Breaking Down the Different Types of Pension in the UK

What is the State pension and the State pension ‘Triple Lock’?

In a nutshell a pension is a way to save money in a tax efficient manner for retirement, providing an income for life after work. In the UK there are state-provided pensions and private or workplace pensions.

The State pension is a universal benefit which continues to make up an important part of most individuals’ retirement income. State pensions are payable from an individual’s State Pension Age (SPA), which is currently 66, but gradually rises to 67 for those born on or after 5 April 1960, with future rises to 68 expected.

Those who reached their SPA on or after 6 April 2016 are entitled to the new State pension. The amount received depends on the individual’s national insurance (NI) contribution record which includes NI credits. Individuals need 35 years of NI contributions or credits to get the full State pension, currently £221.20 a week (£11,502 a year in 2024/25).  At present, the State pension rises each April in line with the so-called triple lock, i.e. the highest rate of either the Consumer Prices Index in September, average earnings or 2.5 per cent.

What are the two types of workplace schemes?

In the UK there are two main pension schemes: defined benefit (DB) and defined contribution (DC).

DB schemes are also known as final salary or career average schemes. These are schemes set up by employers for their employees. The amount of pension received at the scheme’s retirement age depends on an employee’s salary (average or final salary), how long they have worked for their employer and been in the scheme and the scheme’s accrual rate for each year of pensionable service (e.g. 1/80^th). The scheme promises to pay out an income each year from the scheme’s retirement age, with annual pension increases.  The scheme rules will differ for every scheme, some are more generous than others. Some schemes like USS (Universities Superannuation Scheme) have two parts to them – a part linked to your salary up to a specified amount and an investment builder (similar to a DC pension).

Most private sector DB schemes are closed. The proportion of private sector employees participating in a defined benefit pension halved from 24 per cent in 2005 to 12 per cent in 2020. They continue to operate in the public sector.

The majority of employees working in the private sector are now saving in a workplace DC pension scheme, also known as a ‘pension pot’ or a money purchase scheme.  The amount depends on how much has been paid in by the employee and employer, the investment growth and how and when the individual accesses their pension.  The value of the pension pot can go down as well as up depending on how the investments perform.

Individuals can normally access their pension from age 55 (57 from April 2028), the legal minimum pension age. From this age they can take out their pension money as and when they like, including a 25 per cent tax free lump sum, with the remainder taxed as income. Individuals have three broad options: first, buying an annuity providing a guaranteed income for life; second, moving their pension pot into an ‘income drawdown’ product, keeping the fund invested and drawing down income as and when they need it; third, taking out single or multiple cash lump sums from their pension. It is possible to do a combination of all three.

DC schemes offer much more flexibility’ and choice than DB schemes in how individuals can access their pension. However, DB schemes provide much greater certainty of the income they will receive in retirement. The Pensions and Lifetime Savings Association (PLSA) has developed the Retirement Living Standards, based on independent research, to help people picture their lifestyle in retirement and how much income they may need to achieve this by looking at three different levels: minimum, moderate and comfortable. These include the State pension but are based on post-tax income and do not include housing costs in retirement. The PLSA found that 77 per cent of savers do not know much they will need in retirement, with only 16 per cent giving a figure.

How does auto-enrolment play a role?

Auto-enrolment was introduced in 2012 to combat the decline in UK workplace pension saving. This compelled employers to auto-enroll their eligible workers into a pension and pay a minimum contribution. Employers were ‘staged’ by size over five years.

The introduction of auto-enrolment significantly increased the number of pension savers, with over 11 million saving in a pension for the first time. The total membership of DC occupational schemes has risen from 2.1 million in 2011 to 21 million in 2019. In 2021 88 per cent of eligible employees (approximately 20 million) were participating in a workplace pension scheme. Employees have the right to opt out of pension saving.

Auto-enrolment contributions, the statutory minimum amounts paid by employers and employers, were phased in between 2022 and 2019, reaching the full amount of eight per cent a band of earnings (£6,240 – £50,270) in April 2019. Employers must pay a minimum of three per cent and employees five per cent, which includes tax relief. Many employers and employees stick to this minimum level. For most, this is unlikely to provide an adequate income in retirement.

Auto-enrolment has been successful in getting more employees saving into a pension.  But many people are excluded from the policy. Currently employers must automatically enroll workers in a workplace pension once they are aged 23 and above and earn over £10,000 a year in a single job.

This means that people on very low incomes aren’t automatically saving into a pension or benefitting from an employer pension contribution, although they can choose to ‘opt-in’. The earnings threshold has been fixed since the financial year 2014/15, meaning that more lower-income earners are bought into auto-enrolment as salaries rise. However, there is a bigger question about whether lower-income earners should be saving into a pension both on affordability grounds and because the State pension is unlikely to provide a full replacement income in retirement. Should the earnings threshold be increased, so that the lower earners have more money in their pockets? With an ageing population and weak demography if immigration were to fall, there are fundamental questions about adequate pension provision in the UK.