What income will you have when you retire, and how much will it be in real terms compared to what you earn now? When it comes to income, the key factor is not the raw figures, but your purchasing power and any necessary expenses. Millions of Britons will be surprised to learn how current average earnings compare to current average retirement incomes if this definition is followed.

The most recent UK figures should help you determine whether you are saving enough for retirement. We’ll also explain how the pension system works and the various types of schemes you can learn about in this guide.

What is the average retirement income in the UK?

In the UK, a retired person’s average household income is 23,557. (Office for National Statistics, 2020). This amount is considerably less than the £30,600 the PLSA estimates a couple needs to maintain a modest quality of living and is less than half the £49,500 a couple is supposed to require for a good retirement.

The average UK retirement expenditure is £12,000, according to data from the Pensions and Lifetime Savings Association (PSLA), whose members include more than 1300 pension plans with 20 million participants. This suggests a significant variance in average retirement income.

The average retirement income in the UK is also affected by regions. If you live in London, you’re likely to have less than the average retirement income. But if you’re based in Scotland or the North East, you’re likely to have more to spend on average. The gap generally comes down to a difference in living and housing costs.

What different types of pension schemes are there?   

You can receive a pension from three different sources: from the state, from former employers, and from personal pensions (i.e. products you set up yourself). Here’s a quick summary of each pension source.

State Pension

In 2022, the basic State Pension has risen to £141.85 per week, while the full rate of new State Pension has risen to £185.15.

Once you reach the age of 66, you will receive your State Pension every four weeks. To be eligible for a State Pension, you must have made National Insurance contributions for at least 10 qualifying years. Because the rules changed in 2016, if you reached State Pension age before April 6, 2016, you will receive the State Pension under the old rules instead. If this is the case, you may find that your payment is lower.

Even so, that works out to around £9,350 per year, which may be sufficient if you’re in a couple and only need the necessities. However, if you are single or want a more comfortable retirement, you should consider supplementing your State Pension. You can accomplish this by contributing to a private pension and discussing your workplace pension with your employer in order to maximize your contributions.

When you reach State Pension age, you are not required to claim your State Pension. This is known as deferring, and it may result in you receiving more State Pension when you do make a claim.

The amount of extra you receive is determined by how long you wait to claim it. The State Pension increases by 1% for every 9 weeks you delay claiming it, for a total annual increase of around 5.8%. If you receive certain benefits, this may not apply to you.

Private and workplace pensions

While there is no maximum amount you can contribute to your pension, you can only contribute £40,000 per year before your contributions are taxed, or 100% of your income if you earn less than £40,000. This is the standard annual allowance for the 2021/22 tax year. It is also worthwhile to consider the Lifetime Allowance, which is £1,073,100 for the fiscal year 2021/22. This includes both personal contributions and contributions from your workplace pension scheme.

Unless you choose to opt out, all employers in the UK are required by law to enroll eligible employees in a workplace pension scheme. A percentage of your salary, as well as employer contributions and any tax breaks, will be automatically deposited into the scheme.

Most automatic enrolment schemes base your contributions on your pre-tax earnings of £6,240 to £50,270 per year. The total minimum monthly contribution is 8% of your total earnings as of April 2019. The percentage split between you and your employer will differ depending on the type of plan they provide.

If you choose to make private payments into your pension pot, the monthly amount you must contribute is determined by your age when you begin and the amount of income you desire in retirement.

Your target will also differ depending on your monthly salary, as your pot will be larger if you have earned a larger monthly pay-cheque. You can use a number of online pension calculator tools to figure out how much you need to pay, such as the one here  Gov.uk.

If you are an employee, your employer is required to automatically enroll you in a pension plan. You can set up your own pension if you are self-employed. It’s a good idea to consult with a financial advisor about this. The main thing to remember is to not put it off. Every year you wait to start your pension costs you thousands of dollars in lost income, so even if you can only make small contributions now, get that pension started.

The two major types of pensions

Pensions are classified into two types: defined contribution (or money purchase) and defined benefit (or final / average salary). These function in very different ways.

  • What are defined contribution pensions and how do they work?

A defined contribution (DC) pension is similar to a piggy bank in that you put money in and it grows. However, it is far superior to a piggy bank because the funds are chosen to provide long-term growth. This accumulates into a larger sum over time, which is referred to as your pension pot. The amount you pay into your pension is a known figure (hence the term “defined contribution”), but the size of your pension pot will vary depending on the performance of the fund (though you can make a good estimate). When you withdraw money from your pension, you can use it to buy a pension product such as an annuity or a drawdown scheme (hence the term “money purchase”).

This is how most workplace pensions and all personal pensions work.

  • What exactly is a pension fund?

A pension fund is an asset portfolio into which your pension contributions are invested. These assets are typically composed of equities (stocks and shares), with the addition of bonds and, on occasion, cash. Commercial property can even be included in pension funds.

Choosing the right pension fund is critical if you want to make the most of your retirement savings. A young person just starting out in their career will have very different needs than someone nearing retirement. The management fees charged by funds can also vary, which can add up to tens of thousands of pounds over time.

  • What are defined benefit pensions and how do they work?

Consider a defined benefit (DB) pension to be a type of contract with your employer. Your employer (or, more precisely, the pension scheme they use) agrees to pay you a fixed income beginning on a specific date and continuing for the rest of your life. The state pension is a type of DB pension.

Your eventual pension income is known with this type of pension, hence the term “defined benefit.” The amount of this income is determined by several factors, including:

  • The amount of money you will earn when you leave their company (or your average salary over that employment)
  • How long you have been a member of the pension scheme there (your ‘pensionable service’)
  • The ‘accrual rate’ of the pension scheme

The accrual rate of a defined benefit pension scheme is the rate at which benefits build up. For example, if the accrual rate of the scheme is 1/80, you are entitled to a pension equal to 1/80th of your final salary for each year of pensionable service. For instance, if you have ten years of pensionable service and leave this employer on a salary of £50,000, your pension will be 1/80th of £50,000 multiplied by ten, or £6,250 per year. This income is guaranteed until the day you die.

The majority of DB pensions are provided by public sector / government employers, though they are still used by a few private sector employers. They are widely regarded as very appealing.

How do I get access to my pension?

If you have a defined contribution pension, you can access it at the age of 55. Most people, however, will want to wait until they are in their 60s.

If you have a defined benefit pension, it will begin to pay out on a fixed date specified by the scheme (usually referred to as the ‘Normal Retirement Date’ or something similar).

If you have a defined contribution plan, you have a few options for accessing your money:

  • A tax-free lump sum equal to 25% of the pot (everyone is entitled to this)
  • Flexible withdrawals from the pot (referred to as “drawdown”)
  • A lifetime income guarantee (an annuity – you purchase this product using your pension pot)

To sum up

Time is your most powerful retirement saving tool. Compound interest can turn small contributions into large sums over time, so the golden rule is to start saving as soon as possible: the earlier the better.

However, it is never too late to begin. Because every pension contribution you make is boosted by at least 25% due to tax breaks, even putting money away in the final years before retirement is preferable to doing nothing.

Speaking with a financial adviser is one of the most effective ways to increase your retirement income. They will explain in simple terms what you need to do to earn the income you desire – and even better, they will demonstrate how it is possible.