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As of April 2008, the state pension sat at £4,715.40 annually, but we all need extra pension provision, says James Hopegood.

We all do it month after month. Every pay packet we get shows a tidy lump, usually enough for a West End show and a decent meal afterwards - siphoned off into our pension schemes.

Apart from our houses, pensions are the biggest long-term savings commitment we all make, yet very few of us actually understand what we are doing.

The state pension on its own is too small

And we do this despite the fact that the state provides a retirement pension. The problem with the state pension is that at just £4,715.40 a year for a single person and £7,542.60 for a married couple, it is too small. On top of this, to qualify for even these minimal amounts men must pay 44 years worth of qualifying National Insurance contributions and women 39 years worth of them. So it is no surprise that generations of workers have set money aside in pension plans for their old age.

At its most basic level, a pension is very simple. You save money each month and, in return, when you retire you are paid a regular income until you die.

The tax-free advantage of pension savings

The money you pay into your pension benefits from tax relief and grows in a tax-free environment. In simple terms, this effectively means that if you are a basic rate taxpayer (paying 20% tax) it only costs you 80p to invest £1, while higher rate taxpayers (paying 40% tax) only have to pay 60p to save £1. However, when you retire any pension you get is treated as income - so if it's big enough, you will have to pay income tax on it.

New pension legislation adopted in 2006

From April 2006, the pension landscape changed forever as the old system was booted out in favour of a complete set of new rules in a bid to make pensions more straightforward.

The changes are most likely to affect people who are near their retirement or those with very large pension pots. However, if you have a personal pension it could be worth seeking financial advice to make sure the new legislation won't affect your pension.

The main changes include

Contributions

You can now invest up to 100% of your earned income annually, up to a ceiling of £215,000. This figure will continue to rise in line with inflation.

Drawing your pension

You will be able to draw your occupational pension from your employer while continuing to work.

Retirement age

The earliest age from which you can take an occupational pension or personal will increase from 50 to 55 by 2010. But if your current pension allows you to retire at 50, you will still be able to do so by 2010.

Lifetime allowance

Before new rules came into effect in 2006, the world of pensions was riddled with complicated tax systems on how much money you could save into a pension. These rules have now been replaced by a single cap, known as the lifetime limit. This was set at £1.5 million in 2006, and it will rise to £1.8 million by 2010/11. Any assets in your pension fund that exceed the lifetime limit will incur 55% tax - known as the lifetime recovery charge.

Employers will often offer occupational pensions

If you are employed there is a good chance you will be offered the opportunity to join an occupational pension scheme.

Traditionally, the best type of company scheme is the final salary scheme. For every year you are in the pension scheme you build up a percentage of your salary as pension - usually one sixtieth each year. So if you are in a pension scheme for 40 years you will build up forty sixtieths, or two-thirds of the salary you earn in your final year working. So if you retire having earned £30,000 in your last year, your pension will be £20,000 a year.

This promise is made by your employer, not by you, so if more money is needed to meet that promise it is up to your employer to pump in more money.

As a result, these schemes are very expensive to run and many companies are shutting their schemes down. According to figures from the Office of National Statistics, there was a 10% fall in the number of members in final salary schemes between 2006 and 2007 and another survey by Watson Wyatt predicted that over 40% of these schemes will have closed to future accrual within the next five to 10 years.

Alternative employee pension options

The other type of pension you will be offered is a money purchase or defined contribution scheme. You pay in money, it is invested on the stockmarket and when you retire you use the fund you have built up to pay a retirement income. Crucially, the level of income paid out at the end is not guaranteed as it will depend on how well your money has been invested and how the stockmarkets have performed. However, in many cases your employer will pay in money for you as well.

By law, employers with five or more staff have to offer some form of company pension.

The self-employed need to save into a personal pension plan

If you are self-employed you are on your own. You can only save into a personal pension or its low-cost cousin, the stakeholder pension. Both are money purchase-type arrangement, so how much your pension is eventually worth will ultimately depend on how much money you save, where it's invested, and well the investment performs.

Retiring

When you retire you can take up to 25% of your fund as a tax-free lump sum, the remaining 75% must be used to purchase an income for life. This is usually achieved by purchasing an annuity, however you don't have to do this as soon as you retire, so long as it's done by the time you turn 75.

In the meantime you can either leave your fund invested or take an income directly from it via an income drawdown plan. However, this route does carry a number of risks so it should generally only be considered by people who have a large pension and other sources of income.