FOOL SCHOOL
Personal Pensions

June 10, 2002

Personal Pensions give self-employed people, or those working for businesses without occupational schemes, a crack of the pensions whip.

Essentially, they are defined contribution schemes into which the holder pays a percentage of their salary (rising from a maximum of 17.5 per cent at the age of thirty-five or below to 40 per cent at the age of sixty or above). These payments then go into an investment fund, run by an investment or insurance company.

The payment is treated as if it was made 'net of basic rate tax'. In English this means that the government pays an additional £28.21 per month into your pension for every £100 you pay (if you want to know the sums that's because £28.21 is 22% - the current basic rate of tax - of the total of £100 plus £28.21).

If you are a higher rate taxpayer you get tax relief up the 40% level as well. This means you will get an additional tax refund of £23.07 for every £100 you pay in. (Again for fans of maths 40% of £128.21 is £51.28, less the £28.21 already paid by the government leaves a refund for you of £23.07. Phew!).

The fund grows and then, on retirement, you can take up to 25 per cent of your fund as a lump sum and the remainder is used to buy something called an annuity to provide an income and you pay income tax on that.

So personal pensions aren't so much a way of avoiding tax, as is often thought, but of deferring tax. There's quite a big difference between these two things and more detail is given in the section 'How do Pensions Compare with ISAs'.

In April 2001, in a bid to make personal pensions a little more useful and exciting, the Government changed some of the rules. The main change is that you no longer have to be earning an income to contribute to a personal pension. The precise rules are a little complex, but most people will be able to contribute up to £2,808 per annum to a personal pension, even if you have no earnings of your own. On top of this, the Government will add a contribution calculated using the basic rate tax (i.e. 22% as stated above), making a total of £3,600 per year. This is particularly useful for people going through career breaks, but contributions can be made on behalf of non-working partners or even your children.

On top of this, the Government has introduced the concept of Stakeholder Pensions. Basically this means that pensions meeting certain requirements, on costs and terms, can call themselves 'Stakeholder Pensions'. It's a sort of Government seal of approval rather like CAT standards for other financial products.

Another type of personal pension is the Self-Invested Personal Pension or 'SIPP'. These have the advantages of pensions, but you have much more control over what you can invest in. In the past, SIPPs have been prohibitively expensive for most but the advent of the online SIPPs (with charges similar to online brokers) has changed that. If you like to do your investments yourself, they're certainly worth a look.