Pensions

Pensions You may need help understanding your existing pension arrangements and the associated benefits you might expect to receive, or perhaps you are considering a pension for the first time. We can help you understand the options for fund choice and the right type of pension for your situation.

Pensions have long been a topic of conversation and most people are confused and generally unimpressed by the thought of pensions. We will help explain them simply and ensure you have enough information to make up your own mind. There are thousands of different funds available and narrowing the choice down to the most suitable solution is not easy.

Because we are totally independent and can deal with the whole of the market we can talk about such areas as Income Drawdown, purchasing the best annuity at retirement, Self Invested Personal Pensions (SIPPs) and all types of Stakeholder Pension.

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More information on Pensions >

More information on Pensions

What can I expect from the state?
When you retire you will almost certainly be eligible for the basic state pension, and you may also be eligible for the "second tier" as well: the State Second Pension (or S2P). Neither of these is a spectacular sum of money.

As you have probably noticed, you pay not only income tax but also National Insurance contributions - the latter is nominally used by the government to pay for things such as the state pension, the NHS, unemployment benefit etc. Whether or not you are eligible for S2P will depend on how much you have paid in National Insurance over the years.

The problem which all governments in Western Europe now face is an aging population. Birth rates are declining and life expectancy is increasing. The net effect is that governments are having to spend more and more each year on paying pensions, and there are fewer and fewer workers per pensioner to raise the money for this through tax.

All this makes it unlikely - to say the least - that the amount of the state pension in the UK is ever going to be increased significantly. It also explains why successive UK governments, both Labour and Conservative, have put a lot of effort into encouraging people to make their own pension arrangements, and not to be dependent on the state pension.

What can you do for yourself?
The key issue in retirement planning is life expectancy: not just how long you are likely to live for, but what you expect from life in retirement.

With the state pension already at a low level, and unlikely to increase significantly, this means making some sort of provision of your own for replacing your income in retirement.

Of course, there are many ways of doing this. You could buy shares, invest in antiques, or even stuff banknotes under your mattress. However, the reason why people use "formal" pension schemes boils down to one very simple factor: tax.

Pension provision by the state is becoming ever more expensive, and governments are therefore encouraging people to make their own private arrangements. This encouragement takes the form of major tax breaks on pension contributions.

Put simply, any money you contribute to a private (non-state) pension is gross of tax - you pay in money out of your income after tax, and the Inland Revenue pay the tax back in to your pension. No other form of investment, not even ISAs, has a tax incentive as major as this one.

What your employer may provide
Although pension planning is one of the most complex areas which IFAs advise on, there is nevertheless an almost golden rule. If your employer offers a company pension scheme, consider joining it.

The reason for this is quite simply to do with cost. Your employer may make a contribution to the scheme on your behalf, and the charges on the plan will almost certainly be lower than anything you could arrange by yourself. Therefore, it is almost never good advice not to join your company's pension scheme if it has one.

Occupational pension schemes
The traditional route by which employers provide pensions is quite a costly and complex one, involving the strange beasts known as consulting actuaries, and requiring large amounts of administration.

Such schemes are most usually associated with large companies, and the Civil Service and other public sector bodies. There are basically two types of occupational scheme: final salary and money purchase.

In these days when huge numbers of people have invested in ISAs, unit trusts, or even bought shares directly, final salary schemes may seem slightly strange. The size of your pension has little to do with stockmarket performance - it mainly depends on how long you work for the company, and what your salary at retirement is.

Although they are quite flexible, it doesn't take much imagination to see that final salary schemes hark back to a vanishing world where most people work for the same company all their lives, slowly rising up a huge corporate ladder.

To reflect increasing job mobility, money purchase schemes are now more common than final salary ones. These are more readily understandable to the investor of today: your employer makes contributions on your behalf into a pension fund; the fund invests in the stockmarket and other areas; and therefore you build up a pension "pot" whose size is dependent on the amount paid in and the growth of the fund. At retirement this pot is then used to buy an annuity which pays you an income.

Simpler employer schemes
These traditional forms of company pension scheme are complex to set up and quite expensive to run, and therefore have mostly been used by large companies who can achieve serious economies of scale.

In recent years there has been a trend for smaller companies to take a simpler route. They arrange normal personal pension plans on behalf of their employees, exactly like the ones you can arrange for yourself (discussed below) except that your employer will usually be able to get a bulk discount on charges, and will usually make a contribution on your behalf. These are known as "Group Personal Pensions".

Since April 2001 companies employing more than four people have been compelled to provide a pension scheme for their employees - one of the new Stakeholder pensions, as discussed below.

Personal pension schemes
If your employer doesn't have a pension scheme, or you are self-employed, then it's Hobson's Choice - your only option is to open some sort of personal pension.

Personal pensions are very simple in principle (though nastily complex in practice). You pay in money every month, the money gets invested in a range of funds of your choice, the size of the fund grows over time, and when you reach retirement you use the accumulated pot to buy an annuity, which pays you an income.

You can open as many different personal pensions as you like, and the only major restriction is that there is a maximum amount you can contribute each year. And one other thing: once you've paid money into a pension you can't touch it until retirement - the government isn't giving you major tax breaks so that you can take the money out aged 35 and spend it on shoes.

Stakeholder pensions
The government has attempted to tackle some of the traditional issues surrounding private pension provision by introducing "Stakeholder" pensions. Their attack is basically three-fold:

Anyone can contribute (unless you already contribute to an occupational pension scheme and earn over £30,000pa).
You don't need to be in paid employment.
Providers can't charge more than 1.5% per year to run a Stakeholder pension (falling to 1% after ten years), and minimum contributions per month are very low.

The idea is to make personal pension provision much more attractive and accessible than it has been in the past. Charges are much lower than for traditional personal pension plans, almost anyone can contribute, and grandparents can even open schemes for their grandchildren etc.

In addition, companies which have more than four employees are now legally required to make Stakeholder schemes available to their staff. It's all part of the grand design to encourage more people to stop relying on the state pension.

This leaves one thing: how do Stakeholder pensions address the small matter of complexity? The answer is indirect at best. Personal pensions are complex because they are such long-term schemes: if you open one aged 25 the plan needs to be able to cater for changes in your lifestyle over the next 40 years. It's a necessary complexity.

Stakeholder pensions are often less complex than traditional personal pensions, but the reasons for this are not entirely positive. For 1% per year, providers are unable to afford a very wide range of product features, or to provide a large selection of funds for you to invest in.

A lump sum at retirement
If you wanted people to open private pensions rather than relying on the state, the obvious way to do it would be to give them tax incentives. So that's what successive governments have done.

Not only are gains in pension funds not taxable (like ISAs and some other forms of investment), but your contributions to them are tax-free as well. You contribute out of your net income, and the Inland Revenue has to give the income tax back.

Since the point of these schemes is to encourage people to provide their own income in retirement, the government has two very sensible restrictions on pension plans:

You can't take any money out of a pension scheme until retirement.
At retirement you have to use your pension fund to buy an annuity, which provides you with an income. You can't blow all the money on a round-the-world cruise and end up being dependent on the state again.

While the above is largely true (though a slight simplification), there is one concession which the government does make. At retirement you only have to invest 75% of your pension fund in an annuity. You can take the remaining 25% as a tax-free lump sum to do whatever you like with.

Contracting out of the State Second Pension
Most people pay both income tax and also National Insurance contributions. The government uses some of the latter to pay for the second tier of the state pension: the State Second Pension (S2P).

As part of its incentive to encourage private pension provision, you can choose to have your S2P payments put into your company or personal pension scheme rather than "investing" them in the state pension. This is known as "contracting out".

The benefits or disadvantages of contracting out are quite complex, depending on your age and the likely growth of your pension fund. You should always seek professional advice before deciding whether or not to contract out.

What happens if you fall ill?
Pensions are the Methuselahs of the investment world: no other type of financial planning regularly lasts for 40 years or more.

This means that the plans need to be very flexible, to cater for changes in your lifestyle over that time. For example, statistics show that you are very likely to have at least one extended period off work due to illness before retirement, regardless of how hale and hearty you may feel at the moment. If this happens, will you be able to keep up your pension payments?

For reasons such as this, pensions - and particularly personal pensions - include a very wide range of optional features which can be included in the plan. When looking into which pension to buy you should therefore take account not only of charges, the past performance of each provider's pension funds etc., but also examine how their scheme can cater for the unexpected.

Possible features are nearly endless, but the key ones to look for are as follows:
Does the plan provide an option for Pension Contribution Insurance? This is an additional policy which effectively pays the premiums on the pension if you are unable to work due to illness.
What happens if you die? What does your wife/husband receive?
How easily can you move your money between different funds, in case you invest in the US stockmarket and New York gets hit by an asteroid?

Approaching retirement
How would if you feel if you had a blow-out retirement party, and woke up the next morning to find that your pension was going to be 5% or 10% less than you thought it was when you started celebrating the night before?

While this isn't extremely likely, it's far from impossible either. Many personal pension schemes these days are invested in tracker funds where the performance is directly linked to a stockmarket. If the market rises, you make money. If the market falls, you lose. If there's a crash the day before you retire.

For this reason an increasing number of pension schemes offer the option to shift your pension money into low-risk investments as you approach retirement, to safeguard the pot you have spent 30 years building up. There are even plans where this happens automatically.

Preserved pensions
If you join an employer's pension scheme and then leave the company you will usually have two options: transfer the money into a new scheme, or leave it where it is.

If you leave the money in the old scheme you won't be able to make any more contributions to it. Before transferring into a new scheme you should seek expert advice since all sorts of charges need to be taken into account.

If you worked for the company for less than two years you may have a further option: having all your contributions refunded.

Early contributions
There's one vital rule of retirement planning which hasn't yet been mentioned: contribute as much as possible as early as possible.

Let's take two scenarios. In the first one you start contributing £1000 per year into a pension fund when you are 25, stop contributing at 35, and leave the fund untouched until you retire at 60. In the second scenario, you start contributing at 35, carry on all the way to 60, and pay in the same £1000 per year.

Which fund will contain more money at retirement? The answer depends on the average growth rate of the fund, but even at relatively low rates of growth (anything over 5.5%) you will do better by starting contributions at 25 and stopping at 35 - paying in for only 10 years rather than 25.

This graph shows the values of the respective funds assuming 6% growth per year. The red line is the fund to which you stop contributing aged 35, and the blue line is the one you start contributing to at 35.
Pensions Graph

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