What works best when work's over?

David Prosser compares the merits of personal pensions and PEPs in saving up for retirement

Armed with a terrifying array of statistics, pension companies are desperate to persuade you to part with your cash. The traditional state pension is doomed, say the companies (they're right, pretty much), and unless you start saving now it's the poor house when you retire.

Unless you're a member of a company pension scheme, personal pensions and personal equity plans are the main ways to save for retirement. Here's how the two compare:

Tax relief

You get relief on contributions to personal pensions at your highest rate of tax - so pounds 100 in a pension costs a higher-rate taxpayer pounds 60 and a basic-rate taxpayer pounds 76. In addition, when you retire, you can take 25 per cent of the total money accumulated as a tax-free lump sum. The rest, which must be used to provide you with a continuing pension, is taxable.

PEPs, on the other hand, are free of income and capital gains tax when you cash them in, although you don't get tax relief on the money you put in.

While these may seem fine distinctions - your money grows tax-free either way - there are two factors that should give personal pensions the edge on tax. First, there is the 25 per cent tax-free lump sum. Second, you're likely to be paying a higher rate of tax when you're working than when you're retired. If you do move to basic-rate tax when you retire, the relief you received upfront on your personal pension contributions will be worth more than the tax-free income you get from a PEP.

Flexibility

You can contribute to a PEP whenever you like, as long as you keep within the annual maximum investment limits, and you can withdraw money at any stage, tax-free.

With personal pensions you can't get at your money until you are at least 50 and, if you stop contributing for a while, many providers will impose punitive charges. That could be a problem if you lose your job since only people with an income are allowed to contribute to a personal pension.

At retirement, moreover, most pension investors have to buy an annuity to get a regular income from their pension funds. If annuity rates are low when you retire, that's bad luck.

Martin Campbell, product development manager at Virgin Direct, says the choice "boils down to accessibility". Virgin recommends PEPs to younger people who have yet to meet other financial commitments, such as mortgages, in case they need to get some money back later. But, says Mr Campbell: "Once your financial circumstances are set, the personal pension is the better bet."

Charges

Whether pensions or PEPs cost more is debatable - it depends in part on the particular product you choose.

Typically, personal pensions tend to have higher set-up costs but lower continuing charges. On average, PEPs probably cost a little less.

Investment performance

Most pension contributions go into a managed fund which invests in a spread of investments from cash through property to shares. That diversification lowers risk but can also lower your return. PEPs invest predominantly in stocks and shares, and over the longer term they should be rewarded for these extra risks with better performance. Timing is important, however. For example, people near retirement should not pursue an adventurous investment strategy that will leave them stranded if the stock markets suffer a downturn.

David Prosser works for 'Investors Chronicle'.

PEPS VERSUS PERSONAL PENSIONS

PEPs

Tax relief: no upfront relief; tax-free growth; tax free when encashed.

Maximum investment: pounds 6,000 pa; pounds 3,000 in single-company PEP.

Flexibility: withdrawals at any time; any use of PEP money allowed.

Charges: typically lower than for personal pensions.

Personal pensions

Tax relief: upfront relief at highest rate of income tax, tax-free growth; lump sum of 25 per cent of plan value can be taken tax-free at retirement. Remaining pension taxed as income.

Maximum investment: sliding percentage scale of earnings depending on age. Up to 35, 17.5%; 36 to 45, 20%; 46 to 50, 25%; 51 to 55, 30%; 56 to 60, 35%; 61 to 74, 40%; 75+, no contributions allowed.

Flexibility: no withdrawal until retirement.

Charges: suspension of premiums may incur penalties; most of the money must be used to buy an annual pension in the form of an annuity.