Become a pensions expert in five days - day two

by Ed Bowsher on 30 June 2009  |  5 comments
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Today I'm looking at defined contribution pensions. They're simpler than they sound.

In the first part of this guide I looked at the government's basic state pension and also at final salary pension schemes. Here's a one sentence summary: the basic state pension is small and will probably get smaller; final salary schemes are great if you have one!

If you don't have a final salary pension, the next step is to see if you have a defined contribution pension.

Defined contribution pensions

Many people have these schemes. The basic idea is that you (and possibly your employer) save money into a pension pot each year. That money is then invested and will hopefully grow.

Then when it's time to retire, you normally use the money in your pot to buy an annuity. You buy the annuity from an insurance company which, in return, promises to pay you a regular income for the rest of your life. (There is an alternative to annuities which I'll look at later in this series.)

Defined contribution pensions (a.k.a money-purchase pensions) can be divided into four sub-groups:
personal pensions, stakeholder pensions, group personal pensions, and self-invested personal pensions or SIPPs.

1.       Personal pension

A personal pension is a scheme into which holders usually pay a regular amount or a lump sum. The payments go into an investment fund, usually run by a financial organisation such as a bank, building society or insurance company.

This pension provider will then invest the money on your behalf. The final value of your pension fund will depend on how much you've contributed, and how well the fund's investments have done.

The pension provider will charge you for setting up and running your pension.

I think personal pensions are a great option for lots of people. They may work well for you if you're working but you're not in a salary-related scheme (see part one). They're also good if you're self-employed - or if you're not working, but can afford to put aside money for retirement.

2.       Stakeholder pension

A stakeholder pension is a type of personal pension which has to meet certain government criteria.

The government introduced stakeholder pensions as part of a drive to get more people to save for their retirement. These pensions are similar in many ways to conventional standard personal pensions (see above) but they also have to offer certain levels of flexibility, security and value for money.

3.       Group personal pension

This is a type of personal pension organised via your employer.

Employees contribute to individual personal pensions which are then grouped together and managed by a pension provider of the employer's choice.

Some employers choose to contribute to these schemes alongside contributions from employees. Some employers even match employees' contributions pound-for-pound. If that's on offer at your work, join the scheme! It's basically free money....

4.       Self-invested personal pension (SIPP):

A SIPP is another type of personal pension - but you have more control over it because you pick the investments yourself.

In some ways it's a bit like an Individual Savings Account (ISA) because it's a vessel into which you put your chosen investments. And like an ISA, you don't have to pay Capital Gains Tax on any profit you make.

I have a SIPP myself and I love it as I enjoy making investment decisions. Even if you're not interested in investment as a topic, I think a SIPP is still the best option for many people. All you need do is put your money in a stock market tracker fund. Simple.

That's it for today. More to come tomorrow....

My thanks to Serena Cowdy. Some of this blog post is based on an article that she wrote for us in 2008.