Can you survive on just a pension?

Nearly one in five private employers shut their schemes last year, according to the National Association of Pension Funds, and a third of those still offering them are planning significant changes this year.

As such, a salary-linked pension has become a rarity for those working in industry and commerce, when it was once an automatic perk. As recently as 1997, more than a third of private sector employees expected a pension based on their final salary pension.

But tax changes and increased longevity added hugely to the cost, and forced many employers to reconsider whether they could any longer afford the growing bill. First, companies attempted to cut costs by closing schemes to new members, increasing employee contributions and reducing benefits. Finally, they began withdrawing their pension promises from existing staff as well.

By 2009, only 2.6 million out of a private sector workforce of about 24 million were covered by these arrangements.

This number has continued to fall, with an expectation that soon scarcely one million employees outside the public sector will continue to enjoy the security provided by salary-linked pensions.

So how do you survive life after a final salary pension? That depends partly on what replaces it. If you are switched into an "average salary" or "hybrid scheme", you may have to save more to top up your pension, but will still have underlying guarantees and security.

Most employees are transferred into a "defined contribution", or "money purchase" scheme, where your pension depends on how much you pay in, investment growth and annuity rates in retirement. Worse still, most employers take the opportunity of the switch to cut how much they are paying into your pension.

You will have to boost your savings significantly, remembering the new pension will not necessarily offer an automatic annual increase in line with rising prices. You will have to buy this yourself. Similarly, there will no longer be an automatic survivors' pension. This, too, you will have to buy. Both are expensive to provide.

Replacing a 10,000 annual pension will cost around 270,000 if it is to rise annually in line with inflation up to 5 per cent, and include a 50 per cent widow's pension, normally automatic with the final salary scheme.

Finding such sums will involve considerable financial sacrifices. Many wives and partners have relied on a survivor's pension as part of the family's overall retirement planning. The worry for them must be that they will be left unprotected, high and dry.

Now all the certainties of the final salary scheme have been removed, families must urgently sit down and work out the best way of protecting all dependants. John Whiting, Institute of Taxation director, said: "These are important issues and a couple needs to keep talking about their tax and pension position in retirement."

Tom McPhail, head of pensions research at Hargreaves Lansdown, added: "As a general rule, the best return will still come by investing in the husband's pension, because he will qualify for more tax relief and have access to a better scheme. But this will not be true in all cases, or for all savings, and couples must study the alternatives carefully."

Scotland on Sunday answers your questions:

Q: How much more do we now need to save?

A: The short answer is a lot. Final salary pensions typically cost between 20 and 30 per cent of salary; with employees contributing 5 to 10 per cent and employers the rest. With a defined contribution or money purchase scheme, typically, an employer and employee might both contribute 5 or 6 per cent, making a maximum contribution of between 10 per cent and 12 per cent of salary. A good employer may match additional contributions from staff, but only up to a total of, say, 15 per cent.

In other words, only half or a third is being saved towards your pension. If you want to more, you need to understand the scale of the problem.

If a 55-year-old man on 60,000 is switched to a money purchase scheme ten years before retirement, his annual pension expectation will be cut by 10,000, from 40,000 to 30,000, with a 5,000 survivor's pension also lost.

If, for the next decade, he continues investing 20 per cent of salary, or 1,000 per month including the employer's contribution, he might build up a lump sum of around 140,000, according to Hargreaves Lansdown. This will buy an income of 6,410 at 65, rising by 3 per cent a year, if he forgoes the survivor's pension.

Chris Curry, Pensions Policy Institute director, said: "We know hardly anyone buys a survivor's pension if given a choice. When people look at the figures, they almost always decide to give it a miss. The position of spouses is now much less secure than it was."

Q: How much does a widow's pension cost?

A: If the wife or partner has no pension, she must insist a survivor's pension is bought, via a joint life annuity. The main breadwinner's pension will then fall by 12 per cent to 5,644.

Q: How can I best exploit tax breaks?

A: Where one partner is a higher rate taxpayer and the other a basic, or non-taxpayer, more tax relief is available to the better earner.

In our example, if the employer contributes 6 per cent of salary, the employee would have to invest 8,400 annually. After tax relief, this would cost a basic rate taxpayer 6,720 but a higher rate taxpayer 5,040. In other words, over ten years the higher rate taxpayer saves 16,800 (without compounding), compared with a basic taxpayer. This is a very significant saving, and points to the advantage of making the contributions into the pension of the higher taxed partner.However, it is important to consider tax on the way out as well as in.

Q: How does tax in retirement hit the return?

A: When planning your pension, it is important to consider how that pension will be taxed. Unfortunately we are faced with a number of uncertainties on this front.

The ideal way to maximise any return is to qualify for higher rate tax when making the contribution, but pay only basic rate or lower when the pension is paid.

Standard Life's John Lawson said: "It's all about that advantageous tax twist, where you exchange higher tax savings on contributions for lower tax when you draw your pension."

In reality, few people pay higher rates of tax in retirement and, according to McPhail, in totality, most tax is saved, when a 40 per cent taxpayer becomes a 20 per cent payer in retirement (see table).

Nevertheless, the expectation is that, sometime in the next parliament, we will reach a 10,000 personal allowance, and citizens pension of 7,000. This could leave a wife with 3,000 unused personal allowance.

Currently, the over-65s get a higher personal allowance of 9,940 anyway, which is reduced if their pension is more than 24,000. It is not clear if the government intends to maintain this differential.

If spouses are not using their personal allowance, putting pension contributions in their name makes sense, particularly if the breadwinner pays higher tax in retirement.

A 3,000 pension a year, worth 3,000 to a non-taxpayer, is worth only 1,800 to a higher rate taxpayer, or 18,000 less over 15 years.

Q: Are there other reasons to put the money into the breadwinner's pension?

A: You should always maximise any employer contribution, where a company is, for example, matching additional employee contributions.

Where both partners have access to a similar company scheme, look carefully at which is the most generous.

Then compare charges. A money purchase company arrangement will normally be cheaper to invest in, than for example, a personal pension. Sometimes the company will pay all the investment management charges.

Q: Can we invest in my husband's scheme, but then use the money to buy me a pension?

A: No, at least not while he is alive. Should the breadwinner die before retirement, his entire fund can be withdrawn tax-free by a spouse. Similarly, if a husband does not touch the money purchase pension at retirement but leaves it deferred until he dies, his wife can withdraw the whole lump sum tax-free.

Q: Is buying a survivor's pension the cheapest way to provide for a spouse?

A: Probably. You could delay buying the wife an annuity until the husband dies. It costs 46,186 to buy a 2,822 annuity at 80. If rather than annuitising the entire 140,000 at retirement, the couple puts 50,000 into draw-down, the remaining 90,000 would buy a 4,121 annual pension rising at 3 per cent. But they can also take an income from the drawdown pot. At a cautious 3 per cent, this gives an additional 1,500, making 5,612 annually; surprisingly close to the joint life annuity of 5,644.

However, if investment returns are better than expected, or the husband lives beyond 80, the wife could enjoy a higher annuity. If he dies sooner, or investments disappoint, she could be worse off.

Q: Tax aside, isn't it best for both partners to have their own pension?

A: Yes it is. But not everyone is working full time, with access and means to quality retirement saving. But money can still be put aside for a pension for them and there may be psychological reasons for doing so, despite poorer tax relief and higher charges. Where someone doesn't work, 3,600 can be invested in a pension, attracting basic tax relief. If they work, they can claim tax relief.

Scottish Widows' head of pensions, Ian Naismith, said: "As a general principle, it is better if both partners have something in their name."

Q: Is a flexible annuity the answer?

A: Provided you have 20,000 of pension income, money can be withdrawn from the pension subject to income tax.

If the family ploughs money into the higher rate taxpayer's pension, this can be a way of getting the money out again, to set aside for the spouse, if his tax bracket falls in retirement.

On the other hand, if money is left in the pension until the husband dies, then the wife could buy an annuity at that stage, or she can withdraw it, incurring lower tax deductions, provided she has a guaranteed income of 20,000.