The Government introduced personal pension plans in 1988 to encourage such people to save towards their old age. One incentive was to provide generous tax treatment: contributions attract relief at your highest tax rate; there is tax-free growth within the pension scheme; and up to 25 per cent of the resulting investment fund can be taken as tax-free cash.
At the same time, people have been allowed to withdraw money contributed to the State Earnings Related Pension Scheme (Serps) through their National Insurance contributions provided the money is paid into a suitable personal pension plan. More than 5 million people have taken out plans so far.
A personal pension plan is an individual's private retirement savings fund. He or she can choose how much to invest, where to invest and, within limits, when to draw the benefits. However, unlike a company scheme, the investor is responsible for all the charges connected to setting up and running the plan, and he or she will probably have to make all the contributions as well. Some employers will make contributions into an employee's personal pension plan but this perk is not yet widespread.
Most plans are sold and administered by insurance companies, and are only as good as the companies that run them, so careful selection can pay dividends. The choice is huge. It is worthwhile reading pension surveys in specialist financial magazines such as Money Management (available from newsagents) to narrow the field and consulting an independent financial adviser before making your final decision.
Anyone who is earning an income through work (but is not a member of a company scheme) can make contributions to a personal pension. The Inland Revenue sets limits on the size of contributions based on age and earnings. These range from 17.5 per cent of net relevant earnings for people aged 35 or less, to 40 per cent for those aged between 61 and 74.
There are two main methods of payment. Investors can make one-off contributions, known as single premiums, or save on a monthly basis by taking out a regular premium contract. Many experts recommend the former. Bob Young, of Wilcox Young, a firm of independent financial advisers based in Southampton, explains: "You should go for policies known as recurring single-premium contracts that treat each payment like a one-off payment. This type of plan is very flexible, good for those who intend to take career breaks or whose earnings are uncertain, but at the same time you are still able to make regular payments. And the charges are lower."
Pension plans that are linked directly to unit trusts and investment trusts are also good value. The charges are clearer, and there are usually no extras, such as life insurance, to eat into your premiums. Edinburgh Fund Managers has recently launched a relatively good-value investment trust pension plan that allows the investor to put his money into a wide range of trusts while benefiting from the tax breaks associated with a pension plan.
Mr Young also recommends pension plans from companies that refuse to pay commission, such as Professional Life or Winterthur Life. This means that more of your money will be invested on your behalf, and the onus is on you to negotiate a separate fee with your independent financial adviser.
The choice does not stop there. There are several different types of pension structure that determine how your investments will grow. With- profits pension policies benefit from smoothed returns, allowing your investment to grow steadily over time. The insurance company awards a bonus each year which, once added to the value of your plan, is guaranteed.
Unit-linked pensions follow the performance of the stock market, moving up and down in value with the underlying stocks and shares held by the pension funds. These policies do not benefit from any guarantees, and can fall in value just as quickly as they grow.
However Nick Bamford, of Cranleigh-based IFA Informed Choice, says that over the long term, the returns from a unit-linked pension may well be bigger than from an equivalent with-profits policy. "The very fact that with-profits policies are based on guarantees limits the fund manager's freedom to invest," he says. "This can affect performance and over the long run you may earn less, even though your fund has grown steadily."
He says an investor should try to assess his or her attitude towards risk before deciding on which type of pension to buy. Those who are nervous about stock market fluctuations and are within 10 or 15 years of retirement might stick to with-profits. But younger investors may accept more risk because they have time to rectify any downturns before they retire.