It is never too early nor too late to start paying into a pension scheme. Many pensions turn out to be less than expected.

In this chapter, six things that really matter:

• ˜ Maximising the state pension
• ˜ Joining an occupational pension scheme
• ˜ Starting a personal pension
• ˜ Making use of the new stakeholder pension
• ˜ Understanding annuities
• ˜ Planning for your retirement

With tax relief (2001), for those on a marginal tax rate of 22%, a pension contribution of £100 costs only £78 (and for those on 40% only £60). It then earns income free of income and capital gains tax (except that tax deducted from dividends cannot be recovered). So pensions are a very tax-efficient investment.

Income tax is, of course, deducted from pensions in the course of payment, but a tax-free lump sum can often be taken on retirement.

A useful rough guide is that to achieve a pension of £20,000 a year starting from age 65, a man needs to pay about £250 a month if starting at age 30, £500 starting at 40 and £1,000 at 50. Women should add 10%.*

Is this you?

• My state basic pension will not be the full amount because I have missed contributions. Can I make them up?
• I have been paying for a personal pension but my new employer has a company scheme. Should I join?
• I am self-employed and haven’t bothered about pensions until now. Should I start a personal pension?
• I have no earned income and have been told I cannot pay into a pension scheme. Is that correct?
• I am retiring shortly. Annuity rates are so low, should I delay taking one out?
• How do I find out how much pension I will receive?

Maximising the state pension

All state pensions are taxable and are adjusted annually in line with inflation.

Basic pension

A single contributor at the time of going to press receives £72.50 a week if full contributions have been made. A non-contributing spouse receives £43.40 a week.

A contributing spouse whose contributions have earned less can have their pension increased to £43.40. A widowed spouse can have their pension increased to the full amount received by the deceased spouse.

The pension can be left in after normal retiring age, up to age 70. It increases by 7.5% a year, which is not a very good deal as it takes some 12 years to recover the amount sacrificed.

Additional pension (SERPS)

This is paid in respect of each year you have made National Insurance contributions (NICs) in respect of earnings as an employee between the lower and upper earnings limits – in 2001 £80 and £575 a week. It is not available to the self-employed.

The amount of pension payable is a complicated calculation. The formula changed with effect from April 2000 and will result in gradually lower amounts over the next few years. It is fully explained in a Benefits Agency booklet. There is a proposal to change to a flat-rate second state pension.

Contracting out

Many occupational schemes contract all members out of the additional pension. The scheme must guarantee a pension of no less than would have been received. Lower NICs are paid, the difference being called a rebate.

Employees who have a personal pension can also contract out if their scheme is an appropriate personal pension (APP). Instead of a rebate, the scheme receives a payment based on NICs, which must be claimed by the pension provider.*

Joining an occupational pension scheme

These are schemes arranged by an employer for employees. There are two basic types: final salary and money purchase.

Final salary

The pension is based on the final pensionable salary (FPS), i.e. that received immediately before retirement, or a formula such as the average of the last three years. It is the best form of pension for an employee, because the benefits are fixed. Usually the employee contribution is a fixed percentage of salary and the employer pays the rest.

The amount of pension is calculated by multiplying the FPS by a fraction in respect of each year of service, such as 1/60 which achieves a 50% pension after 30 years’ service (called a 60ths scheme).

Money purchase

Here the contributions are fixed and the benefit varies, which is much less attractive to the employee but much more advantageous to the employer (many have switched new employees to money purchase). Most of the accumulated funds must eventually be used to buy an annuity.*

The disadvantage to the employee is twofold: not knowing in advance either how much the invested contributions will earn or what pension the final amount will purchase.

Questions to ask before joining

It is nearly always advantageous to join a company scheme, but first find out:

• ˜ Is it final salary or money purchase?
• ˜ Is it contracted out?
• ˜ What are the contribution rates, for employer and employee?
• ˜ Can a tax-free lump sum be taken on retirement?
• ˜ Is there a contingent spouse’s pension?
• ˜ What happens in the event of death, in service or in retirement?

• ˜ What happens if employment is ended by either party?
• ˜ What would be the effect of being laid off without pay, or short-time working?

If it is a final-salary scheme:

• ˜ How is the pension calculated?
• ˜ Is there any post-retirement adjustment for inflation and is it guaranteed or discretionary?
• ˜ What are the rules for early and late retirement and is there any difference if early retirement is due to ill-health?

Inland Revenue limits

Contributions to and income earned in an approved scheme are tax free if the following limits are not exceeded*

• ˜ Maximum pensionable salary – for joiners since 14 March 1989, £95,400 (this is reviewed annually in the budget). No limit for earlier joiners.

• ˜ Maximum pension – two thirds of FPS (which can include fringe benefits).
• ˜ Maximum for spouse on death of pensioner – two thirds of the maximum (i.e. 4/9ths of FPS).
• ˜ Minimum service for maximum pension – 20 years (i.e. 30ths) for joiners since 17 March 1987, ten years if earlier.
• ˜ Contribution limit for employee – 15% of salary (none for employer).
• ˜ Post-retirement adjustment – full inflation.
• ˜ Lump-sum cash – 2.25 times initial pension for joiners since 1 June 1988, 1.5 times FPS after 20 years’ service (reduced in proportion if less service) for earlier joiners.

Hardly anyone reaches all these limits.

Early retirement

Pensions are lower if you retire early for two reasons – less service and earlier payment. The latter is dealt with by the application of an early-retirement factor (ERF) to the pension, usually at least 4% for each year not worked.

Many schemes waive the ERF in the case of ill-health early retirement and employers wishing to encourage early retirement may eliminate it by paying in extra.

Cash lump sum on retirement

Most schemes have an option to take a tax-free lump sum on retirement, the pension being reduced proportionally.*

If the pension is fully inflation proofed, then it might be better to leave the money in. Otherwise, check whether you can buy an annuity with the cash to provide a higher income.

Additional voluntary contributions (AVCs)

All schemes are required to have a facility for AVCs and anyone who can afford it and is not up to the Inland Revenue limits should consider making AVCs.

Additional benefits earned are usually on a money-purchase basis but may be in the form of additional years of service, which should be better.

For AVCs commencing after 8 April 1987, it is not possible to take part as a lump sum. For this reason it is worth considering a stakeholder pension (see below) instead of some or all of your AVC, as it will then be possible to take the tax-free lump sum.

Free-standing AVCs (FSAVCs) are outside the company scheme. Whilst giving more freedom, they are probably more expensive as you must pay the administration costs instead of the company paying.

There is some debate about whether AVCs are better value than Individual Savings Accounts (ISAs). With AVCs the contributions are tax free, but the benefits are taxable. With ISAs it is the opposite. Most experts favour AVCs because the tax relief comes at the beginning, so funds accumulate on a tax-free basis. ISAs allow more freedom of action, but is this a good thing for pension money?*

Starting a personal pension

Personal pensions are suitable for people who cannot (or do not wish to) join a company

scheme, the self-employed, those who change jobs frequently and those in irregular work. The basis is money purchase so there is no guarantee of benefit amount.

Contributions

These are usually paid regularly each month but can be irregular and some people prefer to wait until the year end to see how much they can afford.

A regular payment has a certain discipline but you are usually tied to a contract and charges tend to be higher. With lump sum payments will not be tied and so can seek the best deal each time. Either way, a flexible arrangement is sensible, so that you can increase or reduce contributions at will.

Contributions can be paid into an individual pension account (IPA) which is a ‘wrapper’ like an ISA and gives much greater control over how the money is invested.

Inland Revenue limits

Maximum contributions start at 17.5% of earnings and increase with age, up to 40% for those over 60, subject to the same earnings limit as occupational schemes. There is no limit to the amount of the pension. The tax-free lump sum can be up to 25% of the fund.

Since April 2001, when stakeholder pensions came in, it is possible to make annual contributions of £3,600 to personal or stakeholder pensions, or both together, the earnings-related limits only applying to higher levels of contributions.

Personal pensions

Shop around with a list of questions:

• ˜ How flexible can the contributions be?
• ˜ What are the charges?
• ˜ What are the penalties (if any) for stopping and transferring?
• ˜ What happens if you die before buying an annuity – is your fund protected from inheritance tax?
• ˜ Are there penalties if you buy your annuity elsewhere?
• ˜ What is the past growth record of the fund you will be investing in?
• ˜ How safe will your fund be?*

Retirement

After taking any tax-free cash, the balance of the fund must be used to buy an annuity. This can be done at any age between 50 and 75 and so can be postponed beyond retirement. The possible advantage of delay is that the stock market and/or annuity rates might improve.

If annuity purchase is deferred, income must be drawn directly from the fund within minimum and maximum percentages.

Deferment may be appropriate if you intend to work part time. Otherwise, experts suggest that it is not viable if your fund is below £100,000.

Making use of the new stakeholder pension

Stakeholder pensions were introduced in April

2001. Contribution limits are the same as for personal pensions. On retirement the fund must be used to buy an annuity but up to 25% can be taken as a tax-free lump sum.

In this case the Inland Revenue adds a tax rebate to your contributions equivalent to the standard rate of tax (i.e. in 2001 just over 28p for each £1) even if you pay no tax. Higher rate taxpayers can claim back the balance at the year end.

Annual charges will be capped at 1% of fund value, with no initial charges and no penalties for transferring the fund or suspending contributions.

Stakeholder pensions can be held alongside existing personal pensions or company schemes (but not where the employee earns more than £30,000 a year in the case of final-salary schemes). Contributions can be paid into an individual pension account (IPA) which is a ‘wrapper’ like an ISA and gives much greater control over how the money is invested.*

Understanding annuities

As already explained, money purchase, personal and stakeholder pension funds must eventually be used to buy an annuity. This is called a compulsory purchase annuity (CPA) and all the receipts are taxable.

Voluntary purchase of an annuity – such as with the tax-free lump sum – is called a purchased life annuity (PLA) and only the interest element of the receipts are taxable (the capital refund element is about half the receipts).

There is a wide choice of type of annuity, such as single life, joint life, impaired life (where you have a potentially terminal health problem, leading to higher rates) and they can be flat-rate or indexed. It is also possible to have an annuity based on the stock market, with variable returns.

There is also a wide variety of rates for each type, so make sure your pension provider gives you all the alternatives and makes it clear whether there is any penalty for shopping around. Because women on average live longer than men, their rates are lower.*

Planning for your retirement

Get a forecast of your state pension entitlement about five years before you intend to retire, to see if you can get more by making additional contributions – ask your local DSS office for an application form.

Shortly before retirement occupational schemes normally provide a quote showing your pension and that is when you decide about taking a cash lump sum.*

With a personal pension the provider will tell you the lump sum available and give an indication of annuity rates. This is when you decide whether to defer taking the pension.

Prepare a new income and expenditure budget for after retirement. Consider whether to use your lump sum to reduce your mortgage.

A year or two before retirement, review your investments to see if you should start switching from growth to income investments.

Summary points

• * Do you know your state pension position, especially if you are nearing retirement?
• * Have you considered making AVCs to supplement your company pension?
• * Consider switching your personal pension if the charges are high.
• * Can you take advantage of the new stakeholder pension?
• * If you have to buy an annuity with your pension money, give careful consideration as to which type of annuity is best for you.
• * If nearing retirement, have you prepared a post-retirement income and expenditure budget, to see where you stand?