The scrapping of tax breaks on pension fund investments, which was announced in the summer Budget, is likely to hit many teachers’ pockets.

While the main Teachers’ Superannuation Scheme (TSS) will not be affected, teachers paying into additional voluntary contribution (AVC) or free-standing AVC funds will probably need to increase their payments to make sure they get the pension income they had expected.

This is also true for teachers who have personal pension plans - either because they work in independent schools or because they have opted out of the scheme.

But how large do these extra payments need to be? The effect of the Budget changes are still uncertain, so there is no easy answer.

“Any member contacting us about this would be advised to consult an independent financial adviser,” says David Jones, deputy general secretary of the Professional Association of Teachers.

“But speaking in a personal capacity I would say that the pensions industry as a whole seems to think that there is no need for anybody to panic. The impact (of the tax change) may be a lot slighter than the headlines suggested. ”

Before the July Budget, pension funds could claim back the tax they had paid on dividends from investments. In the past when a company declared a gross dividend of say Pounds 100, the shareholder would receive Pounds 80 cash, plus a tax credit of Pounds 20 which pension funds would reclaim from the Government - so receiving the full Pounds 100 as cost. Now that funds are no longer able to claim this credit back, their dividend income will drop by a fifth. But this does not mean that their overall income will fall by the same amount. Most pension funds do not put all their money into UK company shares and it is only dividends from these investments that are affected by the tax changes. The reduction in the rate of corporation tax, also announced in the Budget, is likely to cushion the impact of the change further.

The Prudential, which manages the teachers’ AVC scheme, estimates that annual returns on its with-profits fund will now be half of 1 per cent lower than they would otherwise have been.

“Over a 15-year term, this would reduce the fund by about 4 per cent for a new regular contribution scheme starting now. For a single contribution or an existing fund, the reduction in value of the eventual fund over the same term would be about 7 per cent,” the Prudential says.

The company is not at this stage planning to make any significant changes to the investment strategy for either its with-profits fund - where most teachers’ AVCs are invested - or to other funds which hold UK company shares. But since the abolition of dividend tax credits is likely to affect the growth of these funds, the Pru is advising teachers to review their level of contributions.

However, Ken Taylor, the Prudential’s head of corporate pensions marketing, says there is no direct evidence that teachers have started increasing their AVC contributions in response to the Budget changes.

Gordon Sharp of KPMG Pension Consultants points out that the impact of the tax changes on individuals will depend on the kinds of investments they hold. Many AVC and free-standing AVC schemes give members a choice over where their money is invested, and older people who tend to invest more heavily in cash and bonds than in equities are less likely to be affected by the new tax rules.

“If you’re quite close to retirement and you were satisfied before the Budget that you were making the right payments for you and that was against the background of investing largely in a safer cash and bonds fund, then there’s no reason to change that decision,” he says.

Younger people, who are more likely to have invested in equity funds, should now be thinking about increasing their contributions, according to Mr Sharp, though he says they need not rush into making a decision this year.

“Obviously, it depends on what happens to investments but our general advice to people (who are still a long way from retirement) is to think about increasing their contributions by about 10 per cent, if they are capable of doing so both in terms of what they can afford and in terms of still being within Inland Revenue limits.”

The abolition of dividend tax credits has strengthened the case for opting for Peps, which now have a slight edge over AVCs because they still benefit from dividend tax credits. But Peps will have this advantage only until April 1999 when the Government plans to introduce IndividualSavings Accounts. Few details about these accounts have emerged so far and it is not clear whether people will be able to switch their existing Pep savings into them.

Some financial advisers argue that those close to retirement should now invest in Peps to take advantage of the tax breaks these savings plans will continue to offer for the next two years. Others warn against taking out a Pep now and cashing it in after just two years.

As Gordon Sharp says: “That is a very short time horizon over which to make any equity investment, regardless of whether tax breaks are available or not.”