Watch out, high-flyers

Paying more into a pension fund may not save you money, says Paul Gosling

There is an old saying that a bad investment does not become a good one simply because it avoids tax. Similarly, do not be tempted to tie up money long-term in a pension fund just to reduce your tax bill.

But putting income aside for old age is both prudent and highly tax efficient - and should be thought of as deferred pay. For tax purposes, a key question is whether that pay will incur more tax now, or after retirement.

Income tax rates for the higher paid are at historically low levels, but there are fears that they will rise, particularly if the Labour Party wins the next election.

The general view is that you should always invest as much as possible in a personal pension - up to the limit of your tax allowance. But Peter Ratcliffe, a senior manager at the accountants Coopers & Lybrand, says that this is not always the case.

Well-paid employees may be better off not making additional voluntary contributions (AVCs), he says, if they are paying tax at the higher rate now, and expect that they will still have to do so when they retire.

"If you are paying higher rate now, but expect to pay standard rate in retirement, then there is a good case for paying AVCs - but if you expect that you will still be a higher-rate taxpayer on retirement, you would be better paying into personal equity plans," he says.

For many middle-income earners, AVCs can provide a disciplined method of saving for old age, which may be essential if your early career path meant that you were a late starter or you had some gaps in your pension contributions.

If you belong to an occupational pension scheme - one which is sponsored by your employer - the taxman will allow you to pay up to 15 per cent of earnings into your pension, including standard contributions and AVCs.

If pensions contributions provide a disciplined method of saving, the reverse of the coin is that they are inflexible. While we all need to be adequately protected for our old age, we also need some savings that can be drawn on, without significant penalty, in an emergency. Although pension contributions can be used as security for a loan, it this an expensive and inefficient method of borrowing, and the value of the loan will be less than the amount held in a pension fund.

There is a further important, if uncomfortable, consideration. If you die before you get old, then you will gain no benefit from your pension.

"If there is a family history of dying in the sixties, it seems daft to invest heavily in pensions," says Mr Ratcliffe. "But if the family history is of living to the mid-nineties then a pension's guarantee of paying you for life is important, and it doesn't matter so much about tax rates."

Since 1980, state retirement pensions have ceased to be up-rated in line with average earnings, and increase instead according to the retail price index. This is more significant than it sounds, and represents a major erosion in the value of state pensions.

For working people in early or middle adulthood, it is sensible to plan for old age on the assumption that the state pension will have little value by the time retirement is reached. The bulk of the pension will, therefore, have to come from a personal or occupational pension.

Before taking any final decision on whether to increase your pensions contributions, you should review your current arrangements. If you are at all uncertain, it may be wise to see an actuary or pensions specialist to project the level of benefits that your contributions are likely to provide. You can then consider whether they will give you a good standard of living in retirement, and if they do not then you should take steps to increase your contributions, bearing in mind that the younger you do so the more affordable extra payments will be