The Government has in place a State Second Pension (S2P), which is in addition to the Basic State Pension. It is available to employees and is earnings related, with funding coming from your National Insurance Contributions (NICs). It was previously known as the State Earnings Related Pension Scheme (SERPS).

The Government give people the option to contract out of the State Second Pension (S2P) into a personal pension or stakeholder pension. National Insurance Contributions are paid in the normal way but are then 'diverted' into this private pension pot. Added to these contributions is any income tax relief due and other incentives that may be offered by the government. However, such incentives to contract-out are not currently available. These contributions and the pension pot this provides then replaces the individuals S2P.

The fund grows as any other money purchase pension scheme would do. It is based on the level of contributions, the number of years the fund has to grow to retirement and the performance of the assets the funds are invested in. As with all such investments, returns are not guaranteed and so funds can go down as well as up.

However, as a general rule, the earlier you start saving for retirement and the more money you invest, the bigger the final pension fund will be.

At retirement the pension is used to purchase an annuity which will provide an income, which will depend on the annuity rates prevailing at the time of retirement. There are specific rules surrounding this annuity for example, if you have a spouse or civil partner at retirement, the annuity must pay 50% of the income to them if you die first.

One good thing is that the annuity does not need to be purchased from the same company where the pension fund is held. This means that you can shop around for the best annuity rates on offer. The smallest difference in returns available can make a sizeable difference to the amount of income received.

Twenty-five percent of the fund can be taken as a tax-free cash lump-sum when you retire. This will reduce the amount available to purchase an annuity so it is worth knowing what you're going to do with the moeny before you take it. It may well be that using 100% of the fund to purchase an annuity actually proves to be more tax efficient or will generate a better return than other investments on offer.

Whether it is appropriate to contract out from the S2P depends on individual circumstances, though age at the time of contracting out is a key factor. Although it is possible to contract back in to the second state pension at a later date and as retirement nears. It is usually beneficial to contract back in at this time as the contributions into a personal plan will have less time to grow and so returns could well be lower than benefit derived from a government pension.

The Pensions Service and Financial Services Authority (FSA) have guides for those wondering whether to contract in or out or wanting further information on the subject. Visit their website for details.