Pensions - an Introduction

What you need to know about your pension and pension planning. State pensions, basic state pension and State Second Pension (S2P); occupational pensions and personal pensions. How much pension you are likely to need in retirement.

• Your pension - what you may need
• How do you set about saving for a pension?
• What type of pension is right for you?

Your pension - what you may need

The rules governing pensions were simplified in 2006 with one set of rules replacing eight previous regimes. However, despite being 'simplified', pensions are still complex but there are certain basic facts you need to consider.

You cannot rely on the state to provide for your comfort in retirement. As long ago as November 1999, speaking in the House of Commons, Pensions Minister, Jeff Rooker MP said, "Anyone relying on the Basic State Pension in Retirement will live in abject poverty," (Source: Hansard, 29/11/99). This means it is up to you to make provision for your old age.

Saving for a proper pension has never been more crucial - indeed it is the cornerstone of financial planning. Consider these numbers: median gross earnings in the year to April 2006 were £23,600 (source: 2006 Annual Survey of Hours & Earnings) and the average life expectancy at age 65 in 2003-05 was put at 16.6 years for a man and 19.4 years for a woman (source: National Statistics, 21/11/06).

Let's take an average of 18 years and assume you want a gross pension income that is equivalent to 60% of average earnings (£14,160 / year). That's a total spend over the rest of your life of £254,880. Of course, you don't have to save up quite that much.

Unless you are in a pension scheme that guarantees a pay-out linked to your salary (either based on your final salary or your average salary over the term of your employment), assuming an achievable annuity rate of 7% you would need to build up pension savings totalling £202,286. That's still a fairly tall order. Don't forget it is based on average earnings in 2006, not when you retire.

Compare that figure with the size of the average annuity purchased in 2006 - just £24,000 (source: Association of British Insurers, 04/06/07). At 7%, that would generate an annual income of just £1,680 or just over £140 a month, only £32 a week!

So far we have taken no account of the impact of inflation either while you are saving or after you've retired.

Inflation is relatively low but it soared to 27% in the 1970s and nobody can forecast what will happen over the next 50 years. Inflation, even at historically low levels, can have a devastating effect on the value of the pound in your pocket. For instance, with inflation running at the Bank of England's target rate of 2% a year over 20 years, £1,000 today would be worth only £670 and with inflation at 5% a year, the purchase value of £1,000 would be reduced to £380!

For a comfortable retirement, you need a large and growing source of income. This may come from a variety of sources, such as a pension based on your final salary or a pension fund which buys an annuity, which may or may not be inflation-linked, rental income from property, interest from savings, share dividends and so on. Retirement income does not necessarily have to come from a pension, but a pension should generally play a central role within your overall retirement strategy.

To work out how much income you will need, think about the sort of lifestyle you will want in retirement - holidays, hobbies and more time with family and friends.

Moneyextra's Pensions section

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How do you set about saving for a pension?

Quite simply, the sooner you start saving the better because that way your hard-earned savings will have longer to grow. By starting to save in your 20s, you could accumulate a pension fund of £1 million by the time you are 65. Assuming an average annual return over 40 years of 7% you would need to save a gross £390.12 a month to reach the magic million. If you leave it until you are in your 40s, you would have to save a huge proportion of your disposable income to achieve a similar fund. In fact, over 20 years, assuming the same average annual return you would need to save an eye-watering £1899.80 a month!

The government helps - there is generous tax relief on pension contributions. You get it at your highest rate of income tax. So if you're a higher rate taxpayer, you'll do best but the tax relief you receive as a basic rate payer is still worthwhile. For example, as a basic rate taxpayer, if you want to make a £1,000 contribution to a pension plan, it will only cost you £780 with the taxman topping up your contribution with the balance of £220.

A higher rate taxpayer benefits even more, a £1,000 contribution to a personal pension plan also costs them £780 upfront but they are able to claim back a further £180 via their tax return, so the cost comes down to just £600 with a generous £400 from the taxman. The rules governing contributions to occupational schemes are different but the level of tax relief is the same.

Tax relief on your contributions means that your pension plan is boosted from day one. It then provides tax efficient growth in your pension fund and it is not until you take the pension on retirement, that tax, at the basic rate, is deducted at source by your pension provider on its annuity. Your tax office will inform your pension provider if you become a higher rate taxpayer.

Income from your pension is taxable just as any other sort of income. However, everyone still has a personal allowance which will reduce the tax bill, and these allowances rise with age. So you get a bigger tax allowance when you reach 65 and a larger one still when you reach 75, subject to the age allowance income limits (see our tax tables ).

As a result of the introduction of the stakeholder pension the self employed and even those with no income, such as non-working spouses, are able to make pension contributions net of basic rate tax. The only catch is that when you pay money into a pension you have to say goodbye to it until you reach retirement age. The tax relief is designed to encourage long term savings.

Moneyextra's Pension section

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What type of pension is right for you?

Pensions come in three basic flavours - from the state, from your employer and arrangements you may make yourself.

Pension provision from the state includes the Basic State Pension, the State Second Pension (SP2) and Pension Credit, together with a variety of extra benefit payments. The level of pension provision you get from the state will be decided in part by your record of National Insurance contributions. Do not rely on state provision for a comfortable old age. You won't starve or at least you shouldn't but you won't have a particularly pleasant life in retirement.

Occupational Pensions

Occupational pension schemes are those run by your current or former employers. These also come in three basic flavours: defined benefit, where the benefits paid in retirement may be based on a combination of your age, length of service and the pensionable salary you are paid just before you retire - your final salary; defined contribution, also known as money purchase, which will pay out an amount based on the size of the fund, into which your contributions have been invested, at retirement; and group personal pensions, which are low cost personal pension plans bought by groups of employees under the auspices of their employer. The latter are personal pension schemes organised as a group to share lower costs of administration.

Your employer may make a contribution to your occupational pension scheme in addition to deducting a percentage of your salary and paying it into the scheme. You may make extra contributions to your occupational scheme to boost your pension provision up to a maximum of £225,000 a year (2007 / 08). Subject to the maximum limit, tax relief is available on pension contributions of up to 100% of your taxable earnings. You may contribute more than your taxable earnings but no tax relief will be given on payments above that amount.

Personal Pensions

The self-employed and those unable, or choosing not to join an occupational pension scheme, may take out a personal pension plan.

In addition, almost everybody aged 0-75 may have a stakeholder pension plan even if they are already in an occupational pension scheme.

There limits on the contributions you may make to a personal pension are a maximum of £225,000 a year, with a lifetime limit on the pension fund of £1.6 million (2007 / 08). All personal pension plans and stakeholder pension plans operate on a defined contribution basis. The pension benefit you will get when you retire will depend in large part on how much money you save and how well it performs as an investment.

Independent financial advice to help you plan your pension

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23 January 2008 © Moneyextra.com

Our senior editor Robin Amlôt recommends you should consider taking independent financial advice before acting on any article. Please contact us for help with your individual circumstances if any assistance is required.