What is a pension pot?

‘Pension pot’ refers to the savings you build up in a certain type of pension known as a ‘defined contribution’ pension scheme. You and your employer (if you are employed) pay into the scheme and this builds up a ‘pot’ of money over time, which you can use to give yourself an income when you want to cut down how much you work, or stop working altogether. It includes workplace, personal and stakeholder pension schemes.

What type of pension do I have?

There are three main types of pension:

  • defined benefit pensions
  • defined contribution pensions, and
  • the State Pension

Defined benefit pension

You’re most likely to have a defined benefit (DB) pension if you work in the public sector or for a large company.

This is a salary-related pension which pays out a secure income for life and increases each year.

The pension you get is based on how long you’ve been a part of the scheme and how much you earn.

You might have a final salary scheme where your pension is based on your pay when you retire or leave the scheme, or alternatively a career-average scheme where your pension is based on the average of your pay while you were a member of the scheme.

Defined contribution pension

With this type of scheme, you build up a pension pot which you can draw an income from when you cut down or stop working. But you must be aged at least 55 before you can start to take money out. With this type of pension scheme, you can usually withdraw at least 25 per cent (a quarter) of your pot tax-free.

The amount that builds up depends on:

  • the level of charges you pay
  • how well your investment performs, and
  • how much you and your employer (if you are employed) pay into the scheme

Defined contribution (DC) pensions include workplace, personal and stakeholder pension schemes.

State Pension

Most people get some State Pension. It’s paid by the government and is a secure income for life which increases by at least the rate of inflation each year.

You build up your entitlement to the State Pension by making National Insurance contributions during your working life.

In some cases, you can do this even when you’re not working, such as when you’re bringing up children or claiming certain benefits.

From April 2016 a new flat-rate State Pension was introduced. For the current tax year 2021/22 the full new State Pension is £179.60 per week.

However, you might be entitled to more than this if you have built up entitlement to ‘additional state pension’ under the old pre-April 2016 system – or less than this if you were ‘contracted out’ of the additional state pension.

For more information see our guide on the State Pension.

To be eligible for the full State Pension you will need 35 qualifying years on your National Insurance (NI) record.

You’ll usually need at least 10 qualifying years on your NI record to qualify for any State Pension at all.

Your pension choices if you have a defined benefit pension

Most defined benefit pension schemes have a normal retirement age of 65.

If your scheme allows, you might be able to take your pension earlier but this will reduce the pension you get quite considerably.

When you take your pension you usually have the option of taking some of it as a tax-free cash sum.

How much you can take will vary depending on your scheme rules, but often you can take roughly up to a quarter of the value of your pension benefits like this.

Reducing the amount of tax-free cash you take might increase the amount of income you receive.

It is possible to transfer your defined benefit pension to a defined contribution pension which would then allow you to access your pension more flexibly.

However, consider this option very carefully as you might be giving up very valuable benefits.

Before going ahead with a transfer from this type of scheme speak to a regulated financial adviser.

Your pension choices if you have a defined contribution pension

Once you reach 55 you are able to access your pension pot.

However, the longer you leave your pot to continue building up, the more money you will have to live on in retirement.

To understand the choices for using your pension pot, use an IFA and have a free consultation to know what the best option is for you.

Your State Pension choices

You won’t get your State Pension automatically – you have to claim it. You should get a letter no later than two months before you reach State Pension age, telling you what to do.

You can also defer taking it. If you want to wait to claim your pension, you don’t need to do anything. Your pension will automatically be deferred until you claim it and will increase by 1% for every nine weeks you defer. This works out at just under 5.8% for every full year.

The extra amount is paid with your regular State Pension payment when you finally take it.

What is pension drawdown?

Pension drawdown is a way of using your pension pot to provide you with a regular retirement income by reinvesting it in funds specifically designed and managed for this purpose. The income you get will vary depending on the fund’s performance. It isn’t guaranteed for life.

How pension drawdown works

You can normally choose to take up to 25% (a quarter) of your pension pot as a tax-free lump sum. Some older pensions might let you take more than 25% so it’s worth checking with your pension provider.

You then move the rest into one or more funds within a Flexible Income Product that allow you to take an income at times to suit you.

Some people use it to take a regular income. The income you receive might be adjusted periodically depending on the performance of your investments.

There are two main types of drawdown product:

  • Pension drawdown – introduced from April 2015, where there is no limit on how much income you can choose to take from your drawdown funds.
  • Capped drawdown – only available before 6 April 2015 and has limits on the income you can take out; if you are already in capped drawdown there are new rules about tax relief on future pension savings if you exceed your income cap

What is an annuity?

If you’re paying into your own pension pot, you will probably have to buy an annuity when you retire.

An annuity is a product that converts the money you’ve saved up in your pension pot into a monthly or yearly retirement income for you to live on.

When you buy an annuity you normally only have one opportunity to make the right decision. Once it’s done, you can’t change your mind, so it’s important you get it right.

An annuity pays an income when you retire, and it’s designed to continue providing an income, no matter how long you live for.

The amount you will get depends on things like how old you are: the younger you are when you retire, the less you get each year, whether you want your annuity to pay an income to your spouse or partner when you die.

You’ll get a lower amount while you’re alive if you do.

And, most importantly, if you’re ill or you have a medical condition, such as high blood pressure or if you smoke – which can damage your health you could get a higher income through what’s called an enhanced annuity. That’s because you may not be expected to live as long as someone who is healthy.

You don’t have to buy an annuity the moment you retire, although many people do because they need a retirement income straight away.

To find out how much you could get, you should shop around using our annuity tables to compare what’s on offer.

Think about talking to a financial adviser about the best type of annuity and which company will pay you the highest income.