Have you lost the plot on pensions? If so, you're not alone. The government, employers, workers (the pensioners of the future) and even the finance industry itself all seem to be in a state of disarray and even denial.
The Government has commissioned a major report on pensions provision, but even before it arrives, two simple truths are staring us in the face. We are simply not saving enough for our retirement - the shortfall is now estimated to be £27 billion a year. And if you want a decent pension when you retire, you need to take action, yourself, and the earlier the better, making the most of the tax-breaks available.
Stakeholder pensions, which were supposed to provide an entry for lower-paid workers, have made little impact since their introduction in 2001 - three-quarters of the schemes which employers are legally obliged to provide are empty shells, with no members and no investment.
The pensions rot started in 1997 with the introduction of a ‘stealth tax', known as advanced corporation tax, which attacked the share dividends which make up much of the growth in pension funds. This in effect reduced the return on pension savings - their growth - by about 3% per annum, from 7-8% to 4-5%. Combined with the stock market crash of 2000 and more onerous regulation, this has contributed to the rapid demise of the classic ‘final salary' occupational pension. These schemes offered a comparatively simple proposal to employees: a guaranteed proportion of your salary at retirement, based on your number of years' employment, up to two-thirds after 40 years' service.
Many employers have now closed such schemes to new members. Instead they offer money-purchase schemes, which work in exactly the same way as personal pensions, including stakeholder schemes. In these the value of your pension is dependent entirely on the amount of money put in, together with the performance of the fund which looks after it.
The risk, in effect, has been transferred from the employer to the employee. And people are very wary of risk. The stock market crash unsettled us, and so did the high-profile demise of one of the most rock-solid names in the pensions world, Equitable Life - ironically it foundered on an ill-judged attempt to provide reassurance in the form of a guaranteed return.
What with the loss of the ‘final salary' benchmark, falling share prices and other changes which have seen the value of a 20-year plan drop by nearly half in just seven years, and deep distrust of the financial services industry, confidence has eroded. Savers are reluctant to commit their funds and risk making a mistake.
Delay at your peril
But putting-off starting to save could well be the bigger mistake. The effect of compound interest means that even a few years' delay in starting a plan can have a disproportionate effect on the size of the final ‘pot'.
If you start saving £100 a month 20 years before your retirement, with 6% per annum growth, you'll end up with £47,000. Wait five years before starting, say to age 50, and you'd receive just over £29,000 on retirement at 65. On the other hand, if you'd started 10 years earlier, say at age 35, your pot would be worth £102,000, and if you'd been saving for 40 years, from age 25 you'd have a nest-egg of over £200,000.
And how much will you need? When you take your pension, you are required to use it to buy an annuity, which will pay out a fixed amount (inflation-linked if you wish) for the rest of your life. If your annuity pays out at the rate of 5%, then for every £1,000 of annual income you want in retirement, you will need, as a rule of thumb, a fund of £20,000.
So £100 a month, saved for 40 years - amounting to £48,000 - becomes £200,000, which becomes a pension of £10,000 a year, possibly for 21 years (average longevity is now to age 76).
None of these figures of course takes into account the effect of inflation, which works both ways. £100 a month would have been a massive sum, more than many people earned, 40 years ago. £10,000, or even £20,000 a year now, will almost certainly be worth less, perhaps very much less, by the time you come to claim it.
Personal pensions, being a tax shelter, come with strings attached. The stipulation that you have to use most of your fund to buy an annuity means that you are provided-for to the end of your life, but when that day comes there is no capital left to pass on to your heirs. That is part of the bargain made by the government in providing tax relief on pension-fund savings, at the full 40% for higher rate taxpayers, and 22% for the rest of us. That means that for a basic-rate tax-payer £100 of after-tax income becomes £128 immediately it is invested, and for higher-rate payers, £100 becomes £166.66. Pension income is subject to income tax, but you are allowed to take a tax-free lump sum, 25% of your fund, on retirement, which you can spend or invest as you wish.
The fact remains though that the combination of compound interest, tax relief and the link to equities (which can go down as well as up, but generally behave themselves over the longer term) make pension funds one of the best vehicles for saving for retirement.
There are other options. Property may be a sound investment, though it can be difficult to realise. ISAs make good sense - in fact anyone seriously saving for retirement would be well advised to start by using up their ISA allowance. The income you put in is taxed, but the outcome isn't, so, for higher rate taxpayers the net result is much the same as a pension plan, with the added advantage that you can keep your capital. But a pension fund, will, or should, form part of the basket of anyone's retirement planning.
Stakeholder plans are simple, cheap, and have none of the front-end commission loading which used to swallow up much of the first year or two's contributions and got financial advisers a bad name. Intended to make pensions saving accessible to the lower-paid, they have been more successful among the better-off who have picked up on the tax-break introduced to sugar stakeholder pill. This extends the tax top-up, or its equivalent, to non-taxpayers on the first £2,808 pa of investment, bringing it up to £3,600, and they have been signing-up their non-working spouses and even children to benefit.
For existing schemes, begun before 6 April 2005, management charges will continue to be capped at 1%. A fee of 1.5% means that if the growth of the investment is 7%, then the benefit to the plan is 5.5%. With a 1% fee, it would be 6%. There are some competitive plans around that do not, at present, charge the full 1%. But the proof of the pudding is in the eating, and the trick as ever, is to invest in the plan that is going to perform best over the next however many years you need. Impossible to predict, of course - all you have to go on is past performance.
Self-invested personal pensions
SIPPs, or self-invested personal pensions offer an alternative vehicle, suited to the self-employed in particular. The benefit is that you can choose your own investments, and these can even include commercial property, including your own, via mortgage and lease-back, and shares you already own outside the plan which you can sell to realise the capital gains and then buy back within the SIPP. This do-it-yourself approach needs a 'wrapper' from a pension provider, and the fees levels may indicate a fairly high investment level, though cheaper (albeit simplified) versions are now available on the internet.
As an employer, you must offer a stakeholder pension if you employ five or more people and are not otherwise exempt (by already offering an occupational pension or a qualifying personal pension).
You do not have to make an employer's contribution to the scheme, though if you do, you enjoy tax relief and save National Insurance contributions (oddly, with personal pensions, you must make a contribution of at least 3% of basic pay, and can require employees to contribute as well).
You must meet certain conditions including consulting with employees over the selection of a scheme provider, arranging for payroll deductions and most important, paying the contributions into the scheme.
Your employees do not have to join the scheme, or any scheme. If they choose to join another scheme, you do not have to handle their payroll deductions.
For more details visit www.thepensionservice.gov.uk, or obtain leaflet PME1, Stakeholder Pensions, a Guide for Employers.
Working out your pension needs Calculate your income needs in retirement - allow for end of mortgage payments, commuting costs, support for children, but also for possible increase in leisure activities and care needs.
Work out where this will come from:
Assets: property (downsizing your home), sale of business, inheritance.
State pension: currently £82.05 per week, plus possibly State 2nd Pension (formerly SERPS) - this is unlikely to be more than £50 per week and may be a lot less. You can request your own State Pension Forecast - visit www.thepensionservice.gov.uk. Means-tested Pension Credits bring payments up to a maximum of £109.45 per week, but only for those with savings of under £18,000. The state pension system is currently under review, but with the retired population soon to outnumber working taxpayers, there is little likelihood of it becoming more generous.
Existing pension schemes, possibly with previous employers
Is there a shortfall? Start saving, and the sooner the better.