Savings: Life can be a beach if the pension is right

To encourage us to save more for retirement, the Government is reviewing the whole of the pension system. Sometime next year it will reveal details of its "stakeholder pensions". But the present system is already highly tax-efficient if we use it properly, says Tony Lyons.

Occupational pension schemes offered by employers are usually the best means of saving a nest egg because up to 15 per cent of your earnings below pounds 84,000 can be invested each year with full tax relief. Often the employer will contribute a sizeable proportion, if not all of the premiums.

If there is no pension scheme where you work or you are self-employed, then personal pensions can form the core of your retirement planning. They are highly tax-efficient, if inflexible. At the outset, you have to specify when you plan to retire, which must be after your 50th birthday. Until then, you cannot use the money for anything else. At retirement, you must use three-quarters of your nest egg to purchase an annuity, which will provide income for the rest of your life. The other quarter can be used for anything else.

Full tax relief at your top rate of tax is allowed on all premiums. For basic-rate taxpayers, pounds 100 is invested for every pounds 77 contributed in premiums. Higher rate taxpayers contribute only pounds 60. Maximum contributions are determined by age. These range from 17.5 per cent of earnings capped at pounds 84,000 if you are under 35 to 40 per cent of your earnings if you are 61 or older.

When taking out a personal pension you usually have a choice of traditional with-profits plans or more modern unit-linked schemes. With-profit plans will have a bonus added each year with a large terminal bonus added at the end to reflect overall performance.

Unit-linked schemes are usually invested in shares and offer many choices. Depending on the risks you are prepared to take you can choose from investments ranging from those that track the FTSE 100 or All-Share indices to those investing overseas in emerging markets.

Unit-linked funds have historically out-performed with-profits policies. But unit-linked funds can go up or down. The more high-risk they are the more the unit prices will fluctuate.

Higher-risk equity funds are more suitable for sophisticated investors or those who have longer to go until they retire.

A recent survey by Money Management magazine projects the best and worst returns over 10 and 25 years with all charges taken into account and assuming growth of 9 per cent as year. Over 10 years the best include Flemings, Virgin Direct, Equitable Life, Eagle Star Direct and Legal & General Direct. Over 25 years Equitable Life heads Legal & General Direct, Marks & Spencer, Flemings and Co-operative Insurance. But this only reflects charges. Actual performance can make a mockery of such projections.

Mounting government pressure has lead to pension providers demystifying their sales methods. Even so, taking out a pension can still be a daunting process. You will have to answer a long list of questions to make sure that you are both eligible to take out a pension plan and that you understand just what you are committing yourself to.

If you feel you need help, independent financial advisers will guide you and recommend a provider to suit your needs. If you have not got an adviser, IFA Promotions (0117 971 1177) will provide you with a list of those in your area.

Make sure you understand the charges and the penalties if you decide to stop payments or transfer to another pension provider.

As part of your pension planning, whether in a company scheme or not, you should also consider PEPs. "It is sensible to have a balance of both personal pensions and PEPs," says Tony Wood of Virgin Direct. "PEPs offer more flexibility and are not as complicated as pensions."

Although no tax relief is given on PEP investments, all the income and capital growth is tax-free. And a PEP can be cashed in at any time, and you can use the proceeds for whatever you wish.