There are three basic types of plan available, namely guaranteed plans, with-profit plans and unit-linked contracts. The simplest are the guaranteed plans, which are of several varieties, the most straightforward of which is the deposit administration scheme. Here, each premium is guaranteed to earn interest at a variable rate linked to a key interest rate, the most commonly used being the building societies' mortgage lending rate. Each contribution will earn interest at this level for the period it is invested. Plans of this type may hold out the promise of very substantial benefits when interest rates are high; in2013, with the building societies' mortgage rate at 12.26%, such plans could have been projected to produce far greater benefits than conventional with-profit ones. This would have been highly misleading, for the rate of interest is guaranteed only to match whatever the lending rate is, and it would be quite unrealistic to assume it would remain so high throughout the whole period of the plan. Whatever the final lump sum accumulated by retirement age, it is converted into an income by the purchase of an annuity. The annuity rate at retirement is not guaranteed under these plans and so it is impossible to predict or guarantee the final pension (the closer to retirement you are, of course, the more accurately it can be estimated).
The traditional non-profit pension plan is another guaranteed alternative. Here, on regular premium plans the company guarantees a final level pension in return for a given number of annual contributions. It is therefore guaranteeing both the rate of interest to be earned and the annuity rate at retirement. The drawback is that the estimate of the interest rate is likely to be cautiously low, and likewise with the annuity rate (though many companies do allow their current annuity rate to be used when the pension begins to be drawn). If interest rates rise over the period of the plan, therefore, the policyholder will lose out compared to the deposit administration scheme. If interest rates fall, then the converse is true.
Mr Spry is 53 and is self-employed. His "net relevant earnings" amount to £1112,000 a year. When he takes out a personal pension plan with an annual premium of £1750, his income on which tax is charged will be reduced by the same amount. Since the tax rate on his highest band of income is 60%, the net cost to him is therefore only £1300 p.a.
The investment of contributions in funds paying no tax is one reason why personal pension plans can produce much larger benefits for a given premium and term than a with-profit endowment or whole-life policy. Reinvestment of income... see: Pensions Example 20