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Personal pensions

Introduction

A personal pension* is a type of pension that you get from a pension provider – usually an insurance company. The idea is that you contribute to a personal pension fund which is invested to build up a fund to provide you with an income in retirement.

With occupational schemes, the contributions made by you and your employer on your behalf stop when you leave the employer. You stop being an ‘active’ member of the scheme and become a deferred member*. However, with ‘personal’ pensions you can carry on paying into the scheme if you want to even if you change jobs.

Personal pensions work on a money-purchase basis. The term ‘money purchase’ can apply to any pension scheme where the pension you get when you retire depends on: how much you (and where relevant your employer) contribute to the scheme, how well the investments held in the pension scheme perform and the level of annuity rates when you retire (see annuities). As is the case with money purchase schemes generally you take the risk of the investments performing poorly or annuity* rates being unfavourable against you when you come to retirement.

Tax relief on contributions

When you contribute to your personal or stakeholder pension* the pension provider claims tax relief from HM Revenue and Customs at the basic rate (22%) and adds this to your pension fund. If you’re a higher rate taxpayer you have to claim the additional rebate through your tax return.

Who might use a personal or stakeholder pension?

There are a number of reasons why you might use a personal type pension to provide for your retirement. The main reasons are as follows:

  • if you are self-employed and have to make your own pension arrangements;
  • if you work for an employer which doesn’t have an occupational scheme then it may operate a ‘group’ personal or stakeholder scheme. These work in the same way as individual personal or stakeholder pensions but are set up for a group of employees which means that lower charges may apply;
  • employers with 5 or more employees must provide access to a stakeholder pension. If you work for an employer with less than 5 employees, then you need to consider taking out your own personal or stakeholder pension;
  • you can choose not to join your employers pension scheme and want to have more control over your own investments (but you may miss out on valuable employers’ contributions)
  • if you belong to an occupational scheme and want to top up your pension by making additional contributions to a personal type pension scheme. Before the rules changed in April 2006, if you belonged to an occupational scheme and wanted to top up your pension you had to take out an additional voluntary contribution (AVC*) or free-standing AVC (FSAVC). Now you can now use personal type pensions. But it’s worth checking out your employers AVC scheme as these may have lower charges;
  • if you decide to contract out* of the additional state pension* scheme
  • even if you’re not working, you can still save for retirement through a personal type pension;
  • you can set up a personal type pension for someone else – for example, your child. There is no lower limit on the age at which someone can have a pension.

How do personal and stakeholder pensions work?

Personal and stakeholder pensions work in a very similar way – although stakeholder pensions have to conform to certain minimum standards set down by government which mean they can have lower charges and are more flexible than personal pensions.

With both types, you choose the pension provider (although you may have access to a group personal or stakeholder pension through your workplace). You’ll also have to make your own arrangements to pay the contributions to your personal or stakeholder pension – unlike occupational schemes where the employer deducts contributions from your wages. And unlike, occupational schemes, employers tend not to contribute to your pension.

You can make regular contributions or contribute single lump sums to the pension scheme depending on your circumstances – for example, if you’re self-employed you might not get paid on a regular basis.

You will pay charges to the insurance company when you take out a personal pension. Charges will vary between providers – although there are limits on the amount providers can charge for stakeholder pensions (see below). There are two main types of charges – an annual management charge which is deducted from your pension fund (usually on a monthly basis) and what’s known as ‘front-end loaded’ charges which are deducted from your contributions. 

With personal pensions, you can stop contributions or switch to a different pension provider. But you need to be careful about the types of charges imposed by the pension provider. The provider might impose certain conditions for stopping and restarting contributions. The ‘front-end’ loaded charges will mean that if you switch providers in the earlier years you could lose out. In certain cases, providers may impose penalties for switching pensions or retiring earlier or later than planned.

The pension provider will offer a range of investment options to suit your attitude to risk – for example, bond* funds, equity* funds, with-profits funds and so on. The range of options can be daunting and if you are not confident about making investment choices then seek independent financial advice.

Buying a personal pension using advice can provide better levels of protection from regulation as well. The advice may cost you more but the adviser is responsible for recommending a personal pension which is suitable for your needs and attitudes to investment risk. If you buy the pension yourself without advice then you will not have the same rights of redress if you make the wrong choices.   

If you want more information on the choices you might have and the questions you should ask a personal pension provider or financial adviser, then check out the Financial Services Authority guide: www.moneymadeclear.fsa.gov.uk/pdfs/pensions.pdf

When you get to retirement, you need to convert the pension fund you have built up into an income to live on (see What happens when you retire).

Stakeholder pensions

Stakeholder pensions operate in more or less the same way as personal pensions. However, the main difference is that stakeholder pensions have to meet certain standards set down by the government which were introduced to deal with the high charges and inflexibility which plagued conventional personal pensions.

Capped charges
Stakeholder pension providers are allowed to charge a maximum charge of 1.5% a year for the first ten years of the plan – this reduces to 1% a year after this. This charge covers the costs of running the scheme, managing your investments and providing basic advice and information. If the provider wants to levy a fee for more detailed advice this must be set out separately in a contract – not automatically included in the charge.

Low charges can make a real difference to your pension fund as more of your money is actually being invested on your behalf.

Low minimum payments
You must be allowed to pay in amounts as low as £20 whether as a one-off payments or a as a regular contribution.

Flexible contributions
With stakeholder pension schemes, you can choose when and how often you pay into the scheme – you can make regular or occasional contributions with no penalties for missing contributions.  

Penalty-free transfers
If you want to move your stakeholder fund to another pension scheme there is generally no penalty for transferring. However, if you have invested in a ‘with-profits’ fund then you need to check if your provider applies what’s known as a ‘market-value reduction’ if you switch.

Simple investment choices
Stakeholder pension scheme providers will offer a range of investment options. However, if you don’t want to make this choice yourself then the scheme must offer a ‘default’ option into which your contributions are invested. This default fund should be a ‘lifestyle’ fund which means that your money is invested in higher risk assets when you are younger but switched to safer investments such as bonds or deposits the closer you get to retirement. 

Group personal pensions

Your employer may provide access to a group personal pension or stakeholder scheme through your workplace. These are essentially the same as individual personal or stakeholder pensions but the main difference is that your employer may have been able to negotiate better terms such as lower charges from the pension provider. Some employers might make contributions to the scheme on your behalf.

Self-invested personal pensions (SIPPS)

As the name suggests SIPPS are designed for people who prefer to have more control and choice over the types of investment in their pension scheme. There are two parts to a SIPP – the SIPP itself and the investments inside the SIPP scheme. You can choose different providers to manage each bit separately.

The actual SIPP is a ‘wrapper’ which holds the investments you choose until you retire and start to draw an income.  You pay a SIPP manager to handle the administration of the scheme – this may be an insurance company or a specialist SIPP provider.

You then choose the investments to put into the SIPP wrapper. With personal or stakeholder pensions, your investment choices are limited to those offered by the pension provider. SIPPS offer access to a wider range of investments including the opportunity to invest directly in shares and commercial property. Residential property may be held in a SIPP through collective investment vehicles such as real-estate investment trusts or property unit trusts, without losing the tax advantages.

There are some things to be aware of if you are thinking about using a SIPP to plan for your retirement. SIPPS may have higher charges than stakeholder or personal pensions because you can pay separate charges for the administration of the SIPP wrapper and for the underlying investments. SIPPS have tended to be expensive and generally been aimed at very wealthy people although recently some providers have started to offer lower cost SIPPS with a more restricted investment choice where the investment and administration charges are bundled together. However, you need to watch out as you could still be paying higher charges than you would through a stakeholder pension with capped charges. You would need to be confident that you are able to choose investments that would perform better than the investments within a stakeholder pension to overcome the higher SIPP charges. 

SIPPs can only be provided by types of organisations approved by the Inland Revenue.  From April 2007, they are regulated by the Financial Services Authority (FSA). Before this, most SIPPs were not regulated by the FSA. This usually means that complaints and problems that you might have about SIPPS before  this date are not covered by the FSA’s complaints and compensation arrangements.