How to set up a pension – Everything you need to know

17 min Read Published: 25 Jul 2023

How to set up a pension – Everything you need to knowYou may not realise it, but your pension has the potential to become one of the most important assets under your possession. The good news is that under the auto-enrolment rules, all employers must enrol their eligible workers into a pension scheme and make contributions to this scheme.

However, the rules and regulations around pensions are by no means straightforward. Making matters worse, politicians continue to tinker with them. Here’s a step-by-step guide to setting up a private pension and making sure you make the most of your pension during your working and retired life.

What is a pension?

Your pension is a pot of money that you and your employer pay into, which is used to fund your retirement. One of the biggest attractions of investing into your pension is the tax relief offered on contributions, which stands at 20% for basic rate taxpayers and 40% for higher rate taxpayers.

What are the different types of pension plan?

One type of pension you will hear a lot about is the state pension. Firstly, the ‘basic state pension’ is available to men born before 6 April 1951 and women born before 6 April 1953. They must have paid or been credited with National Insurance contributions. The maximum on offer is £156.20 per week. Each year, the basic state pension increases by whichever is highest: average wage growth, the Consumer Prices Index (CPI) or 2.5%, a rule known as 'Triple lock'.

An exception to this rule was made in 2021 when the Government suspended 'Triple lock' when average wages were inflated, thanks in part to the ongoing pandemic. The Government decided instead to increase in line with the Consumer Prices Index (CPI) for one year thanks to what it describes as 'distortions to earnings statistics' with a view to reinstating the 'Triple lock' rule the following year, which they subsequently did.

Those born after 6 April 1953 are entitled to the ‘new state pension’ once they reach the state pension age. This currently stands at 65 for both men and women. The maximum you can receive is £203.85 per week and will depend on your national insurance record.

Outside of the state system, pensions come in two forms - ‘defined contribution’ or ‘defined benefit’. Here’s how they work:

Defined benefit

This type of pension scheme pays out a set income every year during retirement and is largely funded by the employer, although an employee may make contributions throughout their career.

There are two types of defined benefit scheme, which both pay out an income that is linked to inflation.

  • Final salary – pays out a retirement income, based on a proportion of an individual’s final salary.
  • Career average revalued earnings (CARE) - this pays out an income based on an individual’s average salary across their career.

Defined contribution

This type of pension (also known as a money purchase scheme) does not promise to pay out a set amount during retirement. Instead, it is down to the individual and their employer to make contributions, adding to the savings pot over time.

If it is a workplace scheme, the person decides how much they wish to pay into their pension as a percentage of salary and the employer will match all or some of these contributions. Alternatively, if it is a private pension, it is down to the individual to make contributions.

What are the different types of defined contribution schemes?


Auto-enrolment was introduced by the government in 2012 meaning that by law, employers are required to enrol all employees aged 22 or over (and who earn over £10,000 per year) into the company pension scheme. The minimum total contribution currently stands at 8% of which 5% is provided by the employee and 3% by the employer. Employees still have the right to opt-out, meaning they no longer need to contribute 5% of their salary, however, they will also be giving up their employer contribution of 3%, so it isn't a decision that should be taken lightly.

Group personal pension

Prior to auto-enrolment, many employers offered a group personal pension. Much like auto-enrolment, both the employer and employee will typically pay into this type of scheme. It is managed by a pension provider on behalf of the employee, who builds up a sum of money during their working life and is able to convert it into an income at retirement. Many employers have replaced their group pension schemes with an auto-enrolment scheme, however, some have decided to keep their existing group scheme in place and run an additional auto-enrolment scheme alongside, giving their employees a choice in which pension scheme they wish to contribute to.

Stakeholder pension

This offers a flexible way to build up retirement savings for those who are employed, self-employed or not working. It is offered by some employers. Stakeholder pensions have a default investment strategy and capped charges. Individuals can make low and flexible contributions into the scheme.

Self-invested personal pension (SIPP)

This popular type of defined contribution pension provides an individual with the flexibility to hold the investments they wish within a pension ‘wrapper’. This contrasts with a final salary scheme, where the individual has no control over how the investments are managed. Check out our article 'What is a SIPP and how does it work' for more information.

Other types of pension schemes

Trust-based pension schemes

Employers may offer defined benefit or defined contribution trust-based occupational schemes. These involve a pension provider establishing a pension under a trust deed, which means rules are set out to govern the scheme and the pension is overseen by trustees. It effectively separates the scheme’s assets from your employer’s business, and creates a three-way relationship between the employer, employee and trustees.

Is a pension worth it?

There are numerous benefits associated with pensions. The first is the tax relief available on contributions. This stands at 20% for basic rate taxpayers, 40% for higher rate taxpayers and 45% for additional rate taxpayers. It is effectively a refund on the tax you paid when you initially earned the money. During the 2023/24 tax year, you can receive tax relief of up to 100% of your earnings or a £60,000 annual allowance – whichever is lower.

Another benefit associated with building a pension pot over time is that you are able to take 25% of your pension tax-free once you reach the age of 55. However, it is worth noting that the remainder of the withdrawals made from your pension will be taxed at your marginal income tax rate outside of your Personal Allowance (more on this in the section below).

Pensions can also play an important part in inheritance tax (IHT) planning because they aren’t counted as part of your estate for IHT purposes. If an individual passes away under the age of 75, their beneficiaries will receive their remaining pension pot tax-free. If they are aged 75 and over, beneficiaries will be taxed at their marginal rate.

As an individual can accrue significant sums via their pension pots during their working life, this means a sizeable sum of money could be passed on to the next generation. If you are putting together a plan to pass on wealth to your nearest and dearest, don’t forget to include your pension(s). Some older pension schemes can’t be passed on within a will, so you will need to check if this is possible. We cover this subject in more detail in our article 'Are pensions worth it?'

Are there any restrictions with a pension plan?

There are some restrictions associated with pensions. Firstly, you need to consider the lifetime allowance, which is the limit to how big your pension can get over your lifetime. Prior to the tax year 2023/24, if the total value of your pensions exceeded the lifetime allowance of £1,073,100, you would face an extra tax charge when you access your money, turn 75 or die. The charge was 25% if you take money out as income or 55% if taken as a lump sum. Bear in mind that this charge was levied in addition to the income tax you are already liable to pay.

However, it was announced in the 2023 Spring budget that the lifetime allowance was to be abolished. Fundamentally this means that going forward, certain lump sum payments which would have previously been subject to a lifetime allowance charge may instead be subject to income tax at the pension saver's marginal rate. We expect further guidance to be released later this year but if you are in any doubt then you should speak to your pension provider or an independent financial adviser if you have one.

You also need to consider the £60,000 annual allowance for pension contributions, if you exceed this you won’t receive any tax relief above this level and will face a charge.

Once you withdraw money from your pension, the Money Purchase Annual Allowance also comes into action. This restricts how much you can put into your pension further and means that tax relief is only available on contributions totalling £10,000 per year. If you are planning to boost your pension, it therefore makes more sense to do this while you are still working.

Is a pension taxable?

Since the pension freedoms were introduced in April 2015, it has become possible to cash in all or some of a defined contribution pension pot from the age of 55. Once the 25% tax-free lump sum has been taken and your Personal Allowance (equating to £12,570 during the 2023/24 tax year) has been used up, any withdrawals will be taxed as income.

It is important to think about the tax implications associated with making withdrawals; a financial adviser will be able to provide you with some insight on this. For example, if a substantial proportion of your pot is withdrawn in one go, it could push your tax rate up. Think carefully about the impact this could have on the amount you ultimately receive. Here is a handy pension withdrawal tax calculator which can give you an idea of the level of tax you might incur if you cash in your pension.

How do ISAs compare to pensions?

Like pensions, ISAs offer savers the opportunity to accumulate long-term savings in a tax-efficient way. ISAs allow individuals to accrue income, dividends and capital gains completely tax-free within these accounts.

However, smaller sums can be allocated to an ISA in comparison to a pension. During the 2023/24 tax year, £20,000 can be invested across different types of ISAs: stocks and shares, cash, lifetime, innovative finance and help to buy (although only one help to buy ISA can be set up during an individual’s lifetime).

In addition, it is possible to inherit your spouse or civil partner’s ISA if they pass away without incurring inheritance tax. It may not make sense to think about the ISA versus pension debate as binary because both can be used as complementary retirement savings pots. Read our article 'Pension or ISA - Which is the better investment?' for more information.

Should I consider a Lifetime ISA?

Launched in April 2017, lifetime ISAs were set up as an alternative to SIPPs for those aged between 18 and 40. Contributions made before the individual reaches the age of 50 receive a 25% bonus from the government, and up to this age you can add up to £4,000 a year. You can read more about Lifetime ISAs in our article 'Lifetime ISAs explained - are they the best way to save'.

Unlike a pension, it is possible to withdraw money at any time. However, if a person chooses to do so before they reach the age of 60, they will have to pay a 25% penalty on the withdrawal. This, however, doesn’t apply if you are buying your first home valued at less than £450,000 or you are terminally ill.

Lifetime ISAs offer individuals greater flexibility in terms of how they wish to spend their savings. For example, you can buy a first home, fund your retirement or pay for care costs in later life.

This type of ISA also represents a good option for those who are self-employed and do not receive employer-matched pension contributions. In addition, lifetime ISAs can be used to allocate surplus funds. For example, if an individual has utilised their £60,000 annual pension allowance during a tax year and wishes to put more money aside for later on. Check out our article 'Pension vs Lifetime ISA - which is best?'

Who can set up a private pension plan?

Whatever age you are and whether you are employed, self-employed or not currently working, it makes sense to think about your future by setting up a private pension well in advance of retirement. After all, it’s likely that you are going to need to supplement the state pension with other savings. The good news is that it is possible to set up your own personal private pension plan and it may prove to be easier than you expect. Here are a few options that are available to you:

Self-employed (NEST)

One of the biggest drawbacks associated with being self-employed is that it is very easy to forget to set up a pension. NEST, which stands for the National Employment Savings Trust, provides a solution to this by offering self-employed workers the option to set up a scheme. NEST is a defined contribution workplace pension scheme that was initially set up to make sure that every employer has access to a workplace pension scheme that meets the auto-enrolment requirements (see below for more information).

Under NEST’s self-employed scheme, you can make contributions as often as you like (of at least £10 each time). The money you accrue will stay in the pot until your retirement date, which you are able to specify. You can remain in the pension scheme and continue to make contributions, even if you become employed at a later date.

The most important thing is to remember to make contributions, particularly as you don’t have an employer encouraging you to do so. We have written more about the NEST pension in our article "Nest pension – what is it and is it any good?"

Self-invested personal pension (SIPP)

Whether you are employed, self-employed or not working, another option is to set up a self-invested personal pension (SIPP). You can either set one up yourself via an online investment platform, such as Hargreaves Lansdown, or a robo-adviser (like Nutmeg or Wealthify). Alternatively, you may wish to enlist the services of a financial adviser, stockbroker or wealth manager.

Stakeholder pension

If you are looking to set up your own stakeholder pension, it is possible to do this via the larger pension providers, such as Aviva. You can apply to do this if you are under 75, live in the UK, or you or your spouse work overseas for the UK government.

How much should I contribute to my pension?

This is the million-dollar question for savers. Anyone who is planning for retirement faces numerous unknowns. The biggest is how long you will live for. The second is whether you will need to pay for care costs – and if so, how much you will require. The age you decide to stop working represents another variable, and whether you stop completely or continue working on a part-time basis.

The amount you decide to contribute will vary during your working life. It will depend on your age, earnings, whether you have debt outstanding, as well as your overheads. For example, you may need to think carefully if you have significant overheads, like a large mortgage and dependents.

However, to avoid a pension shortfall during retirement it’s best to put as much money aside for retirement savings as you can; this isn’t limited to your pension, it’s also worth utilising your annual ISA allowance if you are able to do so.

There is a £60,000 annual pension allowance after which point you will not receive tax relief. However, you can utilise any unused allowance from the previous three years. Meanwhile, the annual ISA allowance for the 2023/24 tax year stands at £20,000.

Try to give some serious thought to the lifestyle you would like to lead during retirement and whether the potential costs associated with this are viable. The government has provided the following guidance regarding the percentage of pre-retirement income that is required once you stop working:

      • 70% of earnings between £12,200 and £22,400
      • 67% of earnings between £22,400 and £32,000
      • 60% of earnings between £32,000 and £51,300
      • 50% of earnings over £51,300

It’s important to factor in that you will hopefully have paid your mortgage down or off by this point and, of course, the dream is that your children are financially independent. Nevertheless, there are no hard and fast rules and much will depend on your lifestyle, health, outgoings and liabilities.

If you are looking for assistance to calculate how much you are likely to need for retirement and the level of contributions required in order to meet that goal, check out our pension calculator.

Setting up a personal pension plan

The two most common types of personal pension are basic stakeholder and the self-invested personal pension.

Here’s a list of things to consider if you are setting up a pension or choosing which scheme to go for:

  • What are the charges and costs associated with setting up and running the pension? Are these easy to understand?
  • What is the underlying investment strategy?
  • If you are responsible for investing your own pension, what options are available via your chosen platform?
  • Can you stop and start contributions without attracting any penalties?
  • Can you pay in lump sums, as well as regular contributions?
  • What is the reputation and track record of the pension provider? What do existing customers say about the support they offer and the user experience?

How to find the best and cheapest SIPP options

If you are planning to set up your own SIPP, make sure you have a good understanding of the charges involved. These include the following:

  • Administration fee – typically levied annually. Also look out for any charges to transfer money in or out of your SIPP (known as SIPP transfer charges)
  • Dealing charges – these are applied when you buy and sell funds or shares. They vary amongst SIPP providers and platforms, so make sure the charging structure fits with your style of investing and requirements
  • Fund charges – it’s important to take note of the ongoing charges figure (OCF) of any funds you hold within your SIPP, as well as the charges incurred to switch between funds and the bid/offer spread.
  • Additional charges – an investment platform should provide a full fee list, so make you take a look a look at this to ensure there are no hidden charges.
  • Exit fees - if you are planning to move to another provider, make sure you check to see if there are any exit fees

To find out which SIPP providers are rated highly, check out our article "The best and cheapest SIPPs - low cost DIY pensions".

Where should I invest my pension?

The following investments can be held within a SIPP:

  • Funds
  • Shares
  • Exchange-traded funds
  • Investment trusts
  • Gilts and corporate bonds
  • Cash
  • Property (largely commercial)
  • Unlisted shares
  • Insurance bonds

Make sure that any prospective platform is able to provide access to the investments you require.

A SIPP can either be managed by yourself or a third-party, so consider which route you are most comfortable taking from the outset. If you prefer to enlist the services of a professional, you might consider buying a pre-packaged diversified ‘fund of funds’ or using the services of a financial adviser or ‘robo-adviser’ like Nutmeg, Moneyfarm, Wealthify and Scalable Capital. They are online investment managers which use computer models, known as algorithms, to manage portfolios. Their services are lower cost than traditional wealth managers but provide little to no human interaction with their customers.

If you feel happier selecting and managing your own investments, think about your objectives, time-horizon and attitude to risk. These factors will have a bearing on whether you are investing for income and/or growth. In turn, this will determine the types of investments you hold within your SIPP.

There are thousands of funds available to buy, so it can feel overwhelming if you are selecting investments for your portfolio. The good news is that it doesn’t have to. There are plenty of tools out there to help investors to make investment decisions.

Money to the Masses’ 80-20 Investor Service is a prime example. It uses a unique algorithm and research to identify the best funds to invest in. We analyse thousands of unit trusts, investment trusts and ETFs to produce a shortlist of funds that should be available to buy on your chosen platform.

Since launch, the portfolio has performed better than the market, passive investment strategies and 90% of professional fund managers. You can start a free trial or find out more here.

For insight into the best performing funds, check out our article "The best performing funds to invest in right now."

Do I need a financial adviser to set up a pension?

Under the pension freedoms, introduced in April 2015, free and impartial pension guidance is available for all individuals who are aged 55 and over. Retirees can access this guidance via the Moneyhelper website (previously known as the Pension Advisory Service) or through their employer’s pension scheme provider.

Money to the Masses also offers a free 30-60 minute pension consultation in partnership with Vouchedfor. For more information click here - Get a free pension healthcheck with a local IFA*

You may feel more comfortable seeking assistance from a financial adviser in the following scenarios (although financial advice is by no means mandatory):

Investing your pension to get adjustable income

It may make sense to take an adjustable income from your pension during retirement. Known as ‘flexi-access drawdown’, this is only possible with defined contribution schemes. After the 25% tax-free lump sum is taken, the remaining 75% of your pension pot is invested in funds and securities that allow you to take a regular income (which is then taxed at your marginal rate). Your investments will be guided by your objectives, requirements and attitude to risk. In addition, the investment strategy can be adjusted over time, in line with your circumstances and the performance of your investments.

A financial adviser will be able to provide some guidance on how much income you are likely to require. They can also construct an investment strategy that focuses on delivering the income you require. For more information about pension drawdown, check out our article "What is a sustainable amount that you can drawdown from your pension?"

Combining pension options

It may make sense to use some of your pot to buy an annuity and invest the rest to generate an adjustable income. If you are thinking about the practicalities of doing this, you will need to explore whether your pension provider offers both options. Alternatively, if you have two pensions you could buy an annuity with one pot and invest the other.

You may wish to consult a financial adviser to put a financial plan in place or to discuss the implications of combining different pension options.

Meanwhile, financial advice is either strongly recommended or it can represent a legal requirement in the following scenarios:

  • Making withdrawals from your pension
  • Buying an annuity
  • Cashing in your pension
  • Leaving your pension in a will

How much does pension advice cost?

The average cost of an initial review stands at around £500, according to research produced by Unbiased. Meanwhile, for a £200,000 pension pot there was an average at-retirement advice fee of £2,500. The average hourly rate for a UK adviser is £150, according to MoneyHelper. However, some advisers charge as much as £300.

Charges are likely to vary from firm to firm. Before proceeding, ask the adviser to provide an estimate of the overall charges (not just the headline fees), as well as when they expect you to pay them. Also, find out if there is a fee for an initial consultation.

There are a number of services out there which are designed to help consumers to find a reputable adviser who can meet their requirements. These include VouchedFor*, Unbiased*, Financiable or the Chartered Institute for Securities & Investment’s Wayfinder. For more information on the cost of financial advice, you may wish to check out our article "How much does financial advice cost?"


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