How do pensions work?

This content was reviewed and approved by Tamlin Russell.

The information on this page should not be considered as financial advice. If you are unsure what’s right for you, please make sure you speak to a financial adviser.

A pension allows you to save for retirement in a tax-efficient way. But with so many different types and features, understanding pensions can be complicated.

In this guide, we’ll walk you through the world of pensions and highlight the benefits of paying into one. In most cases, the earlier you start saving into a pension, the more retirement income you could have to enjoy life.

How do pensions work and what are the different types?

There are three main types of pensions: Workplace pensions, State Pensions, and personal pensions/self-invested personal pensions (SIPPs).

You can access your pension savings from the age of 55 (rising to 57 from 6 April 2028) and take money as a lump sum, regular income, or a combination of the two. But you must remember that, like any investment plan, the value of your pension could fall as well as rise and is not guaranteed. If you’re unsure about your options, you could seek further information from a qualified retirement and pension adviser. Alternatively, Pension Wise is a government service from MoneyHelper that offers free, impartial pensions guidance about your defined contribution pension options. 

More about the three main pension types:

Workplace pensions

A workplace pension scheme is set up automatically for you by your employer, known as auto-enrolment. Typically, you’ll pay a minimum of 5% of your annual salary into a workplace pension, and your employer also puts in a minimum of 3% to boost your pot.

There is no limit on the amount of pension contributions you or your employer can make to a registered pension scheme. But this can have a direct impact on your retirement income and tax liability.

The two types of workplace pensions are:

• Defined contribution schemes: Both you and your employer pay into your pension. Your contributions are usually deducted from your salary before it’s taxed. The amount you get on retirement depends on how much money you pay in and how much your pension pot has grown.

• Defined benefit / final salary schemes: You receive a retirement income from your employer based on your final salary and length of employment. It provides a fixed sum of money and a guaranteed income for the rest of your life.

To join a workplace pension and qualify for employer contributions, you must meet the following conditions:

• You’re classed as a ‘worker’ as defined by the UK government.
  

• You’re aged between 22 years and State Pension age.
  

• You earn a minimum of £10,000 per year.
  

• The UK is your usual place of work.

State Pensions

The State Pension is a regular payment from the UK government. Most people can claim it when they reach the State Pension age which is currently 66 for both men and women, rising to 67 by 6 May 2026.

The amount of State Pension you’re entitled to can vary depending on your National Insurance (NI) record and the contributions you’ve made during your working life. You’ll need to have paid at least 10 years of NI contributions to qualify for the State Pension, or 35 years of contributions to receive the full weekly amount.

For many people, the State Pension is only a part of their retirement plans that may also include a workplace pension plus other savings and investments.

Personal pensions / self-invested personal pensions (SIPPs)

Personal pensions and SIPPs are set up by you. You select a pension provider and set the amount of contributions to make, and how often. Many schemes also allow you to boost your pot with additional contributions along the way.

Any personal contributions you make will likely benefit from tax relief. Personal pension schemes may include one or more investment options that suit your retirement income needs. This gives you more flexibility, choice of assets, and control over your pension and where your investments are spent.

How do pensions work and what is the process?

We’ve broken down the process of saving for retirement into four simple steps to help you understand exactly how pensions work.

1. Pay into your pension

Contributions to a workplace pension are automatically taken from your salary by your employers before any tax is deducted. This happens with each payday, however frequent.

If you have a personal pension or SIPP, you can make regular monthly payments or pay in as and when you choose in line with your financial goals.

2. Benefit from tax relief

Any money you receive is often subject to Income Tax. Putting that money into a pension scheme means the tax you’d normally pay is usually added to your pension instead. HMRC tops up your qualifying pension contributions at the basic rate of tax.

This form of pension tax relief will typically boost your savings by 20% or more depending on your Income Tax rate. Taxpayers who qualify for a higher or additional rate could get extra tax relief via the self-assessment process.

3. Invest your pension savings

Your investment options depend on the type of pension you have and what your provider offers. Your provider buys investments on your behalf to grow your pension pot. Pension investments could be spread out across stocks and shares, bonds, real estate and other areas like commodities.

Some pensions may allow you to move from higher to lower-risk investments as you get closer to retirement age, and your attitude to risk changes. Similarly, SIPPs allow you to decide on the type of investment that suits your risk appetite and aligns with your retirement goals. Pension investment options are wide and diverse and vary between different products and providers.

4. Draw your retirement income

One day, you’ll want to start drawing money from your pension as retirement income. You can access your private pension from the age of 55 (rising to 57 from April 2028). It’s up to you how you receive the money, whether as regular payments or a lump sum.

You can usually take up to 25% of your pension as a one-off tax-free sum before deciding what to do with the remainder. You may want to withdraw the rest of your money, look at other investments, or keep paying in. If you've started flexibly accessing your pension, the Money Purchase Annual Allowance (MPAA) can limit the amount you can contribute to your pension.

How do I take my pension?

There are several ways to take your pension money. Whatever method you choose, you can take up to 25% as a tax-free lump sum.

• Purchase an annuity: A pension annuity uses your savings to provide you with a guaranteed income for life.
  

• Get a pension drawdown: Choose when and how much money you want to take by pacing your pension into a flexible pension income drawdown.
  

• Explore fixed-term retirement plans: Secure a regular income for a fixed term chosen by you by purchasing a fixed-term retirement plan.
  

• Cash in now: Access your pension savings and take all the money as cash to spend or invest as you like. This will need careful consideration as you could end up with a large bill and you may have little or nothing left to give you an income in retirement.
  

• Take a flexible approach: You could base your retirement plans around a combination of two or more of the options above, whether simultaneously or one at a time.

Your pension provider will update you on your savings as you near retirement age. It’s always wise to explore your options before deciding what to do with your pension pot as you don’t need to choose just one option - you could use a mixture of options as part of a blended solution. You don’t have to stick with the same provider and can transfer your pension from one scheme to another.

Remember, deciding what to do with your pension is one of the most important financial decisions you’ll ever make. Some decisions are irreversible, so it's important you are well informed to make the right choices.

I want to open a pension – how do I do it?

Anyone can set up a pension, whether you’re employed, self-employed, or not working. You can open a pension with a private pension provider or talk to a qualified pension adviser about your options.

You don’t have to open a workplace pension as your employer will do this for you if you meet the criteria. But if you don’t have access to a workplace pension, or want to supplement it with other income, a pension is a common way to save for retirement.

If opening a pension is something you’re thinking about, you should find a provider that can help you meet your retirement goals. Some common considerations may include:

Is there a maximum limit to pension contributions?

No, pension contributions are unlimited. However, there is a government ceiling for how much you can pay into your pension and still receive tax relief, known as your ‘annual allowance.’ Also, you won’t get tax relief if your pension contributions exceed 100% of your annual earnings.

The four main pension thresholds to remember are:

• £10,000: The Money Purchase Annual Allowance if you have started to take flexible pension benefits. 
  

• £60,000: The standard annual allowance for the 2025/26 tax year.
  

• £268,275: The total amount of tax-free lump sums you can take from all your pensions, known as the Lump Sum Allowance (LSA).
  

• £1,073,100: The maximum tax-free benefits you can take from all your pension schemes, known as the Lump Sum & Death Benefit Allowance (LSDBA). Your limit may be higher if you have a protected retirement plan.

Pensions are designed to provide long-term benefits by helping you save through your working life in a tax-efficient way. If you have short-term financial goals or require additional money before you’re old enough to access your pension, there may be other products to consider such as an ISA.

How much pension income will I need when I retire:

How much pension income you need is a personal choice. It depends on the age you want to retire, your long-term financial goals, any other assets or investments you have and the kind of lifestyle you’re seeking when you finally give up work.

Only you know what you can afford to pay into a pension, whether as smaller regular payments or larger contributions now and again. Either way, you’re entitled to government tax relief on any payments you make.

As always, the earlier you start contributing to your pension pot the more time it has to grow. However, investments like pensions carry a degree of risk and can go down in value as well as up.

Use our pension annuity calculator to find out what your pension income is likely to be when you retire.

Unsure what to do with your pension when you retire?

Choosing what to do with your pension is one of the most important financial decisions you’ll ever make. Contact our expert retirement and pension advisers today for a commitment free chat about your pension options, or request a call back.