts reducing. At £360,000+, it drops to £10,000. This is designed to limit tax relief for very high earners.

Why People Neglect Pensions

Retirement feels impossibly far away. Your 30-year-old self struggles to care about your 70-year-old self's income. The connection feels abstract. Plus you have immediate needs—rent, bills, life right now. Retirement is future-you's problem.

Except future-you is still you. You're not saving for a stranger. You're saving for yourself, just the older version who can't work anymore. The earlier you accept this, the easier retirement becomes. Start late, and you're making life harder for your future self.

Think of pension contributions as paying future-you for work already done. You've earned this money. You're choosing to defer receiving it until you need it more. That's not sacrifice. That's sensible.