Pension MoneySaving Buy a different way to boost returns

For those in their twenties to forties, it's unlikely the State will provide a decent pension. Fail to put money aside and a cold baked bean retirement looms. Scared? You're meant to be, the pensions crisis is personal. Yet it's possible to get a pension that pays thousands more just by buying it a different way.

Don't forget the humble state pension; you may even be able to boost what you get.

No private pension has ever underperformed

Confused? Ignore whatever you've heard. This all stems from a fundamental misunderstanding of what a private pension is. It isn't a product, but simply a tax-free wrapper to save money for retirement. Their bad rap is because the ‘with-profits' type investment used for most people's pension performed dismally (see Martin's ‘the one word that caused the pension crisis' blog).

The distinction sounds arcane, but crucially means there's nothing wrong with pension saving, it's a superbly tax-efficient option that isn't implicitly risky. The risk comes from the investment choice and safer investments such as pension ‘cash funds' are available.

Please note that this article isn't for anyone who has a 'final salary pension' - they work differently to the private pensions described here.

Pension's killer feature: the tax boost

Money is paid into pensions before income tax is taken off. So when a basic 20% rate taxpayer invests £100, they only pay £80 because this is all that would've been in their pay packet; it only costs higher 40% rate taxpayers £60 (though you have to claim some of this back yourself).

Thus basic rate taxpayers get an instant 25% investment boost (i.e. pay £80 get £100) and higher rate taxpayers 67%. This is why pensions should be taken seriously.

Salary sacrifice - the extra boost

Simply paying into a pension gets all taxpayers a tax-break, but for an extra bonus as well as added ease, 'salary sacrifice' is worth considering.

This is simply where you gve up some of your monthly earnings in order to pay for something - in this case private pension contributions - out of your PRE-TAX salary. This increases tax relief for all because not only do you avoid tax on contribution, you don't pay national insurance (NI) either.

• Basic rate taxpayers: Here, as well as avoiding the 20% income tax you would normally face, the salary you sacrifice doesn't attract NI. All told, this means for every £680 of pay you sacrifice, £1,000 goes into your pension pot.

• Higher rate taxpayers: If you pay tax at the higher 40% rate, salary sacrifice means you don't have to claim back the extra tax relief yourself - it happens automatically. To deposit £1,000 in your pension pot, you only have to give up £580 from your paypacket, as no tax or NI is deducted.

However, one thing to consider is that you are taking an effective pay-cut - albeit to get a great benefit back. However, if having a lower upfront salary may hit you eg, about to receive maternity pay, or apply for a mortgage, think twice before sacrificing.

How much to put in a pension

Before starting, it's worth noting those in debt, especially at high rates of interest, should consider whether it’d be better to get rid of that before starting a pension. Plus a pension's only one form of retirement planning, combining it with other investments is often a good course.

Yet, the simple answer is as much as possible, as early as possible. There is a rough rule of thumb for what to contribute for a comfortable retirement.

Take the age you start your pension and halve it.
Put this % of your salary aside each year until you retire.

Thus someone starting aged 32 requires 16% of their salary for the rest of their working life. This huge percentage would scare the pants off anyone; even so this rule of thumb helps us set some aims:

• Don't delay. The sooner you contribute the longer your money has to grow and the compounding effect makes a massive difference.
• Keep the payments up. It's important to put away a constant proportion of your earnings, so as your pay increases, ensure contributions increase proportionately or you'll fall behind.
• Use the ‘pay-rise trick'. Most people will be unable to contribute enough at the beginning so my tip is start with whatever you can, but each time you get a pay rise, immediately start putting a quarter of it each month into your pension. Thus you'll be basking in the glory of more money, without getting used to spending the money destined for your pension.
  

The different types of private pension

Private pensions fall into two main camps:

• Personal Pensions and Stakeholders.

  Pension providers set plans up and offer you a limited choice of funds to invest in, usually based around stocks and shares type investments.

  The main difference between personal and stakeholder pensions is that with stakeholders (which were introduced in 2001) the provider's annual charge is capped at 1.5% of the pension's value and they must allow easy transfers of investments between funds and providers. Many stakeholders have less choice of investments than personal plans, but the differences are closing.

• Sipps provider greater flexibility

  Self Invested Personal Pensions (Sipps) are completely DIY pensions, allowing you to choose any providers fund or even individual shares. These are primarily for those with larger pension pots, but charges have come down, so active investors prepared to do the leg work themselves can run a SIPP on the cheap, if you use the right provider. Read a full guide to SIPPs.

What happens to your pension cash

Once the money is in a pension, it can't be withdrawn willy-nilly, but it must stay there until you're at least 55. At that point, 25% of it may be taken as a tax-free lump sum with the remainder to provide a taxable income for the rest of your life.

Before April 2006, this meant buying an annuity, a fixed annual payment until you die. Yet there are now a variety of other options, which provide more flexibility.

As getting an annuity wrong can mean you're trapped in a poor investment which can't ever be changed, it's one of the very biggest financial decisions you'll make. Read or our full printed or PDF annuity guide and possibly consult an Independent Financial Adviser (IFA).

How safe is my pension?

With normal savings accounts, the simple rule is that up to £85,000 per person per institution is fully protected should your bank go bust, by the UK's Financial Services Compensation Scheme (FSCS) (Read Savings Safety guide). Yet if you put money in stocks and shares or funds that invest in them, then you’ve got a “risk based” investment NOT savings, and a totally different FSCS protection applies. Critically...

FSCS protection for pensions is very complex, and can vary with each product's structure. This is just a general guide, always check with your provider.

It's very important to understand that this protection with investments applies if you lose money due to the product provider of the investment going bust, in this case the fund manager that you've bought into through the pension.

Yet if the underlying investment goes bust, i.e. you have shares in a company and it goes kaput, or you've bought a fund and it performs poorly, then you’ve no protection as that’s the nature of investing.

What level of protection do I get?

Usually with pensions, the broker you buy it through e.g. Cavendish, doesn't hold any of the cash; it simply acts as a conduit for you to put the money into whatever funds or investments you want. Therefore in the unlikely event it went bust, your money should be OK, and still held with by the fund manager or bank it resides with. The protection applies should any of those go into default.

• Stakeholder pensions.
  
  If you invest using a stakeholder pension, this is usually covered under the 'long-term insurance' FSCS coverage. This means only 90% of everything in the pension (with no upper limit) is covered. For details of previous limits, see the FSCS website.
• Cash funds.
  
  If the operator of a cash fund that you have put money into via a pension goes bust, you are eligible for compensation of 100% of the first £50,000. For details of previous limits, see the FSCS website.
• Cash.
  
  If you have a Self Invested Personal Pension (Sipp) and decide to hold the money as cash, you are normally covered under the standard £85,000 cover per person per institution, the same as normal savings get.
  
  Ask your Individual Sipp provider which bank the cash is held in (often they spread it around up to five). Then check whether any other savings you may have are in institutions linked to those used for the Sipp cash, as cumulatively you'll only get up to £85,000 protection in each (See Institutional links table).

The trick to beat the system

Normally a chunk of the charges on a pension is designated to paying an IFA's commission, there's nothing wrong with this, providing you're actually getting advice. Yet, many people with straightforward affairs, simply head straight to the pension company, however the pension company then retains the commission itself.

Claw back the cash.

There are a number of specialist pension discount brokers, with whom you just tell them the pension you want and they arrange it without advice. This means they can rebate some or all of the commission they receive back into your fund, effectively reducing the charges compared to going direct. Even though it's only fractions of a percentage point, the effect of compounding means it can add up to £1,000s.

The UK's top discounters

Only a few companies do this, so the comparison is swift. The overall winner is phone and internet company Cavendish Online. It rebates all the commission, and instead charges a one-off fee of £25 for online applications and £35 by post. However, for the vast majority the extra growth massively outweighs the fee. The biggest no-fee discount is offered by Moneyworld-IFA.

Both these companies offer a very bare bones service, alternatively Hargreaves Lansdown's discount arms take you through picking a stakeholder and investment choice (though it's not technically advice) via their website and a printed brochure. There's no fee, but they still rebate a proportion of the commission.

To see the difference using a discounter would make to you, simply ask the pension company and the discounter for an illustration based on an identical set-up. It worth noting, occasionally buying direct via the provider's website, will result in a better discounted charges, but it's rare.

Picking a stakeholder pension

Using this route means you're unadvised, often not a problem, but if you're confused, unsure, or have complex circumstances, it's best to be safe and see an IFA. Website www.unbiased.co.uk lists advisers local to you.

When choosing a provider fund choice, charges and institutional safety are the keys. MoneySaving's not investing, so you'll need to do some research into this.

For details of picking funds within stakeholder plans read pension extras.

The Size of the Saving

IMPORTANT - This calculation was done in 2008

Put £200 a month into a Norwich Union stakeholder pension over thirty years, assuming 5% annual growth, and the fund would be £136,000; yet buy the same pension via Cavendish for a £35 fee and it'd grow to £148,000, £11,000 more, just by buying it a different way.

Warning: This is simply an example to show the impact of using a discount broker on a fund, the choice of Norwich Union is random.