10 Personal pension schemes
Personal pensions are those that people organise for themselves as opposed to those organised by their employers.
The pension depends on:
- the amount paid in, which is invested in a pension pot
- how much the invested pension pot increases in value
- how much is taken out of the pension pot in charges
- how much the saver decides to draw out as a cash lump sum at retirement
- how much pension the remaining pot can buy at retirement. Most commonly the pot is used to buy an annuity (an annual pension income), but an alternative is ‘income drawdown’, which is simply withdrawing money from the pot in stages, rather like taking money out of a savings account.
Anyone can have a personal pension and anyone can pay into a personal pension for someone else – so, for example, the main earner in a couple could pay into a plan for a partner who has a caring role.
Personal pensions (unlike occupational defined contribution schemes) do not necessarily offer a package of benefits. It’s up to the individual to choose whether to buy extra benefits, such as life cover, a pension for a partner or increases to the pension once it starts to be paid.
Personal pensions and occupational defined contribution schemes expose the individual to a variety of risks. To understand these risks, put yourself into the position of someone who is currently many years from retirement and who has to organise their own pension scheme to provide themselves with retirement income.
How much should you pay into the scheme? It’s important to get this decision right because if you pay in too little, your pension will be too small. Pay in too much, and you could limit your current spending and standard of living. You can’t be certain of the correct amount. The eventual cost of the pension will depend on these factors.
- Investment returns: when investing for the long term – and pension savings are very long term – stock market investments, like shares and bonds, are likely to be most suitable. What counts here is the investment return after all the charges have been deducted. An investment fund that offers the chance of higher returns but has high charges might be a poor choice compared with a less ambitious investment fund with modest charges.
- Inflation: rising prices reduce the buying power of money. To protect against this, you would need to invest extra money to compensate for the effect of inflation both over the years when the savings are building up and once the pension starts.
- Longevity: the aim is that the pension, when it starts, will provide a regular income, usually paid monthly, until your death. The longer you live, the more months of pension have to be paid out, and the greater the total cost of the pension.
Therefore, personal pensions, defined contribution schemes, lead to individuals shouldering the risks up to the time when the pension starts. This means that different people saving the same amount can receive very different pensions, and a person’s pension can be markedly different depending on when they retire.