What is a pension plan? It is a simple enough question, but the answer is so complicated that a straightforward reply defies even the experts.
Essentially, a pension is a savings pot to provide income in retirement. But within that definition are enough sub- definitions to make the mind boggle. There are state pensions, second state pensions (S2P), occupational schemes, defined-benefit schemes, defined-contribution schemes, final-salary pensions, money purchase pensions, stakeholders and self-invested personal pensions (Sipps).
Legislative reform was introduced this year to simplify the UK pension system, but if you are still muddling the PPF with the NPSS, and NICs with S2Ps, let Times Money be your guide.
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Why is saving for a pension different to a normal savings account?
Pensions come with tax advantages that regular savings and investments do not have.
You gain tax relief on the money going in and mostly tax-free growth. You also receive 25 per cent of the money tax-free, although you have to pay income tax on the remaining 75 per cent. In exchange for the tax breaks are restrictions on the pension fund. For example, you cannot remove money until you retire.
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What are the different types of pension plan?
There are two main types: occupational pensions from employers and personal pensions taken out by individuals.
Occupational schemes are either defined-benefit plans, which include final-salary schemes, or defined-contribution plans, also known as money purchase schemes. Defined benefit means that the pension you receive is calculated using a formula based on your final salary. However, most companies have been closing these schemes.
A defined-contribution scheme is sponsored by an employer, with a trustee body overseeing the scheme. Both you and your employer contribute a set percentage of your salary. The more that goes in from both parties, the better the scheme. Tom McPhail, of Hargreaves Lansdown, the independent financial adviser (IFA), says: “It does not matter so much about the benefit structure. More important is the amount that you invest.”
Most pension schemes are linked to equities. If the stock market does badly, so will your pension fund. You can choose the level of risk you wish to take on. “Lifestyle profiling” means that the risk exposure is reduced as you grow older.
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Personal plans are taken out by individuals independently. Stakeholders are a low-cost type of personal pension, with charges capped at 1.5 per cent for the first ten years and 1 per cent thereafter. Discount brokers start as low as 0.6 per cent. Mr McPhail recommends the Scottish Widows stakeholder, invested in the Newton Managed Fund, or the AXA Retirement Distribution Fund.
Sipps allow you to invest in a wider range of assets, such as multiple funds, commercial property and gold bullion, but the charges are usually higher than on stakeholders. Both the Hargreaves Lansdown Vantage Sipp and the AJ Bell Sipp deal are linked to more than 1,000 funds.
Most pension schemes have a maximum contribution limit and fund value.
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Can I simply live off the state pension?
The basic state pension, funded by national insurance contributions (NICs), is not generous. A single pensioner is currently entitled to only £84.25 a week. The NICs that you make do not contribute to your pension but to the pot for current over-65s. However, an ageing population means that more and more pensioners are being supported by fewer and fewer workers.
Stuart Ferris, of Punter Southall Financial Management, another IFA, says: “Over the long term, the proportion of people in retirement will be so large compared with the working population that there will not be enough to go around.”
To be eligible for a full state pension men must pay NICs for 44 years and women for 39 years, but this will change, The state second pension, or S2P, is an earnings-related pension. Therefore, someone earning £30,000 will be entitled to more than someone earning £20,000. You can “contract out” of S2P if you invest the money in another pension plan.
A new National Pension Saving Scheme (NPSS), to be introduced in 2010, will aim to boost retirement savings for workers who are not in high-quality schemes. To be eligible you would have to opt in to the scheme.
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How much should I be saving?
Mr McPhail says: “If you are not saving at least 10 per cent of your income, then you are probably not saving enough.”
Pension returns are not guaranteed and you could lose out if the funds in which your money is invested perform poorly. The Pension Protection Fund (PPF) is a government organisation that provides compensation for employees who have invested in pension schemes that have collapsed, but the compensation is not guaranteed to cover the full amount lost.
CASE STUDY: ‘It’s all so confusing’
Jessica Patterson, left, will have more than 40 different funds to choose from when she signs up to her employer’s stakeholder pension scheme next February.
The 26-year-old Londoner’s employer will pay 3 per cent of her salary into the scheme, run by Legal & General. But her contributions will be voluntary and she does not know where to start.
Jessica, a conference organiser, says: “I will join because I know that I should, but I am confused by it all. I
do not really know enough about funds to choose between them.”
Until now, Jessica, who has student debt of £10,600, has shied away from pension saving because of her loan repayments and because she did not know where to turn for advice. “Having a student loan to repay means that lots of graduates are put off pensions,” she says. “I also had no idea where to invest or how much. Financial advisers seem so unapproachable to someone in my position.”
For more on pensions visit www.timesonline.co.uk/pensions