FOOL SCHOOL
Get To Grips With Pensions

September 1, 2003

Over the next few weeks, the Fool School series will be looking at pensions.

A pension is simply an income that you receive when you retire. To build up a big enough pot of money to provide that income, someone has to do some saving. What makes one pension scheme different from another is down to how this money is saved, whom it is saved by and how the income is eventually generated.

To encourage us to save enough for our retirement, the Government provides a tax break. So, as long as a pension scheme fulfils the criteria they have set down, then the money that goes into it comes out of your pre-tax earnings. Think of it this way: you put some money in, then the Government chips in the tax that you have paid (or would pay) on that money. There is a limit, of course, on how much you can pay in. The limit will depend on what type of pension scheme you are contributing to. In the case of some schemes, the older you are, the more you can put in.

These contributions form a pension fund, which is invested over the years until your retirement. In theory all this seems fine and dandy. In practice, life is once again about to take a shot across your bows. There are some complications along the way.

It is often said that most of us don't put enough into our pensions. That's only part of the truth. What is really meant by this is that most people don't invest enough for their retirement. A pension is only one way of investing for your retirement. Like all investment decisions you need to balance the pros and cons and compare various options. The benefits of pensions are:

• The tax break;
• The fact that you aren't able to succumb to temptation and spend the money prior to your retirement.

Offsetting this are the two main flaws:

• The charges tend to be more complex and higher than other long-term investment schemes;
• They aren't particularly flexible, particularly in respect to how you receive your pension money once you retire.

The Basic State Pension

The value of the Basic Pension is slowly being eroded and by the time some of you reading this come to retire you'll be lucky if it buys you a packet of Mr Kipling's jam tarts and a box of teabags. It's also worth bearing in mind that not everybody qualifies for it - you have to have made a minimum level of National Insurance contributions (roughly speaking, you'll be OK if you've paid at least the same amount as the basic pension for most of your working life).

You can get a state pension forecast from the Department of Social Security to check if you're up to date with your NI contributions and if not, you may be in a position to top it up. But don't rely on the Basic Pension too much when you're making your retirement calculations as it'll amount to a pittance by the time you're able to claim it.

Having said all that, it's currently worth £77.45 per week (around £4,000 a year). The Government plans to increase it with inflation. Pension rates used to increase in line with wages (which typically increase at a higher rate than inflation) but this link was broken in the 1980s. Married couples currently get £123.80 but, if you qualify for more than this with two single pensions, then you get those.

Sometimes more relevant is the minimum income guarantee, or "MIG". This basically sets a floor to what the State will give you in retirement. The floor is a little some way above the basic state pension, so if that's all you get, then you'll qualify to get the MIG instead (although the benefit reduces if you have £6,000 or more in savings). Currently the MIG stands at £102.10 for a single person and £155.80 for a couple.

Not much is it? A full state pension for a married couple taken together with the MIG is around £8,000 a year. That's why there is so much talk about us having to make extra provision for our retirement out of our own pockets.

Find out more in our pension centre.