Age concern

By Sarah Modlock

12 October 2005

Here's the good news... one day, you wont have to go to work any more. Now the bad news....unless you have enough money saved, your retirement will be a miserable struggle. Not everyone dreams of five star cruises when they hit their sixties but wouldn't it be nice to have your mortgage paid off and enough cash for a comfortable life?

It may seem a long way off but the reality is that you need to start planning and saving now if you want to avoid poverty as a pensioner.

Pensions may seem dull or confusing but they are simply a pot of money you save during your working years to provide an income when you stop working. Because we are all living longer, retirement can last for 20 or 30 years or more so it's crucial to make sure your income lasts that long and provides enough.

If the State Pension still exists when you retire it's unlikely to buy you more than a pair of warm slippers and a bag of humbugs, so relying on it is a no-no. The current payout is just over £82 a week which doesn't go far when there are still bills to pay and basics to be bought. To encourage us to set up our own pension, the government allows us to pay money in from pre-tax earnings. If your employer does not offer a company pension scheme then you can set up a personal pension. Here's how pensions work:

Company pensions

If you are an employee and can join an occupational pension scheme, you will normally be better off doing so. This is because most employers make contributions to the scheme and some run schemes where you don't have to pay any money at all. There may also be extra benefits such a pension for your spouse when you die or a pension if you become ill and have to retire early. A pension scheme linked to your salary will also increase in line with your pay rises.

Your company may give you the option of topping up your pensions with Additional Voluntary Contributions (AVCs). Alternatively, you can top-up your contributions independently of your employer in a free-standing AVC - an FSAVC - which can move with you between jobs. However, an employer's AVC scheme will usually have lower charges, so could be more cost-effective.

Unfortunately, occupational pensions are not completely without risk. The Pension Protection Fund set up this April pays some compensation to scheme members whose employers become insolvent and where the scheme does not have sufficient funds to pay out members' benefits.

Personal pensions

With a personal or private pension, you set up your own fund if you cannot pay into an occupational pension scheme. It can move with you from job to job. Before you go down the personal pension route, make sure it is the best option for you and check whether your employer offers a company scheme. An independent financial adviser can help.

You will also have to pay charges for the setting-up and running of your personal pension. Find out what they are.

Tax relief on contributions to a personal pension is the government's was of encouraging us to pay into pension schemes. With a basic rate of income tax of 22%, every £100 that goes into your pension currently costs you £78. If you pay income tax at the higher rate of 40% every £100 that goes into your pension fund costs you £60 and you can claim back the tax difference (compared with the basic rate of income tax) from the Inland Revenue.

Stakeholder pensions

Stakeholder pensions are simplified, cheaper versions of personal pensions, and providers cannot charge anything other than an annual management fee, capped at 1%. Employers who choose not to offer a company scheme must give employees access to a stakeholder pension scheme, although they don't have to contribute. Stakeholder pensions are also flexible. You can transfer to another scheme at no cost and you can stop, start and vary contributions without any penalties.

Defined contribution and defined benefit schemes

All pensions available to you privately plus any stakeholder pensions and some company pensions are all run as defined contribution schemes, sometimes known as 'money purchase' schemes. These work by building up a pension fund using your contributions plus investment returns and tax relief.

When you retire you can take a tax-free lump sum from your fund and use the rest of the fund to buy an annuity - an income for life. This is why they are called 'money purchase' - you are swapping your fund for a regular income for the rest of your life. The amount of pension you'll get at retirement will depend on how much you pay into the fund, how much your employer pays in (if anything), how well your invested contributions grow, the charges taken out of your fund by your pension provider, how much you take out as a tax-free lump sum, the 'annuity rates' at the time you retire and the type of annuity you choose.

With a 'defined benefit' or 'final salary' pension scheme, the final benefit - your payout - is guaranteed. Typically, your eventual benefits from this type of scheme are defined as a proportion of your final salary. Your pension comes out of the total pension pot that your employer has been building up over the years for all employees. If the investments have performed badly and there is not enough money to pay your guaranteed sum then your employer has to make up the difference.

And finally...

•  It's a myth that you can be too young to start a pension. The sooner you start saving, the better off you will be when you need the cash because your pension savings need a chance to grow over time.

•  When working out how much you should save think about the lifestyle you want when you retire and calculate how much you can afford to contribute towards your pension fund each month. Put away as much as you can as soon as you can.

•  Once you have set up for retirement plan, keep it under review so that you remain on track for a worry-free future.

More information is available from the government's website: www.thepensionservice.gov.uk.