Pension need-to-knows The 15 key points for retirement saving

1. What is a pension? Isn't it only for old people?

A pension is not necessarily what people think it is, and it most certainly isn't only for old people.

A private pension is fundamentally a simple product:

It is just a pot of cash you, your employer or the Government pays into, that the taxman doesn't touch, as a way of saving for retirement.

At retirement, you can draw money from your pension pot or sell the cash to an insurance company in return for a regular income until death, called an annuity.

It's important to understand how a pension affects your income.

• Yippee! I'm getting a pay rise. Any employer contribution, plus the tax you get back on your money, means your overall income will rise as extra cash is pumped into your pension pot. You may not get that extra cash in your pay packet to spend immediately, but it's going towards your future.
• Damn! I'm losing disposable income. If you contribute to your pension, it means you'll get less in your pay packet, so consider this carefully when budgeting. See our free Budget Planner tool.

2. What's this about auto-enrolment? what's that?

For many years, your company may have set up and contributed to a workplace pension. Now many employers are forced to offer you a pension, starting with larger firms.

This is designed to address a chronic lack of retirement savings. At the moment, fewer than one in three UK adults are contributing to a pension.

You have the option to say no to auto-enrolment, however, as it is optional. If you do nothing, you'll be opted in.

Auto-enrolment key facts

Who will be auto-enrolled?

When will I be auto-enrolled?

How much must I and my employer contribute?

I already have a pension, what happens to me?

I'm self-employed - why aren't I getting an automatic pension?

I want to opt out of auto-enrolment, what do I do?

3. Is it really worth it? How much do I get?

The killer boost of a pension is the tax relief, which comes in two forms.

You get some tax back on the money you put into a pension, while gains from the investments you make with that cash are largely tax-free.

Tax relief on contributions

You get the tax back you've paid on all contributions, if you're under 75, subject to an annual allowance. This usually goes straight into your pension pot.

What tax relief do I get?
If you pay the money into your pension yourself, or if it is taken by your employer from your pay packet, you automatically get 20% tax back from the Government as an additional deposit into your pension pot.

If you are a higher rate taxpayer you can claim an additional 20%, while top rate taxpayers can claim an additional 25%. If you are part of a workplace pension, you may not need to reclaim any tax if your employer simply deducts less tax from your pay packet.

If your employer puts the money straight in from your pre-tax pay then it's never taxed in the first place, so you still win.

How does the tax relief work?
If you get 20% tax relief, it doesn't mean you get 20% back of what you contribute.

Instead, the taxman works out your earnings on your contribution amount before tax was deducted. You then get back the difference between your contribution and your pre-tax earnings.

So when a basic 20% rate taxpayer invests �80 of their take-home pay in a pension, they'd have actually earned �100 before tax to come out with �80 (20% of �100 is �20, leaving �80). In that example, the tax relief is �20.

The graph below illustrates the tax boost.

Is there a limit to tax relief?
There are two limits. You get tax relief on contributions up to your annual earnings. Imagine you earned �20,000 each year, but had �30,000 in savings, and decided one day to put all your savings into a pension. In this situation, you would only earn tax relief on the first �20,000 of your contributions.

The second limit applies to higher earners. You also can also only get tax relief up to your current annual allowance. It's made up of the current year's allowance - which is �50,000 - while you can also carry forward unused allowances from the previous three tax years. It's explained below...

Money paid by someone else, such as your employer, counts towards those allowances.

The annual allowance is set to fall to �40,000 per annum from April 2014.

You can still save more into a pension but you will only get the tax breaks up to the stated maximums above.

Tax-efficient investments

Like when you invest within an ISA, most of the gains are usually tax-free, so there's no savings tax and no capital gains tax.

There are some exceptions, though. See the HMRC website for full info.

4. I've been offered 'salary sacrifice'. Eh, what's that?

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.

Salary sacrifice applies to a number of workplace benefits, not just pensions.

It's where you give up some of your monthly earnings in your pay packet, with your employer instead putting it towards something else � in this case, private pension contributions.

As it comes out of your PRE-TAX salary straight into your pension, not only do you avoid tax on contributions, 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 12% NI. All told, this means for every �68 of pay you sacrifice from your pay packet, �100 goes into your pension pot.
• Higher or top rate taxpayers: If you pay tax at the higher 40% or 45% rates, salary sacrifice means you don't have to claim back the extra tax relief yourself - as you are never taxed on those contributions in the first place - and you don't have the 2% NI deducted on those contributions either. To deposit �100 in your pension pot, you only have to give up �58 from your pay packet, as no tax or NI is deducted as a higher rate payer. For a top rate payer, you only give up �53.

One thing to consider is you are taking an effective pay-cut � albeit to get a great benefit back. However, if having a lower upfront salary may hit you � for example, if you're about to receive maternity pay � think twice before sacrificing.

5. How much should I put in a pension?

While this guide has already dealt with the minimum you have to put in under auto-enrolment, often, you really should be contributing more - if you can.

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 methods is often a good plan.

If you opt for a pension, the simple answer of how much to put in 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 pre-tax salary aside each year until you retire.

Make sure you include your employer's contribution in that percentage.

So someone starting aged 32 requires 16% of their salary for the rest of their working life. This huge sum will scare the pants off anyone; but the rule helps us set some aims:

• Don't delay. The sooner you contribute, the longer your money has to grow. The compounding effect - where the cash your investment earns can, itself, attract additional earnings - makes a massive difference.
• Increase payments. It's important to put away a constant proportion of your earnings. As your pay increases, make sure your 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 start with whatever you can, but each time you get a pay rise, put a quarter of it each month into your pension. Then you'll be basking in the glory of more money, without getting used to spending the cash destined for your pension.

6. IF my employer offers me a pension, should I take it?

If you're employed, your employer may top up your pension as part of your benefits package, so absolutely consider it.

This is effectively a pay rise, so don't give that away, plus there's no tax to pay on that contribution (subject to annual allowances, above). It may not be going into your pay packet, but it is cash going towards your future.

Of course, you may not have the cash to afford the compulsory contributions, and there's no point getting into costly debt if that's the case. See our free Budget Planner tool to help you decide.

But also check out our Pensions Calculator to work out what's actually going into your pension from your contributions, to show the boost a pension can give, factoring in any employer boost, plus tax relief.

7. Hang on, aren't pensions a load of rubbish?

Confused? Ignore whatever you've heard. This all stems from a fundamental misunderstanding of what a private pension is. It's simply a tax-free wrapper to save money for retirement. Their bad rap comes from investments that don't pay off or high charges (see Martin's blog: The one word that caused the pension crisis).

Pension saving is a tax-efficient option that isn't implicitly risky. The risk comes from the investment choice. Safer investments, such as putting your money in cash rather than exposing it to the risks of the stock market, are available.

8. Pensions are confusing, tell me about the different types

Pensions come in all shapes and sizes. The first distinction is whether the pension is a final salary or a private pension.

Final salary pensions

These pensions, sometimes referred to as defined benefit schemes, are largely funded by employers, though staff sometimes have to pay into them. With one, you get a percentage of your final salary before retirement, or when leaving that firm, as an annual income.

What that percentage is depends on how long you worked for that particular firm. There is normally an 'accrual rate' set by your employer as a fraction of your final salary.

Say the rate is 1/60th, you get 1/60th of your final salary as a retirement income for each year you worked for that firm. So if you worked for 30 years, you'd get 30/60ths, or 1/2 your final salary with that firm.

Private pensions

The majority of this guide is all about private pensions. The way you save, by putting cash in a pension pot, is the same for all private pensions. How they differ is the way the money is invested and/or the level of charges.

Private pensions fall into three main camps:

• Standard pensions. This is where you and/or your employer make regular monthly payments, with that money invested by a pension company until you hit retirement.
• Stakeholder pensions. These are similar to standard pensions, but have low and flexible minimum contributions, capped charges and a default investment choice so you don't have to make the decision where to put your cash.
• Self-invested personal pensions (Sipps). These work in the same way but are DIY pensions, allowing you to choose your investment. Investors prepared to do the legwork themselves can run a Sipp on the cheap, if they use the right provider. Read a full guide to Sipps.

Don't forget the state pension. This is where you get a small pension from the Government when you hit the state retirement age. The basic state pension is currently �110.15 a week. You build up entitlement to the state pension by paying national insurance throughout your working life (see the State Pensions guide).

The table below shows how the different pensions differ.

9. It's years until I retire, so who's got my money till then?

If part of a workplace scheme, your employer chooses which company manages your investments, though you can decide the type of risks you want to take with them.

The Government has set up its own scheme, called Nest, which many employers who have yet to start a workplace plan are expected to join.

In a standard pension (not a final salary scheme), where the money is managed by a third party, the fund manager may choose the particular investments, but you can let it know the type of risk you want.

If you start your own pension, you choose the manager. If you opt for a self invested personal pension (Sipp), it will also be managed by another firm but you make the investment decisions (see the Cheapest Sipps guide).

10. So, how do I get a pension?

Under the new rules, many people will end up in a company pension so all they need to do is go ahead with what their employer offers. To pocket any contributions your employer makes, you need to agree to be part of its scheme.

If you opt for your own pension (where only you contribute) then you will need to scour the market for the best deals.

Unless you are financially savvy it is usually best to get advice from an independent financial adviser (IFA) given there are a plethora of charges to watch out for.

See our Financial Advice guide for how to pick an IFA, including what getting advice will cost you.

11. How do I get a pension on the cheap?

If you don't get a workplace pension, it's time to do your homework.

Claw back the cash (if you know what you're doing)

Normally, your adviser earns cash via commission taken from your pension pot.

However, if your pension is straightforward, or you have the financial savvy to know what you want to invest in, you can head straight to the pension company and set that up. But the pension company then retains the commission itself.

There are a number of specialist pension discount brokers. Here, you just tell them the pension you want and they arrange it without giving you advice. This means they rebate some or all of the commission and other charges back into your fund, effectively reducing the charges compared to going direct.

Even though we're only talking about fractions of a percentage point, the compounding effect means your fund could be �1,000s better off.

Using this route means you get no advice, which may not be a problem. But if you're confused, unsure, or have complex circumstances, it's best to be safe and see an IFA. It's better to pay a few hundred pounds upfront so you don't end up losing thousands over your lifetime, if you've no idea what to do. Unbiased.co.uk lists local advisers.

Important! Even if you pay a low set-up fee and/or get commission rebated, you may still pay what's called an annual management fee charged by the fund manager that looks after your investments, so there are additional costs to consider.

12. Some of the cheapest firms

There are two companies that charge small set-up fees, and offer an execution-only service, meaning you don't get advice; you need to make your investment decisions yourself.

Cavendish Online rebates all the commission, and charges a set-up fee of �35 instead. Moneyworld-IFA charges �25.

Alternatively, some companies give you information/brochures on their funds, though this is not technically advice, so you don't pay for any advice. There's no set-up fee, and they still rebate a proportion of the commission. These are BestInvest, Commshare, Close Brothers, Chelsea Financial Services, Fidelity, Hargreaves Lansdown* and TQ Invest.

It's impossible to state how much commission you'll get back because it depends on the fund you choose.

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.

Note: Occasionally buying direct via the provider's website will result in a greater discount. Also, the firms mentioned above all offer decent deals, though it may be possible to beat them - it's not a definitive list.

13. What happens to my pension cash at retirement?

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

This is based on current rules, which the Government may decide to change over time.

When your regular income stops... it's decision time. Ideally, start preparing a few years beforehand. Most people buy an annuity with their pension pot (after taking any tax-free cash), which is a product that gives an income for life.

What if I've got a small pension pot?

If the total of all your funds is less than �18,000, you can take your fund as a
cash lump sum instead of income, with 25% of it tax-free.

You must be at least 60 but not yet 75, and you have to convert all your pension funds to cash within 12 months.

14. Must I buy an annuity?

Until April 2011, you had to buy an annuity by age 75. Now, you can still buy an annuity, or take you can what's called a 'flexible drawdown' or 'capped drawdown' product. This is basically drawing cash directly out of your pension.

However, not buying an annuity can be risky, especially for those with pensions pots smaller than �200,000, as you may simply run out of cash.

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.

15. 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, under the UK's Financial Services Compensation Scheme (FSCS, see the Savings Safety guide).

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.

The FSCS does not protect performance losses, say if the companies you invest in go bust, that's the investment risk you take. Protection with investments only applies if you lose money due to the product provider of the investment going bust, in this case the fund manager you've bought into through the pension.

What protection do I get?

Usually with pensions, the broker you buy it through 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 goes bust, your money should be OK, and still held by the fund manager or bank it resides with. The protection applies should any of those go into default.

If protection kicks in, the FSCS will first try to transfer your funds from the failed company to another company. If that's not possible, you get 90% of whatever you have saved in a pension back.

For failed IFAs or brokers that mis-sold or provided dodgy pension advice, there may be a claim against the firm for mis-selling via the FSCS. This would be up to the investment limit of �50,000.

• 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
  
  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 What Counts As A Financial Institution?).