Personal Finance: Small can be bountiful

FINANCIAL MAKEOVER: NAME: CATHY HAWKINS AGE: 42 OCCUPATION: PLAYGROUP SUPERVISOR AND CHILD-MINDER

Cathy is married and has two teenage sons. Her husband is a self- employed graphics designer and writer, and she works from home. For some time she has been worried about the prospect of having only the state pension, especially as both her income and her husband's income are somewhat uncertain. She was recently left a small sum of money, which she thought might be enough to "kick-start" a modest personal pension plan. She estimates that she could also afford pounds 50 a month in regular contributions. She was disappointed to be told by an independent financial adviser that she did not earn enough to get a pension.

The adviser: Jon Briggs, Associate Director of Chartwell Investment Management. 9 Kingsmead Square, Bath BA1 2 AB (01225 321700).

The advice: On the assumption that Cathy can afford to save on a regular basis, the comments of the IFA she contacted appear bizarre. The only option considered appears to be the use of a personal pension contract. We would suggest that consideration be given to a broad range of investments that could be used to accumulate capital for Cathy's retirement.

Throughout their working life, people effectively convert their income into capital - usually but not always through a pension contract - so that on retirement they can convert the capital back into an income. It does not really matter how this capital is accumulated, as long as there is sufficient to create the income providing financial security in retirement.

Cathy has already expressed her determination to build up a retirement fund and, with the savings market in the UK being as diverse as it is, there is absolutely no reason why someone in her situation on a low income should be prevented from achieving those financial goals.

There is a range of investment groups and products that could be used. The amount of money she has available for investment can be used on an ongoing basis, in order to boost her state pension in retirement.

A pension is a form of savings plan that happens to have certain tax advantages, the main one being that tax relief can be claimed on the premiums at the individual's highest marginal rate of tax. Basic rate taxpayers get basic rate tax relief, and non-taxpayers who are employed get basic rate tax relief, too. The funds also grow in a tax advantageous environment.

There are, however, restrictions on both the level on contributions that can be paid into pension plans, and on how benefits are taken at retirement. Cathy will have to give her IFA details of her earned income for the current year, and also, if she wants to make a single premium contribution, of her income over the past six years. The IFA will determine the maximum amount she can contribute to the pension plan. Any surplus can be invested into a different scheme.

Cathy is not necessarily restricted to putting money into a pension, but she needs to save. If she is looking for total flexibility and does not want to lock her money away indefinitely, then she could consider using an individual savings account (ISA), which will be exempt from income tax and capital gains tax, or maybe an investment or unit trust savings plan.

Such schemes do have significant attractions and are readily available to all investors. They provide a low-cost and flexible method of saving, with contributions as low as pounds 25 per month in some cases. One of the most cost effective schemes on the market is offered by the investment house, Foreign & Colonial. Lump sums can usually be added at any time.

Having accumulated her savings at retirement, Cathy will need to create an income from them. This can be done in many ways. She could invest the sum on deposit, and live off the interest. Normally, however, she would use her capital to buy a "purchased life annuity" (rather than a compulsory purchase annuity bought from a pension fund). Purchased life annuities are more tax-efficient than pension annuities, because they are taxed at the savings rate of just 20 per cent rather than basic rate of 23 per cent, and, in fact, part of the income is treated as a return of capital and is therefore not taxed at all. (With a pension based contract, the income in retirement is taxable, but 25 per cent of the accumulated fund is available as a tax-free lump sum.)

Of course, we cannot know what the tax regime will be when Cathy retires. So, whichever method of capital accumulation she uses, it is difficult to predict with any certainty what will be the boost to her income. But many financial planners now have sophisticated planning tools that can help people plan accurately for their re- tirement. It is very important to take the "guesswork" out of such a crucial aspect of life, so we do strongly recommend that the investment plan is taken seriously.

In summary, a pension is simply an investment in its own right. It is not some magical plan that will outperform and create a much higher income than any of the alternatives. The point is to try to build up capital in the most efficient and flexible way, which suits the individual in question.

There is no particular harm in putting money into a personal pension. Equitable Life offers suitable pension plans for people in a similar situation to Cathy, who want to make relatively small contributions and have a degree of flexibility in funding.

Alternatively, we would strongly suggest that Kathy investigates the idea of a regular savings ISA, unit or investment trust scheme (perhaps within an ISA) that invests in equity-based funds.

If you would like to have a free financial makeover, worth hundreds of pounds, please write to Andrew Verity, Financial Makeover, `The Independent', One Canada Square, Canary Wharf, London E14 5DL