These notes apply to an individual who is looking to establish a personal pension or stakeholder. This may be because you are self-employed, in employment where your employer does not offer a pension arrangement, or perhaps where the employer has agreed to invest a certain amount and you are considering how much to add.

The fundamentals of a pension plan are very simple. You put money into a savings fund, it hopefully grows in value and at  retirement you convert the fund into a regular income payment, which will replace part, or all, of your earnings from employment.

1. PAYMENTS IN

Saving in pension plans is typically done in the following ways:

• Regular Instalments
  Once a direct debit is established the pension payment is taken automatically each month so you don’t have to worry about missing a contribution. Depending on whether you decided to increase your contributions over time, you may need to check that you are paying the right amount in relation to your salary. If your pension is set up to automatically increase contributions each year, the pension provider will change the direct debit accordingly. Once you start making regular contributions in this way it is easy to become accustomed to the regular payments going out of your account thus helping you to plan your budget accordingly.
   
• One-Off Investments
  Many people prefer not to be committed to regular monthly contributions and prefer to make one-off investments at a time of their choosing. Providers usually place minimum contribution amounts on single premium payments and this can be useful for self employed people or those paying higher rate tax, as the amount of contribution will attract tax relief at the individual’s highest rate. It is also possible to choose a different provider, or investment fund, each time an investment is made and in this way a balanced portfolio of pension investments can be built up over a number of years, although consideration should be given to the charges associated with establishing new pensions or entering new funds. Again, there are disadvantages to this method: the responsibility is yours to make sure that an investment is made. The pension provider will not automatically remind you that a payment is due and it is easy to find other things to spend the money on. Regular investment plans usually offer“pension contribution insurance” (PCI), which can ensure investments continue even if you are unable to work through illness. This is not normally available for one-off investments.
  
  
   
• A Combination Of Regular And One-Off Investments
  To achieve the “best of both worlds” investors might undertake a combination of investment frequencies. This provides both the discipline of regular investments and enables one-off investments to also be made so that the best use of the available tax relief can be made.

2. TAX CONSIDERATIONS

• Tax Relief
  Tax relief is granted on pension contributions and the effect is obtained in different ways depending on whether you pay only basic rate tax or whether some of your income is charged at the higher rate. Currently, the basic rate of tax is 20% and higher rate is 40%.  For employees contributing to a personal pension or stakeholder plan, the contribution is made net of basic rate tax. The balance is paid by Her Majesty’s Revenue and Customs, from whom the pension provider will reclaim the difference. So if you invest £80 into a personal pension, the provider will add the remaining £20 and invest £100 on your behalf. Claiming the tax relief back can take a pension provider 4-8 weeks but for practical purposes the provider assumes that it is received immediately.
  
  If the investor pays any tax at higher rates it is possible to claim back the marginal rate when they complete their tax return. In the example above, £100 is declared on the self-assessment tax return. The tax office will then credit you with £40 of tax, less the £20 already received and invested.  The net credit of £20 will usually be reflected in  your PAYE code or schedule D assessment. The overall effect of this is that an investment of £100 will actually cost you £60.
  
  The change to current year taxation for the self-employed has created a complex system of claiming back pension tax relief based in part on what you have paid and in part on an assumption that further payments equal to past payments will be made in the future. Whilst this has the affect of possibly deferring tax, it can cause a nasty shock in January, 2 years hence! Care should, therefore, be taken to understand the effect on self-employed tax assessments when a large single contribution is made or regular premiums are stopped.
  
  Tax relief for those earning over £130,000 will be reduced from April 2011.  Those earning up to £130,000 will receive full relief as at present, those earning over £180,000 will be entitled only to basic rate relief, and those with earnings in between will be entitled to a rate between the basic and higher rates. 
   

• Special Note on Tax Relief
  To prevent very high earners from making substantial contributions before April 2011, there will be a ‘special annual allowance’ of £20,000 for those who have total income exceeding £130,000 in the current tax year or either of the two preceding ones.  In broad terms:
   - if there is any single contribution or increase to a regular contribution and the total paid in during the tax year is over £20,000, tax relief is available as normal, but there will be a 30% tax charge on the excess over £20,000; but
   - current regular contribution levels of over £20,000 in the tax year will be eligible for tax relief as normal without any special tax charges, but any increase or single contribution will attract the 30% charge.
   - for those high earners who have previously made contributions less frequently than quarterly, the ‘special annual allowance’ is increased to £30,000 or the average of the contributions made in the 2006/2007, 2007/2008 & 2008/2009 Tax Years, whichever is the lower with a minimum of £20,000.’ 

• Restrictions On Payments
  The government lay down limits as to how much can be invested in a pension plan. With effect from April 2006 these limits are 100% of salary subject to an overall maximum in 2010/11 of £255,000. It is possible to invest up to £3,600 per year gross in a personal pension (and still receive the 20% tax credit) even if a person has no earnings.  As the person making the contributions does not have to be the same as the person benefiting from the pension this facility can be helpful in providing a pension for a non working spouse or for children and grandchildren as part of inheritance tax planning.

3. INVESTMENTS

Having established a pension fund and started to make contributions to it, you will have to decide on the type of fund in which your money will be invested. Most pension providers have a wide range of funds available, indeed, some have literally hundreds available. Essentially, funds break down into two categories: unit linked and with profit.

• Unit Linked Funds
  The principle of unit linked funds is that they are pooled funds linked to the performance of the underlying investments. These underlying investments are usually equities, i.e. stocks and shares, but can also be property, gilts etc. Every time money is invested in the fund the investor is credited with units purchased at the prevailing price. The money is used by the fund manager to purchase more of the fund's underlying assets. The price goes up and down in line with the investments it holds. For example, if these investments are UK equities and the market falls, the unit price will fall. When this happens this can be good news for people investing with a long time to go until retirement. The price is low and so a new cash investment will buy more units than would be the case when the price is high. On the other hand, a market fall is bad news for people about to use their fund to provide retirement benefits. The value of their pension fund will have reduced. It is to avoid this risk that those approaching retirement tend to switch funds into less volatile investments. 

• With Profit Funds
  With profit funds also invest in stocks and shares and other assets, but the fund manager tries to smooth out the peaks and troughs of unit linked funds by holding back some of the growth as a reserve. This can provide a smooth increase in value in your investments. 

4. PROJECTIONS

• Growth Assumptions
  When projecting pension fund values certain growth assumptions are made by pension providers. These are currently 5%, 7% and 9%. A better way to predict growth is to try to link inflation in and establish “real growth”. In other words, if a fund achieves 5% per annum growth but inflation has been 3% per annum, the real growth is 2%. With effect from April 2003 this more realistic real growth assumption became the norm.
   
• Pension Options
  At the time of retirement there are several options as to how you take your pension. For example, you may take tax free cash and buy an annuity, or buy an annuity without taking tax free cash. You can also remain invested and draw down part of the fund, and defer annuity purchase to age 75.  What is best for you will depend on your individual circumstances.

5. HOW MUCH SHOULD I INVEST?

You should invest as much as you can comfortably afford, as soon as you can. You should not over-stretch yourself and you should make certain that if you make a commitment to a monthly investment this will be continued for a long time.

The actual amount will be different for each individual and once you have arrived at a figure it is useful to try to link that to salary. For example, if you have decided that you can afford £100 per month and you earn £20,000, a quick calculation will show this amounts to around 6% of salary. Try to maintain that link in future years.

Many investors “target fund”, in other words they ask us to confirm the level of savings necessary to achieve a certain level of income at their chosen retirement date in today’s terms. This target funding is then reviewed on a regular basis to take into account revised objectives, investment performance and changing annuity and investment conditions.
 

6. WHAT ABOUT STATE BENEFITS?

State benefits for most of us form a major part of our retirement income. The introduction of the minimum income guarantee (MIG) (now the pension credit guarantee) has also greatly complicated retirement funding as it is means tested, so taking into account income from personal pensions. It is easily possible to end up in a position whereby 40% of your pension income is lost to subsidising the MIG, meaning your long term savings have been poor value for money.

If you are serious about your retirement you should get a state pension forecast. Application forms are available from us, your local DWP (formerly DSS) or the DWP website.

7. WHAT ABOUT OTHER FORMS OF SAVINGS?

Obviously if you are serious about retirement planning you should not necessarily concentrate all your savings into the one area of personal pensions, but personal pensions will certainly form part of your overall strategy.

8. CHANGES TO PENSIONS LEGISLATION

The much vaunted “simplification” of pensions legislation came into effect in April 2006. This radical legislation swept away all the previous rules and replaced them with a new regime. Some protection was given to accrued benefits under the previous formats. However, there will inevitably be winners and losers from the changes proposed.

9. SUMMARY

In summary, if you are considering starting retirement savings:

• Is the level of savings you are proposing realistic from a retirement and state pension perspective?
• Do you want the discipline of a monthly investment or could you make lump sum payments from time to time (or both)?
• Work out how much you need to live on if you had retired today. We can then confirm how much it will cost to achieve that objective.