Money Tips Network

The field of pensions is one of the most complex of all to cover. Everyone knows about the basic old-age pension, funded by National Insurance contributions. Few think it is adequate as a sole source of income. In addition to the basic pension, there is the SERPS (State Earnings Related Pension Scheme), which was designed to give a higher benefit to those who wish to make extra payments in return for a higher pension at the end.

A large number of people belong to company pension schemes which ‘contract out’ of SERPS, offering instead a private scheme, part funded by employers, part by the employees themselves. Such funds must be approved by the Inland Revenue and are set up as independent trusts. They provide a very good benefit for those who retire after a long period of service for on firm. The maximum benefit available is generally retirement on two-thirds of the final salary, and there are guaranteed benefits for widows (whether the staff member dies in or out of service). The majority of schemes allow employees to take part of the pensions as a tax-free lump sum. Contributions from both employers and employees are free of tax and the fund itself can accumulate tax-free.

Company-run schemes do not offer a good deal to those who move jobs frequently. Those who are 26 or over and have worked for five years or more must have a pension right preserved by law; the amount is determined by dividing the years of service by the years which could have been served if the employee had worked through until retirement. So if an employee joins at 25 and leaves at 30, and could have worked till 65, he will receive an eighth of his entitlement.

If your service is just under five years, you can opt to take a lump sum in lieu of the final pension but if you do you will be taxed. Your contributions had been exempt of tax only because they were going towards a final pension. So the lump sum you receive will be less than you expect. It often would have been much more profitable to invest the money in a building society. However, few companies allow employees to opt out of making contributions.

There are reasons for the onerous provisions outlined above. If companies had to give all people who worked for them a decent pension, no matter how short their period of employment, and if employees could opt out of contributing, pension schemes would never fund themselves. However, the economic effect of such pension provisions is surely bad. It encourages workers not to be mobile but to stick with one job. An efficient economy is one where there are no barriers on labour movement.

Accordingly, the government now allows individuals to opt out of company pension schemes. Instead they can take out personal pensions, whereby they pay monthly instalments to a financial services group. The financial group then invests that money, so that by retirement time is has grown to a size sufficient to pay out in pension.

There are disadvantages to such schemes. If the fund is managed badly, or stock markets deteriorate, there is no guarantee that the eventual pension will be adequate. Also, there are no employer’s contributions under personal pensions. However, the advantage of a personal pension is that, however many times the individual move jobs, the fund keeps growing.