Pensions For Beginners: All You Need To Know

Are you thinking about setting up a pension plan? Not sure where to start? This plain English guide to pensions should point you in the right direction.

The subject of pensions is always in the news. Is the State providing enough for people to live on? What sort of pension should you choose? How can you avoid being short-changed in your old age?

The options can seem endless, complicated and daunting. Those of us without a personal pension know we should probably set one up - but many people don't know where to start.

Lots of us feel a bit silly asking the basic questions. So before you make any decisions, here's a guide, in plain English, to what pensions are actually all about.

What is a pension?

Simply put, a pension is an income you receive when you retire.

Where this money comes from, how it's saved - and by whom - are all factors that determine what sort of pension it is.

There are three main types of pension in the UK: The State Pension (provided by the government), salary-related pensions (provided by some employers) and money-purchase pensions (which you and/or your employer may pay money into.) The latter schemes are also often known as personal pensions.

No tax?

You might have heard that pensions come with tax breaks.

This is how it works:

• The government provides a tax incentive to encourage us to save for our retirement. Providing a pension scheme fulfils certain criteria, you're not taxed on the money you put into it.
• Everyone gets pension tax relief of at least 22% (the current basic rate of tax). This includes people who don't pay any tax at all, for example children, students or the unemployed. Put simply, for every £78 you contribute to a pension, the government will put in at least another £22. (This will drop to £20 when the basic rate of tax becomes 20%, in April this year).
• If you pay the higher level of tax (40%), you can claim 40% back as pension tax relief.
• There are various limits on how much relief you'll get. For example, you'll only get tax relief on contributions up to 100% of your yearly salary.

It's worth bearing in mind that most people's pensions do, in effect, end up being taxed. This is because tax will have to paid on the income you receive from your pension fund when you retire.

In other words, the tax is delayed (allowing your money to grow faster), but you will have to pay it in the end.

Pensions - The Pros:

 As discussed, the tax relief on offer is a major pro.

 You may work for an employer who is prepared to match your contributions to your personal pension scheme.

 Personal pension funds typically invest your money in shares, and although there are risks involved, shares usually deliver a better return than cash savings over a long period.

 Because money in a pension fund usually can't be accessed until you retire, you won't be tempted to fritter it away needlessly.

...And The Cons:

• Because your money is inaccessible until you're at least 50, you normally can't lay your hands on it in a financial emergency.
•  Because of the way personal pension funds are usually invested, the eventual size of your pension fund can't be guaranteed. If the investments chosen (such as particular shares) perform badly, you could end up with less of a return than you hoped for. 
• Many holders of personal pensions have been disappointed by the income they eventually received in retirement. In other words their pension fund generated a smaller income than they expected. This is due to problems with what are known as annuity rates. I'll look at this issue in more detail in a later article. 

What are the alternatives?

There are other ways of providing for your old age. Two of the most popular alternative sources of retirement income are property and Individual Savings Accounts (ISAs).

Are these alternatives better to invest in than a pension?

Property

Years of rapid house price growth have led many Britons to plump for property as their retirement nest egg.

But buying a property for investment isn't risk-free, particularly if that property is also your home. When you retire, you may be forced to downsize or release equity in your property to provide for your old age.

Read Pension Or Property: The Big Dilemma to find out more.

ISAs

There's no income tax relief on payments into ISAs, like there is on payments into pensions. However, unlike with a pension, you don't have to pay any tax on the money you withdraw, as it is exempt from Capital Gains Tax. So with an ISA, you're paying tax the other way round from a pension (at the beginning, not the end).

You can access your funds more easily than you can a pension - for example, to fund an urgent financial commitment. Obviously, this also means discipline is required to avoid spending your retirement fund early!

However, there are heavy restrictions on how much you can invest, and higher earners may find these limits too low. Read Pensions Versus ISAs to find out more.

People who are able to often choose to have a pension and one or more alternatives sources of retirement income. If you can afford it, this avoids putting all your eggs into one basket.

Your Pension Options

So, hopefully you now have a general understanding of pensions and what they're all about.

Still want a pension? If so, have a look at Part Two, where I'll explain what your pension options are,  what you can expect the government to provide, what (if anything) your employer contributes, and how you can invest in a pension yourself.