How to make the most of your workplace pension

Even if your retirement feels a long way away, getting your pension in order is likely to be one of the best things you can do for your future self.

In this article we're going to focus on one of the most common ways to save for retirement: workplace pensions.

So what exactly are workplace pensions, how can you make the most of them, and what can you do if you aren't currently saving into one? Let's explore...

What is a workplace pension? And how do they work?

If you're an employee, there's a fair chance you're already paying into a workplace pension. That's because 'automatic enrolment' was introduced in 2012.

Auto-enrolment explained

Auto-enrolment means that employees aged between 22 and the State Pension age, who earn at least £10,000 per year will now be signed up to a workplace pension by default.

Auto-enrolment was introduced by the Government to give employees a friendly push towards saving for retirement after it was becoming obvious that the average UK worker wasn't saving enough for their later years. The idea behind auto-enrolment was that if employees were automatically added into a workplace pension, many wouldn't actively choose to opt out.

While there are still a number of workers who still don't have any sort of pension provision, there's no doubt that auto-enrolment has been successful in boosting the number of workers saving for their post-working lives.

Workplace pensions explained

Now we've covered auto-enrolment and why it's important, let's now take a look at how workplace pensions work...

Workplace pensions may seem rather complicated at first glance. However, the way workplace pensions work is actually quite simple.

All employers are now legally required to sign up their employees to a workplace pension and both the employer and employee must contribute.

In total, at least 8% of a worker's salary must be paid into a workplace pension. Crucially, however, this minimum figure can include employer contributions. By law, employers must contribute at least 3% to their employee's workplace pensions, and some good employers will go above and beyond this. This is the reason why employer contributions are often referred to as a 'free money' in personal finance circles!

If you were previously offered a workplace pension and you opted out, you've the right to opt back in at any time.

What are the tax benefits of saving into a workplace pension?

Saving into a workplace pension is a tax-efficient way to put money aside for your future. That's because any contributions you make to your workplace pension come from your gross, pre-tax, salary.

Saving into a pension can be especially advantageous if you're a higher or additional rate taxpayer. This is because putting your money into a pension will help you swerve the higher, 40-45% income tax rates. For example, if you're a higher rate taxpayer, a £100 contribution into your pension will only reduce your pay packet by £58. (It's £58, and not £60 as you don't have to pay National Insurance on your contributions either).

Yet despite the obvious tax advantages of saving into a pension, it's worth knowing that when the time comes to access your pension, you may have to pay tax on the amount you withdraw. That's because income from pensions is taxed just like normal working income. However, thanks to 'Pension Freedom' rules introduced in 2015, pension savers can now access 25% of their pots tax-free once they hit 55 — though this minimum age is rising to 57 by 2028.

Defined Contribution Vs Defined Benefit pensions: What's the difference?

If you have a workplace pension, it will either be a defined contribution (DC), or a defined benefit (DB) scheme.

DC pensions are now the most popular type of workplace pension. That's because they're less expensive to operate than defined benefit schemes, which are becoming less and less common, especially in the private sector.

If you have a DC workplace pension, anything you save for retirement will be stashed into a pot and invested on your behalf. As mentioned above, when you reach 55 years old (57 from 2028), you'll be able to access this pot, and take up to 25% of it tax-free in the form of a lump sum.

Anything you don't take out at retirement age will stay invested, and you can draw from this throughout your later years. However this pot of money can run out. Because of this, many DC pension holders may wish to buy an annuity. An annuity gives a guaranteed income until you die. However, annuities have earned a bad reputation over the past few years as rates have been far from generous. Thankfully, for those with DC pensions nearing retirement, annuity rates have been on the rise over the past year or so.

According to annuity rates are at a 12 year high (as of March 2023). In February alone, annuity providers increased their rates by an average of 0.22%.

DB pensions differ from DC pensions in the way that they pay the retiree a guaranteed income for life. The sum payable will depend on how long an employee has worked at a company and may be based on a final salary, or a career earnings average. In addition to a guaranteed ongoing payment, some DB pensions will also pay a tax-free cash lump sum upon retirement.

Many older workers — especially those in the public sector — may have a DB pension. However, they're far less common today than they used to be.

How much should you be saving into a workplace pension?

The amount you should be saving into your workplace pension will depend on a number of factors. For example, if you've DB pension to look forward to, then you may be less inclined to stash away huge wads of cash as you'll know you've a guaranteed income for life once you give up work.

If you've a DC pension, however, then you may wish to put aside bigger amounts to give your pension pot a cushion in the event your investments underperform in the run up to retirement.

Another factor to consider is your current financial health. For example, if you're in debt then it's probably best to focus on clearing it before you think about boosting your retirement income.

You age is another factor. The sooner you start saving into a workplace pension, the more time your money has to grow. As a rule of thumb, it's often suggested that when you start saving into a pension, you should put away a percentage of your salary equivalent to half your age. For example, if you start saving into a workplace pension at 24 you should aim to put away at least 12% of your annual salary into a pension. This 12% figure should also include any employer contributions (so if your employer contributes 3% you'd have to pay in 9%).

Another factor to consider is your anticipated lifestyle in retirement. It may sound obvious but if you're aiming for a comfortable retirement, you should probably consider upping your pension contributions as much as you can. In contrast, if you'd be happy with a retirement that covers your basic needs, you may not feel the urge to put away large amounts.

Can my State Pension impact my workplace pension?

The full new State Pension is worth £203.85 a week. To get it, you must have made at least 35 qualifying years of National Insurance contributions by the time you reach the State Pension retirement age. This age is currently 66 years old, though it's set to rise to 67 by 2028 (and to 68 before 2046).

It's important to note that the State Pension is entirely separate from private, workplace pensions. This means you can be in receipt of both a private AND State Pension once you give up work.

In reality, there's every chance the State Pension retirement age will continue to rise, and may even surpass 70 years old over the next few decades. Some pessimists may even doubt the future viability of the State Pension due to the sheer cost of servicing it, especially when we consider the fact that the UK has an aging population.

What this all means is that it's now arguably more important than ever to pay close attention to your private pension. So, if you're offered a workplace pension and you can afford the regular contributions, it's probably a good idea to make the most of it.

So, in summary, when it comes to thinking about your workplace pension, here are the key points you need to know:

  • Workers aged between 22 and the State Pension age are now automatically enroled into a workplace pension.
  • At least 8% of a worker's salary must be paid into a workplace pension including both the employee and employer contribution (assuming you haven't opted out)
  • Employers must contribute a minimum of 3% to their employee's workplace pension.
  • Contributions to a private pension qualify for tax relief.
  • The State Pension is entirely separate from a workplace pension.

To learn more about workplace pensions, take a look at our article that explains what you give up if you opt out of a workplace pension.

Disclaimer: Before making decisions about your pension, conduct you own research and consider speaking with an independent financial advisor. This content should not be considered financial advice.