This piece first appeared in Reader's Digest in January 2002
 The text here may not be identical to the published text

After years of working, today we can look forward to a longer, healthier retirement than our grandparents could have dreamed of, to two or three decades of finally doing exactly as we please. That is, if we can afford to.

Britain is facing a pensions crisis. More than half of us do not pay into a pension plan and will have to rely on the state pension when we retire. At just £3,770 a year that’s not enough to live on.

Even those who do have a company or personal pension aren’t putting in enough. The average single man is retiring on just £10,500, a woman on £8,400, under half the average wage. Pensions are boring––until you face poverty in old age. And that is what millions are heading for, unless they do something now. But it is never too late. Whatever your age, there is always something you can do.

Ben Riley, a 26-year-old computer consultant from London is not paying into a pension. “I did when I had a permanent job, but now I’m a freelance contractor I’m not sure what to do.” Ben’s girlfriend stopped paying into her pension because it was £80 a month and she said she couldn't afford it.

They are typical of thousands of young people, who don’t earn much. They may be paying off a student loan, buying a car, or just going out and having fun. Saving up for an event 40 years away comes bottom of their list. But it’s short-sighted.

“Because of his erratic work patterns Ben would find it easier contributing to one of the new stakeholder pensions,” says Alastair Conway, managing director of independent financial advisors Clear Financial Management. “They are guaranteed to have low charges––no more than one per cent a year and are very flexible. You can keep the scheme if you switch jobs, and stop, start or change what you pay in, without penalty.

“Ben should try to pay money into a scheme regularly, in stages. That spreads the risk of buying into the market at the wrong time. So if he has a six-month contract, make six payments.”

Stakeholder pensions are also for people in salaried work. Since October every employer with more than five employees has had to offer access to a pension scheme and normally this will be one of the new stakeholder schemes. If your employer will contribute to it too, so much the better. To find a good stakeholder, websites such as www.moneyfacts.co.uk or www.moneyextra.com are a good start. Or go to an independent financial adviser.

Anyone, working or not, can put up to £2808 a year into a stakeholder pension and the Chancellor will top it up by £792 tax relief––even for people who do not pay tax!

Some people are using this loophole to start a pension for their children or grandchildren. If a relative keeps paying in at the maximum for the first 18 years of a child’s life, by the time he is 50 the fund could have reached more than a million pounds––all for an investment of just over £50,000.

It is an important lesson in the power of compound interest and why it is better to start saving early. No wonder John D. Rockefeller called it the eighth wonder of the world. Someone who starts saving for their pension at 20, only needs to put aside 10 per cent of their pay to have an income of half their salary at 65 [see table p.] If they wait until they are 40 they have to save between a fifth and a quarter of their income every year to hope for a similar pension. The biggest factor in building wealth is getting money into the system and giving it time to work.

The peak time for saving in a pension is 45-54. Roger Farmer and his wife Daryl, from Kent, both put money into their company pension schemes. Roger, 55, is an engineer with a drugs company, Daryl, 47, a teacher. “I’m confident that our retirement will be happy,” says Roger. “My only worry is that some of my money is with troubled insurers Equitable Life.”

Roger’s concern is understandable, but he is fortunate that he has a variety of pension plans. Many people put all their money into what seemed like a rock solid company. It is far better to have more than one pension plan to spread your risk. Diversity gives security.

Almost a third of employees [32%] in this age group do not contribute to a company pension scheme. That is very foolish, particularly since many employers put money into the scheme.

Employer run schemes come in two forms. The pensions elite are those people like Roger and Daryl who have a scheme that guarantees a pension which is a proportion of their pay in the final year before retirement. These so-called final salary schemes are found in the public sector and in the best company schemes.

Normally the pension will be 1/80^th of your final pay for each year in the scheme––if you work there for ten years you will get a pension of an eighth of your final pay, after 40 years’ it will be half your final pay, guaranteed by your employer. If your job offers a scheme like this, join it.

In the other sort of company scheme the money you pay in is saved up in a pension fund. When you retire you have to use your fund to buy a pension in the market. These are called money purchase schemes––the new stakeholder pensions also work this way. What pension you get will depend on how well the fund has performed and how much pension you can buy with it.

However good your company scheme you may want to put more into it through additional voluntary contributions, or AVCs. These can be paid in through arrangements made by the company, or with another provider altogether––through free-standing additional voluntary contributions or FSAVCs. The former is normally better––charges may be less and the company may add money to your contributions.

In some final salary schemes you can buy ‘extra years’. These are not AVCs and are better value.

The basic principle of spreading your risk by putting money in at different times and with different providers applies to people in their 40s as much as it does to Ben. But Roger and Daryl already have a good pension each, guaranteed by an employer. So Alastair Conway’s advice is different for them.

“If they put money into AVCs now they are stuck when they retire with buying an annuity. These are bad value at the moment. So they may be better off paying into an ISA. Although they lose the upfront tax relief, an ISA is much more flexible. They will already have a good income from their company pensions, so an ISA will give them the possibility of having some extra cash, to buy, say, a car.”

As they approach 60 Valerie and Graeme Lupton face a worrying time in their Derbyshire home. “I took early retirement after ten years in my job and have a very small pension,” says Valerie. “Graeme worked for a small firm and they had no pension scheme.

“Now we live on our savings. Shares are too worrying. We have a few but that’s all. I constantly look at interest rates and move our money around, though I don’t trust Internet banks. But with interest rates going down, it gets very depressing.”

The best interest rates are found on the Internet, though Alastair Conway appreciates Valerie’s nervousness. “The key thing is to look who is backing the online bank. Cahoot for example may sound unfamiliar but it is part of the Abbey National. Interest rates are higher on these accounts.

“Valerie and Graeme clearly don’t want to take any real risk. So they should make sure they use their ISA allowance every year. They can move £6,000 between them over to a cash ISA account earning a good rate of interest tax-free. They may also want to keep an eye on National Savings––not good value now but that may change.”

He also suggests learning about gilts, or Government securities––basically IOUs from the Government which pay a guaranteed rate of interest. “They do not currently offer good returns, but I believe the Government will soon have to borrow more so in a year or two gilts could be paying at a better rate.”

Even people who have saved hard for a pension often face disappointment at retirement. The final pension fund may seem enormous, but even £100,000 buys very little.

The problem is that the Government only allows you to buy an ‘annuity’. You give the insurance company your fund and it gives you an income for life. Nowadays you can put that off until your are 75, but the amount you are allowed to take out of the fund before then––it is called ‘income drawdown’––is much the same as you would get from an annuity.

And that can seem very mean. A man aged 65 with a £100,000 pension fund would only get around £9000 a year from the best annuity available today. But that amount will not go up with inflation. Over the course of a typical life after retiring at 60, rising prices would almost halve his income.

Far better to choose an annuity that rises in line with inflation, though you pay a price for that. The best inflation protected annuity a man of 65 can buy for £100,000 is around £6750. So to get a pension of even half average earnings––around £10,700 a year––protected against inflation you will have to have a fund of around £160,000. The average fund is around £30,000, though some people have more than one.

Annuity rates very enormously from one insurance company to another. Even among the top ten providers the difference can be well over £1000 a year. The company you saved up your fund with will almost certainly not be the best one to buy your annuity from.

To find the best provider for your circumstances, go to an independent financial adviser who specialises in annuities. Remember, once you have made your choice––it’s called exercising your open market option––you cannot change your mind.

This inflexible system, which forces us to buy a poor value annuity with our pension fund, was first introduced in 1898 for civil servants. It is extraordinary that more than a century later such patronising paternalism persists, condemning millions of hard-working savers to years of poverty.

So far New Labour has stuck by old policies. But if the Government wants to persuade everyone to save hard for the future it must start treating us like adults. Let us decide how to turn our savings into a pension, and our dream retirement into reality.

No-one knows how fast savings will grow in future, but the table assumes it will be at 7 per cent a year, [insert “the middle rate”?] in line with the standards set by the Financial Services Authority, which regulates nearly all financial deals.[Given climate should we be giving lowest rate: 5%?]

In predicting how much pension your savings will buy, the table uses the rates you’d get today––they may be different in future. The percentage of gross pay for women is higher, as women live longer, so will get less.

January 2002

e-mail Paul Lewis on paul@paullewis.co.uk