# How does the pension contribution work in the UK?

I do not understand the basics and every source online is just entering into a whole load of details without clarifying what is going on with my money.

The contract states that the company will match my pension contribution up to 5% of my basic salary, of £25.000 gross per annum, accruing from day to day, working a minimum of 37.5 hours per week.

All the calculators online are also very unclear to me regarding all these details. Can somebody shed some light over these matters for me please? I want to know:

How much do I pay into the pension fund?

How much is the employer paying as well?

What are my choices, what does up to 5% mean?

What are the conditions for me to get the money (when, after how much contribution)?

How does the whole scheme work? (with numbers and functions so I can fully understand)

What happens if I opt-out, what do I get, what are the advantages and disadvantages?

How much do I pay into the pension fund?

How much is the employer paying as well?

What are my choices, what does up to 5% mean?

It's up to you what you pay into your company pension.

If you choose to contribute nothing – from what you've stated above, it sounds like the company also contributes nothing. (But see note)*

If you choose to contribute to the company pension scheme, they will double anything you contribute, with a limit to their contribution of 5% of your gross salary. As follows:

Figures = monthly, based on gross salary of £2,083/mth.

=========================================================
you pay in      |  they pay in      |  Total added to
(%)    (£)      |  (%)    (£)          your pension fund
---------------------------------------------------------
0%     £0         0%      £0           £0
1%     £20.83     1%      £20.83       £41.66
2%     £41.67     2%      £41.67       £83.34
3%     £62.50     3%      £62.50       £125.00
4%     £83.33     4%      £83.33       £166.63
5%     £104.17    5%      £104.17      £208.34
6%     £125.00    5%      £104.17      £229.17
[…]
10%    £208.33    5%      £104.17      £312.50


Important note: Tax relief

These contributions are taken from your salary before Income Tax and National Insurance. This makes them very tax-efficient. In other words, whatever you have put into your pension you have not been taxed on. So what you would have paid in tax, is now in your pension fund and can be invested for your later life.

How does the whole scheme work? (with numbers and functions so I can fully understand)

Cannot answer without knowing the scheme, but most pensions are set up like this:

• Contributions are added to the pot monthly on or shortly after payday
• This is invested in a portfolio – usually a selection of funds (unit trusts or OEICs), which are pooled investments run by an investment manager. Your pension pot holds ‘units’ in these funds. The funds then buy shares or bonds or similar assets. Any growth or dividends from these underlying investments are shared equally among unit holders; charges are taken by the fund managers. This is with the aim of growing your money over the long term.
• Many pension schemes give you a choice of funds – the breadth of which, and the charges, varies from provider to provider – but since many employees either don't have an interest in their investments or don't understand funds enough to make their own choices, there is usually a ‘default fund’ which is a middle-of-the-road option designed to be diversified and not particularly high risk.
• You get a statement every year detailing how much you've paid in, how the underlying investments have performed, and – if you were to retire based on the current situation (not usually a helpful or realistic scenario until you are getting close to that age) – how much income you would typically be able to expect in retirement.
• So to sum up: your money is invested, charges are taken out every year, and how much your fund is eventually worth will depend a lot on the performance of the stock and bond markets, the ability of the underlying companies to pay dividends from their profits, and the cumulative effect of these charges. It's important to realise that this means the value of your pension pot can go down as well as up. The logical conclusion being that if things go truly terribly you could even end up with less back than you put in. However, time is your ally. Over longer timer periods, the ups and downs (volatility) in the market usually smooth out into a positive growth rate, usually higher than inflation – and, crucially, the growth rate actually accelerates over time due to the marvel of compounding.
• In other words – hopefully over the years your pension fund follows a trajectory something like this: (excuse the $signs, couldn't find British equivalent) When you reach retirement you decide what to do with your pension pot and when. And here we enter a whole other feast(?) of options, well beyond the scope of this answer – including but not limited to taking up to 25% of it as a tax-free lump sum, buying an annuity (a kind of insurance product designed to pay you a guaranteed and predictable income for the rest of your life), or keeping the money invested and drawing down as needed. If this still sounds complicated – honestly, it just is. Of course it is. It's a major financial product. It's money and time, risk and return, all abstract concepts, and there are lots of choices, which you as a consumer should expect. But if you can summon the effort to look into and understand it, the incentive is a wealthier life. What are the conditions for me to get the money (when, after how much contribution)? It's not a matter of how much contribution, but minimum age. To qualify for tax relief, pension funds are inaccessible until the minimum retirement age. At present this is normally after you are 55, and before you are 75. Under present rules you are able to take up to 25% of your pension pot as a tax free as a lump sum. I believe the majority of retirees take this option. Many use it to pay off what remains of any mortgage. Some use it to help the kids / grandkids with a deposit or what have you. I am sure cruise lines must also derive a fair bit of their business from this rule. NB: Tax rules can change. What happens if I opt out – what do I get, what are the advantages and disadvantages? What do you get? Well, see note* below, because UK employers these days are obliged to auto-enrol you in a pension scheme and pay some kind of minimum contribution. Beyond that, what you get (assuming sufficient National Insurance qualifying years) is the State Pension, which is designed to provide an income level more or less sufficient to avoid malnutrition or freezing to death – but if you’re relying solely upon that income you may have to forget about running a car, repairing the house, visiting grandchildren, going on holiday, etc. Advantages of opting out: • If you opt out of this scheme in order to open a different private pension, you might get a wider choice of investments, or lower charges, if these are things that matter to you. • If you opt out and make no other pension plans, you will have more money to spend money now instead of saving it for later life. This assumes you will make better choices with the money at present and either don't intend to outlive your working years or believe you would tolerate a relatively impoverished retirement. Disadvantage of opting out: • You miss out on the employer’s additional contributions. This is usually game set and match. These contributions are usually far more valuable (particularly at the earlier stages of your working life) than any • If you choose to save in other ways rather than a pension, you miss out on tax relief (see “Important Note” above). As my old boss used to say, to buy a £200,000 house costs a basic rate taxpayer £250,000 in gross earnings. But to get £200,000 in your pension costs you £160,000. That's a 45% difference. This is at 20% income tax, the difference is even starker if you move up a tax band. Sure it’s simplified, but you get the point. In general, opting out of pension schemes runs the considerable risk of missing out on a comfortable or adequate retirement income, and only realising it when it is too late to start doing anything about it. When it comes to pension savings, time is far more of an ally than most workers realise. * Note In practice I don't believe it is lawful for the employer to contribute nothing, thanks to auto enrolment – see source https://www.gov.uk/workplace-pensions/joining-a-workplace-pension. • That was a very useful insight, thank you very much for that. It is excruciating to find this information online, all put together in a crystal clear manner. Following that, I would like to ask your input on the following: What do you personally recommend me to do? I am interested in entrepreneurship myself and I have already set up my own company, providing some little services and aiming to outgrow the performance of an average job. – Joe Dec 16, 2020 at 17:57 • If I don't intend to work over a very long period of time for a different company, and instead to stick to my own in a matter of years, as it has grown to the desired level, is it still a wise choice to stick to the pension scheme? How do I have access to the pension pot and what are the decisions I can make at this stage? I am 23 and I have got employed last week. Pretty early, but I have been given a deadline to opt-out, so I need to make up my mind about this. – Joe Dec 16, 2020 at 18:01 • Which percentage should I choose, if I decide to keep contributing to it? What are some figures that I can use to get an idea of how the pension will look like if I am contributing for 5,10,15 years for example? – Joe Dec 16, 2020 at 18:04 • None of the content on this site should be construed as personal advice. You have far more information on your financial circumstances, hopes, dreams, career possibilities, risk attitude etc. than we do, or than you could possibly disclose here, so you will have to form your own view on what to do. If you do want somebody to help you decide, it would be worthwhile finding an IFA (independent financial adviser). Personally I've found it more rewarding to educate myself on the topic (15 years and counting, I knew very little at the outset) so as to confidently make my own investment choices. Dec 16, 2020 at 19:15 • @Joe. Remember that the employer match is FREE MONEY. You put some of your money in, and your employer gives you a matching amount. Try finding any other investment anywhere that does the same. If you opt out, then you are turning down the offer of that free money. The employer gets to keep it and give it to the shareholders instead. Even if you leave your current employer, the money stays in the pension fund ready for when you retire. Dec 16, 2020 at 23:12 Firstly, you choose how much to pay in - typically 2% is the minimum, there's often no maximum. Then they match that amount, up to 5% - so if you put in 3%, they put in 3%, but if you put in 8%, they'll only put in 5%. So if you choose 5%, you put in £104/month (5% of 1/12th of 25k), and they also put in$104, so you gain £208 each month.

This all gets invested by the pension fund, so hopefully grows that way too, although obviously it can also fall if the stocks and shares do badly.

You then get a choice in how to use it when you retire (I think the earliest you can take it is 10 years before your government pension age, but that may well change...), either buying an annuity, taking a lump sum, or a mixture - there are different tax implications, but chances are it'll change a lot by the time you retire.

• Thank you Nick. Any advice on how to see what is going on with the pension fund and to try different investment methods with it?
– Joe
Dec 17, 2020 at 19:18
• My own provider has an online dashboard to see how it's performing. I'm afraid I don't know enough about the different methods to provide decent advice. Dec 18, 2020 at 20:18

This is a very broad question and @marktristian has covered much of it, but there are a couple of key points to bear in mind in the UK.

How much do I pay into the pension fund?

Historically pensions would be calculated from your basic salary. So for a salary of £25k, 5% would be £1250 per year (25000 * 0.05).

With newer, "auto-enrolment" pensions, contributions may be based on "qualifying earnings". In 2020/21 this was earnings between £6,240 and £50,000. So a 5% employee contribution of a £25k salary would be £938 ((25000 - 6240) * 0.05). The employer's contribution would be adjusted in the same way.

You've said in your question that this employer calculates the pension based on basic salary rather than qualifying earnings, so in your case it should be the higher amount. But do double check the wording of the contract and bear this in mind when you switch employers.