Wake up to the pension time-bomb

TAX FREE SAVINGS: Too few people are putting enough away for old age. The Goverment wants to change that.

Not enough of us are putting away sufficient money to provide for a comfortable old age. The value of the state pension is rapidly declining and by 2010, it is estimated that it will be worth less than one-fifth of average earnings.

The Government is so concerned about this, and about the fact that millions of us make no savings at all for retirement, that it is carrying out a review of pensions. It will be looking at ways to encourage us all to have a second pension, the so-called stakeholder pension, including ways of funding this for those who cannot work or are carers.

But even when further details of its thoughts are published, some time this autumn, we should save for retirement in the most tax efficient ways currently available.

Around 11 million employees are members of company pension schemes, where contributions are paid by both the employer and the individual. The best of these schemes pays out a pension equal to two-thirds of final salary after 40 years of service.

Few of us can expect to work that long for the same employer any more. But do not worry. The tax man allows us to make additional contributions to make up for any missing years, known as additional voluntary contributions (AVCs). Up to 15 per cent of salary can be invested in total in pension contributions, with tax relief given at your top rate of income tax.

If your company pension scheme does not offer a good AVC in-house, you can purchase free-standing schemes (FSAVCs) from insurance companies and other pension providers. The rules are the same as for AVCs, but do watch out as the charges are often a lot higher. You may find that you could be better off using your money to invest in PEPs and Tessas while you can, or ISAs when they are introduced in April.

Those who work for employers without a company pension scheme or who are self-employed, have to make their own provisions. This is usually done by investing in a personal pension.

These give a pension based not on salary but on how well the underlying investments perform. In fact, many companies are now switching from final salary schemes to similar money purchase or group pensions to cut costs. In these schemes your pension at retirement will be unknown and will depend on how well the pension provider has invested your savings.

All premiums paid into a personal pension attract tax relief at your top rate of tax. This means that if you pay the higher-rate tax of 40 per cent on your income, putting pounds 5,000 a year into a personal pension will only cost pounds 3,000 after tax relief.

Because of the generous tax allowance, only a limited percentage of income up to the earnings limit of pounds 87,600 can be invested in a personal pension. The maximum is based on the age of the individual, as shown in the table.

Traditionally, pension premiums were paid into the with-profits fund of an insurance company, which invests in a mix of fixed interest, property and equities.

Every year a bonus is declared which cannot be taken away. At retirement, a sizeable one-off terminal bonus is added to reflect the fund's overall performance during the life of the policy.

Nowadays, modern pensions are unitised with no guarantees about future values. They usually invest in equities and because their unit prices are published regularly, investors can work out how much their fund is worth.

There is a wide choice of unitised funds available and most good pension providers allow investors to move easily between the funds, usually at minimal or no cost. Some pension funds carry high charges that can seriously affect the value of your fund on maturity. Others impose high charges if premiums are stopped or changed. Pension providers now have to show these charges, but even then it is difficult to make comparisons.

Over the past few years, direct providers have begun offering personal pensions. Merchant Investors Assurance was the first, offering a range of funds linked mainly to investment trusts. It has been joined by a large number of other companies including Virgin, Direct Line, and Marks & Spencer.

Generally, anyone buying a pension from one of these companies will pay lower charges. However, some of the traditional pension firms such as Equitable Life, Scottish Equitable, Eagle Star, Norwich Union, Standard Life and Legal & General offer competitive pension plans, providing performance is as they project. And many of them have also set up direct selling arms.

The best personal pensions treat each contribution as a single premium, thereby not attracting any charges if contributions are stopped because of a change in employment, redundancy or whatever. In addition, they carry low annual management charges, typically under 1 per cent.

Pension plans are relatively inflexible. At the outset, a retirement date has to be set. The minimum age a personal pension can be cashed in is 50, but most opt for either 60 or 65. This means that it cannot be cashed in before the specified age.

Although PEPs disappear next year, they can still form part of pension planning because of their flexibility. Up to pounds 6,000 a year can be put into a general PEP and pounds 3,000 a year into a single-company PEP.

All income and capital gains earned by the PEP are accumulated tax-free. As they can be cashed in at any time, PEPs offer an additional means of retirement planning. ISAs, the PEP replacement, will also be able to be used in a similar way, except that the maximum investment will be pounds 5,000 in any tax year - pounds 7,000 in 1999/2000.

For those not in a company pension scheme, retirement planning can be very complex. An independent financial adviser will be able to help. Most advisers are paid commission by pension providers on any sales made. So always check to see what commission he or she is receiving. Better still, use an adviser who charges a fee or is prepared to split the commission.

Merchant Investors Assurance 0117 9266366; Virgin Direct 01603 215717; Norwich Union 01603 622200, Equitable Life 0171-606 6611; Scottish Equitable 0131-339 9191; Legal & General 0171-528 6200; Standard Life 0131-225 2552

PAY CODE

Age on 6 April

Maximum % of earnings

Under 35 17.5

36-45 20

46-50 25

51-55 30

56-60 35

61-74 40