How does a pension actually work?Easy

Two entirely different machines share one word. In one, somebody promised you an income; in the other, you own a pot and the income is whatever the pot buys.

4 min read · 769 words

The short answer: there are two machines wearing the same word, and almost every confusion about pensions comes from mixing them up. In one, an employer or a state promises you an income for life and carries the problem of paying it. In the other, money is put into a pot in your name, invested, and the income at the end is whatever that pot can buy.

The promise kind

Somebody — an employer, a scheme, a state — owes you a defined income from a defined age until you die. Your salary and your years of service decide the number. What the investments did is not your problem, at least not directly.

It is not free of risk; the risk simply sits somewhere else. The scheme has made a promise stretching decades into the future and has to hold something today that will still be worth enough then. That is a matching problem, not a return problem: the liability grows with interest rates and with inflation, so the assets have to move the same way. Pensions is the seat that does this work, and long-dated government bonds are the instrument it does most of it with.

What happens when that matching is done with borrowed money is not hypothetical: the UK gilt episode of 2022 is the case study, and the mechanism was collateral, not investment returns.

The pot kind

Contributions go in, they are invested, and what comes out at the end is the pot. Nobody has promised you a number. The three things that decide the outcome are how much went in, how long it was invested, and what was deducted along the way.

The third one is the one people underweight, because it is a small number attached to a long period. A charge is taken every year on the whole balance, including on the growth of previous years, so its effect compounds in the same direction as the returns do. Costs and fees works through the arithmetic, and what the fees actually cost puts numbers on it.

Why the mix changes as you get older

A pot forty years from being spent and a pot two years from being spent are exposed to different things. The first can sit through a fall because there is time for the recovery; the second cannot, because the money is needed on a date. Schemes usually shift the mix towards assets whose value moves less as the date approaches — which is a statement about the shortening horizon, not a forecast about markets.

This is also the point where the two machines meet. If the pot is going to buy a guaranteed income, what matters near the end is not the pot's value alone but the price of that income, and those two move together: when rates fall, the pot may rise and the income it buys gets dearer at the same time.

Turning a pot into an income

A pot is a balance. An income is a series of payments that has to keep arriving however long you live, which is a different thing to arrange. Broadly there are two routes and they can be mixed.

• Buy the promise. An annuity is an insurer taking the pot and paying an income for life. You have handed over the risk of living a long time and given up the capital.
• Keep the pot and draw from it. You keep the investment decisions and the flexibility, and you keep the risk that the money runs out or that a bad run early on does lasting damage — the order of returns matters when you are withdrawing, which is not true when you are only contributing.

This page explains what those two mechanisms are. Which of them fits any particular person is not something a page can know, and nothing here is advice about your own arrangements.

Where a pension fits in the market

A pension scheme is one of the largest kinds of buyer in the market and one of the least free: a scheme matching a liability buys what matches it, not what it finds interesting. That is why the participant map on every asset class page sorts holders by whether anybody had a choice. Pensions usually sit on the forced side, and prices reflect it.

The one sentence to take away

Ask first which machine you are in: if somebody owes you a number, the risk is theirs to manage and yours to check they can; if you own a pot, the risk is yours and the three levers are contributions, time and what is deducted.