Are you safe in your employer's hands?

A series on pension planning continues with a look at the pros and cons of company plans
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The Independent Online
PEOPLE should not rely solely on the ever-diminishing state pension. It is a message increasingly proclaimed. But there is a danger that people may be over-optimistic about the sort of retirement income their company pensions can give.

It is now widely accepted by financial advisers that an employer-run pension scheme is preferable to an individually selected personal pension plan for the great majority of employees. Even so, membership of an employer's scheme does not on its own guarantee a comfortable retirement.

People expecting a pension worth two-thirds of their pre-retirement pay will, in most cases, be disappointed. The two-thirds company pension is the maximum allowed by Inland Revenue rules, and the maximum pension provided by many schemes.

How long you have worked for an employer and, more important, how long you've been a member of the pension scheme, are the key factors.

There are two broad types of employers' scheme. The money purchase variety works like a personal pension: your contributions are invested in a fund and, on retirement, your accumulated money is converted into an annuity - a guaranteed pension for life - although part can be taken as a tax- free lump sum. The actual pension will depend on both the value of your fund and on annuity rates at the time of retirement.

Despite this uncertainty, employer-based money purchase schemes are still likely to offer better value than personal plans, not least because employers will top up your own contributions.

Most company pension scheme members, however, are covered by a "final pay" formula. With this arrangement, the pension is a proportion of pre- retirement earnings, and depends on whether you take a tax-free lump sum (optional, in most cases). It does not depend on the investment performance of invested contributions. The employer takes on the risk of meeting any shortfall.

Each year's membership of the scheme buys a proportion of earnings - one-sixtieth, for example. So 40 years' membership of a one-sixtieth scheme would earn a pension of two-thirds of pre-retirement pay. But it is important to read the small print for the exact formula. For example, many schemes are contracted out of the state earnings-related pension scheme (Serps). Some plans pay the pension using a formula that makes a deduction for the basic state pension, which you are always paid separately.

You also need to look at the precise definition of pre-retirement earnings on which the pension will be based. Is it, for example, the average of the past three years, or the past 10 years? Does it take into account overtime and bonuses?

And what if you are likely to change jobs ( widely seen as a reason for going with a personal pension plan)? Most people will change their jobs several times.

Deciding on the best option inevitably involves making assumptions. First, assume you will be with an employer for, say, three years. Get an estimate of what sort of pension your contributions to the employer's scheme would earn after three years. Note, too, that under existing rules the value of the pension will be increased by inflation of up to 5 per cent a year until the time you retire.

Then get an estimate of what the same contributions to a personal plan might be worth in terms of eventual pension income. A competent specialist pension adviser should be able to produce projections.

Getting a forecast of likely pension income can be sobering. But if it is less than you would expect or need, you have the option of making additional contributions. If you are in a company scheme, you can make total pension contributions of up to 15 per cent of gross pay. That is on top of anything your employer puts in.

Some employers allow additional contributions to buy added years of membership. With others, extra pension will depend on the invested value of the contributions.

An alternative to extra contributions to the employer is to invest them in a special class of pension plan called a free-standing additional voluntary contribution (FSAVC) scheme. Life insurers and other financial companies offer them.

It is possible that more of your money will be eaten up in charges with a free-standing scheme than in an additional voluntary contribution plan (AVC) run by your employer. On the other hand, you might find the FSAVC adopts a less conservative investment strategy than the employer's scheme.

It is sensible to join a company pension scheme as soon as possible. Watch out for restrictions. Some schemes will not let you join after a certain period or a certain age (or before you have completed a defined period of service or before a particular age).