Fools think twice about a pension

Our final extract from Motley Fool, the best-selling investment guide

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This week: pensions, annuities and endowments: the Foolish story

YOU'VE got to have a pension, haven't you ?

Well yes, and then again, no. Before we answer this in a slightly more helpful manner, let's tour the different pension options available and also scoot Foolishly through the thorny issue of annuities.

The state pension. This is slowly being abolished. By the time many people reading this retire, they'll be lucky if the state pension buys them a bottle of blue hair rinse. Do not factor the state pension into any of your retirement calculations.

Occupational pensions. The days when you worked for the same company for 40 years, and in return got a carriage clock and a generous pension, have gone forever. The best occupational pension schemes are in the public sector. If you are in the police force, your pension will be generous indeed and will be paid for out of the organisation's budget. In the private sector, pension contributions are paid into an investment fund into which both employer and employee pay. This fund will be invested in a variety of things, although generally it is heavily weighted towards equities.

Occupational schemes can take one of two forms:

1. Where employees know exactly how much pension they will get on retirement.

When the employee retires, the pension paid will be defined by a formula based on salary and years of service. Not surprisingly, this is known as a defined benefit or a final salary scheme. If the investments in the fund underperform, the company has to stump up the difference to pay the guaranteed pensions. The maximum you are allowed to get with this scheme is two thirds of your final salary. Employers take a risk when they offer these schemes, so they are stampeding to the other option:

2. Where the employee doesn't know exactly what to expect in retirement.

Contributions go into an investment fund. However, the employer is not obliged to make the pension up to any defined amount. This is called a money purchase scheme or defined contribution scheme.

For most people, an occupational pension is probably worth having but they are not going to provide the single, all-encompassing answer to a prosperous dotage.

Personal pension plans (PPPs). Personal pensions give people who are self-employed, or who don't have access to a company scheme, the chance to save for retirement. They are similar to the second type of occupational scheme, the defined contribution scheme.

The pension plan holder pays a percentage of his or her salary into a fund run by an investment or insurance company, and the government also contributes the tax the policy holder would have paid. In other words, they get tax relief.

PPPs are not as simple as they sound. In the late1980s and early 1990s pension salesmen working on commission persuaded millions of people to switich out of perfectly good occupational schemes into personal pensions. The mess is now being (slowly) sorted out and compensation paid to investors.

But there's still the thorny issue of charges on PPPs. What would you think if you were told 80 per cent or more of your first two years' contributions into a PPP went on charges ? This is money that will not fund your future, but someone else's - either the financial adviser who sold you the plan or the investment company itself.

Over time, the effect of charges can erode your pension fund by many thousands. A July 1998 survey in Money Management magazine found a policyholder paying in pounds 200 per month for 20 years would pay pounds 20,000 in charges on a Lincoln pension - one third of the total contributions!

The Government has announced plans for "stakeholder" pensions, which will be low-cost, portable pension plans. This is good news but policy holders will still face the same big problem when they retire as those with personal pensions and company money purchase pension schemes - namely, annuities (see below).

AVCs and FSAVCs. More acronyms. AVC stands for "additional voluntary contributions" and FSAVC stands for "free-standing additional voluntary contributions". The difference between them is that every occupational pension scheme has a "tied" AVC for members to make extra contributions. You use these schemes to "top up" payments into your pension. Both schemes are similar although the charges on AVCs are much lower. If someone tries to sell you an FSAVC, to run alongside a company pension scheme, remember that he or she is getting commission. Recent reports suggest FSAVCs are being sold inappropriately by financial advisers. You have been warned.

Annuities. An annuity is the way most people currently convert the money built up in a PPP fund or money-purchase company pension scheme into a regular income to see them though retirement. The new stakeholder pensions will also be run in the same way.

It works broadly like this:

You retire.

You take the dosh in your pension funds and use that to buy an annuity, either from the pension company or another firm. The annuity pays a fixed income until you die.

The precise amount of income depends on how long you have to live. Women, who live longer than men, will get less than men of the same age. Fat smokers can negotiate larger annual payments than thin non-smokers. And so on.

Unless you have agreed to accept a substantially reduced initial annuity payment, the amount you receive will not rise in line with inflation.

Unless you have agreed to accept a substantially reduced initial income, your spouse will get nothing when you die.

Now, you and your spouse both die. Biff! The annuity company pockets the money. Your heirs get nothing.

One of the problems with annuities is that we are living too long for them (which makes them very expensive), and the rate of inflation is just a bit too high to make them last as worthwhile sources of income. People reading this may live for 30 years or more in retirement.

Let's see why annuities are not good investments.

Hermione wins pounds 1m on the lottery when she is 50. As she has no relatives and can't be bothered with investment, she swaps the money for an annuity paid for the rest of her life. She gets an income of pounds 70,000 a year. Whoopee !

But this does not increase with inflation. A long-term inflation rate of just 3.5 per cent would mean Hermione enters her 75th year with an income worth just pounds 28,725 in real terms. Supposing she makes it till she is 85, she'll get the equivalent of pounds 14,000 a year. Bad news!

The amount of annuity you can buy also depends on the value of Government bonds (which are called gilts). These move up and down in line with interest rates. Interest rates are currently low - and falling. Your money buys you a lot less than it used to. It's a long term problem.

Luckily, you don't have to spend all your pension fund on an annuity right away. The exception is any money you have invested in AVCs and FSAVCs.

Extracted from the `Motley Fool UK Investment Guide' by David Berger with David and Tom Gardner, published by Boxtree at pounds 12.99. David Berger, David and Tom Gardner 1998. To order a copy, post free, call 0181-324 5522.

This is the last of our extracts from the book. In the new year, we will be continuing to offer you Foolish investment tips in an exclusive, regular Motley Fool column.