Put your pension to the test

Iain Morse examines the options for employees who want to ensure that they can retire in comfort

Anyone offered membership of an employers' pension scheme may consider it a better and probably a cheaper alternative to a personal pension. But how do they work, will they pay enough pension and if not, how can a member build up extra benefits?

The most an employee can contribute to a employer's pension scheme is 15 per cent of earnings up to pounds 82,000. Personal contributions attract tax relief at the highest rate paid by the member. (In practice this means that contributions are deducted from taxable income.) No limit is placed on an employer's contributions, which are fully tax deductible.

There are important differences in the two most common types of employer's scheme - final salary and money purchase.

Final salary schemes are offered to public service employees and by larger private employers. They allow you to build up pension income, based on years in the scheme and final salary, calculated at various accrual rates, such as 1/60th or 1/80th of salary for every year of service. The more you earn and the longer you work, the bigger the pension, and finding the money to pay it is the employer's problem.

Money purchase schemes differ in that the pension is determined by the amount of money invested, the investment performance of the fund, and prevailing annuity rates - or annual retirement income - at the time one stops work. Final salary and length of service are irrelevant.

Since 1995, employers have been obliged to offer pension top-up schemes, called AVCs, which are additional money purchase schemes run by the employer or his chosen fund manager, even if the employee is in a final salary scheme. If you add an AVC with a different fund manager this is known as a free-standing AVC. But should an AVC be first choice?

Public service employees may have the option to buy back added years in their final salary schemes. This is a facility whereby a member can purchase years of membership in the scheme against any employment he has held as long as it has not previously been subject to pension provision. A teacher who has been in pensionable employment for 19 years could be eligible to buy up to an extra 17 years of pension rights.

When teachers buy extra years in their scheme, each year counts as an extra 1/89th of final salary. The cost of buying the extra years is a percentage of salary, determined by age and the period over which payment is made.

So, a teacher aged 50, earning pounds 28,500, buying in two added years over a 10-year term, will pay 4.24 per cent of salary or pounds 100.60 a month. That will buy an extra pounds 712.50 of pension income, index-linked to inflation with half a widow's pension.

Contributing pounds 100 a month over the same term into an FSAVC from Equitable Life, however, would build up a projected fund value of pounds 17,960, assuming fund growth of 9 per cent a year. That would buy pounds 763 in extra pension, escalating at 5 per cent a year thereafter, plus half a widow's pension. That makes money purchase look the better option, but it is worth remembering that neither fund growth or annuity rates are guaranteed.

Limits placed on buying added years with actual years in the scheme make it impossible to reach the two-thirds maximum of benefits available. In practice combining the added years with money-purchase AVCs is likely to be the best route to increasing pension income.

If buying added years is not an option, then a choice must be made between an AVC offered through the employer's scheme or a "free-standing AVC", sold in the open market.

These share common characteristics. Contributions are made net of basic rate tax, with any high rate relief to be claimed at the tax-year end. Unused allowance from previous years cannot be clawed back. Both are money purchase; a fund is created which can only be used to buy a pension annuity. The key differences lie in costs, fund choice and portability.

AVCs are in-house group schemes that should benefit from reduced management charges, and pay no commission. But fund choice may be limited. Because they come with an employer's scheme, they must be cashed when the main pension is taken. Someone retiring early may be penalised.

Buying an FSAVC can cost more, but confers some distinct advantages. Fund choice is now very wide. If an FSAVC is paid-up when leaving an employer's scheme, then it can be cashed in at any time between the ages of 50 and 75, regardless of whether benefit are taken from the main scheme.

Who to contact about your pension scheme? Start with the scheme trustees or administrators and ask for the scheme handbook, plus a benefit statement. Ring Opas (The Occupational Pensions Advisory Service) on 0171-233 8080 for independent advice