Personal pensions

Personal pensions are offered by life insurers, banks and building societies. Investors can make regular or lump sum payments and get tax relief at their normal rate, up to an annual allowance of £235,000, above which contributions are taxed. They can then withdraw money from their pension from age 50, rising to 55 in 2010. Some employers offer access to a group personal pension plan – not to be confused with an occupational scheme.

Pros: Charges are lower than those for some self- invested personal pensions (Sipps) and are on average 1-1.5 per cent a year. Investors are offered a choice of funds, although within a limited range. If you save into a group personal pension, your employer may have negotiated lower costs.

Cons: Life companies usually offer a limited number of funds in their personal pensions and run the funds themselves so investors cannot access all the funds or asset classes they might wish to. Funds in cash, bonds and equities and possibly a property fund are standard. However, some personal pensions offer a range of around 60 funds.

Stakeholder pensions

Stakeholder pensions are a form of personal pension and are targeted at lower- paid workers.

Pros: Charges are capped at 1.5 per cent a year, while personal pensions have no cap. The schemes are government-approved, so are unlikely to be high risk.

Cons: Stakeholder pensions offer fewer funds and less choice than a personal pension. Usually only about 10 funds are on offer.

Self-invested personal pensions

In a Sipp, the investor decides what funds or assets to invest the pension money into and can change them at will – although this is likely to incur a charge. Sipps come in many forms. Low-cost Sipps offer access to funds only – but with a choice of hundreds of providers. High-end Sipps also offer the option of investing in commercial property and unquoted shares.

Pros: Sipps offer a lot of choice and control. Charges can be lower than those for a personal pension, particularly with low-cost Sipps. However, charges on high-end Sipps tend to be higher.

Cons: Sipps are not for everyone. A recent study found that many people were advised to switch from a personal pension to a Sipp for no good reason, as they did not take advantage of the investment choice. Sipps have also been criticised for opaque charges. There is no industry standard for how providers explain charges, making it difficult to compare products. High-end Sipps may charge a few hundred pounds a year for both set- up charges and annual charges, plus fund charges of 1.5 per cent.

Workplace pensions

These are occupational schemes offered by employers to employees and come in two main forms.

Final salary

A final-salary pension scheme, also called a defined benefit scheme, pays a pension for life to an employee on retirement based on final salary at retirement. However, with many people living longer, the cost of providing the pension means that very few final-salary schemes are still open to new employees and existing schemes are closing their doors.

Pros: The guaranteed income for life – of up to two-thirds of final salary – makes these schemes the most generous and stable form of pension.

Cons: There are fears over the stability of some final-salary schemes. If the company goes bust, this is likely to affect the pension scheme too, and compensation levels are relatively low. Some schemes are considering moving from paying an income based on final salary to the career average, which is likely to be lower.

Defined contribution

Most employers now offer a defined contribution (DC) pension, also called a money-purchase scheme, instead of a final-salary scheme. An employee chooses how much of their income to put into the scheme – usually up to 5 or 6 per cent on a “defined” basis – and the employer can match or sometimes double that amount. Often the employer selects one pension provider to manage the scheme and employees can select where they want their pension to be allocated from a small range of funds.

Pros: Defined contribution schemes usually offer “lifestyling” whereby a member’s funds are moved into lower-risk investments as they near retirement. This gives capacity for growth but also more protection.

Cons: The main disadvantage is that the member bears the risk, not the employer. The value of a DC pension depends on how successful the provider has been at managing the money and what happened with stock markets over time. It also depends on what annuity rates are at the time of retirement.

Retirement options

Whatever form of pension you choose, with the exception of final-salary schemes, a decision has to be made at retirement about how to take the income from it. There are two ways to do this.

Annuities

The money saved in any kind of pension, except for a final salary scheme, can be used to buy an annuity on retirement – or from age 50. The pension money is handed to a life insurance company which calculates an annual income to be paid to the pensioner for life. Annuity rates are tied to life expectancy and, with many people living longer, annuity rates have been falling. A new innovation is the “third-way” annuity, which combines elements of an annuity and income drawdown, by keeping the pension invested in the stock market but with an income guarantee.

Pros: An annuity pays an income for life, so there is no danger of the pension fund running out or being lost on the stock market. There is no compulsion to buy the annuity from your original provider. Better rates are available for smokers or those in ill health.

Cons: Anyone who dies sooner than expected hands their pension money to the life company and their heirs cannot get it back. Buying a “level” annuity – one that pays a fixed income that does not rise over time – can be risky as inflation could erode the value of that income. Third-way annuities have come under criticism for their high charges – as much as 4 per cent a year.

Income drawdown

Income drawdown (IDD), also called an unsecured pension, is the alternative to buying an annuity. The pension money stays invested in the stock market and pensioners take an income from it.

Pros: Investors can retain control over their pensions. If the pensioner dies while in IDD, the remaining pension money can be passed to heirs – but with a tax charge of 35 per cent. Or it can provide an income for a spouse on death.

Cons: Staying invested in the stock market is a risk. Many providers charge for moving into an IDD and it is only possible until the age of 75 when the government requires people to buy an annuity, although there are some alternatives (see box above).