The truth about pensions
By
Deputy Editor
Tim Bennett Dec 18, 2009
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How can you best secure a comfortable retirement?
Is it worth buying a pension? Probably not. But you should still save for your future. Here's how. By Tim Bennett and John Stepek.
The recent survey from National Statistics on Britain's wealth revealed some surprising facts. For example, a full 11% of the nation's wealth is tied up in collectibles, such as vintage cars. But one fact that probably won't surprise anyone is this: we'd rather not think about saving for our old age. Apparently, 44% of people would rather have a good standard of living now than worry about providing for a comfortable retirement, and have racked up an average of more than £7,000 in unsecured debts to do so.
This head-in-the-sand approach is understandable. It's hard to plan for some distant day in the future when you'll no longer have to work when there are so many more immediate demands on your money. The trouble is, you can't rely on anyone else to take care of your retirement. Even the most frugal households would struggle to live comfortably on the state pension, which currently stands at around £10,000 a year for a couple (including the government's means-tested pension credit top up, assuming you can tackle the paperwork involved). And with Britain's public finances in the state they are, you can't assume it will be even that generous when you come to claim it.
Even if you're one of the lucky people who are still on track to receive a final salary pension, you should make provisions of your own. Public sector workers are bound to see their pensions come under attack in the coming years. As for the private sector, more and more companies are taking steps to tackle their pension deficits by switching staff from defined benefit (where the company takes the investment risk) to money purchase pensions (where the employee does).
The four rules of saving
So what's the best way to save for yourself? Most people associate retirement with pensions. Yet a pension is just one way to save for old age. The ideal long-term investment vehicle has a number of features.
• First, you want low costs so that your returns aren't eroded by fees.
• You also want the lowest possible slice to go to the tax man.
• Flexibility is important too – how fast can you get at your money if you need it before retirement?
• Finally, what sort of return can you expect once you've retired?
If you take these factors into account, then for many people an Individual Savings Account (Isa) is a far better bet than a personal pension.
The beauty of Isas
Isas allow you to stash away a fixed amount every tax year (starting 6 April). That amount is currently £7,200 a year, rising to £10,200 from 6 April 2010 (or 6 October 2009 for the over-50s). The limit can be used to invest in cash – up to £5,100 from next April – or stocks and shares, or a mixture of the two.
That may not sound like much. But as Danny Cox of Hargreaves Lansdown points out, if a married couple had fully invested in an Isa every year since they launched in 1999, then they would have sheltered £160,000 from tax. That's excluding any growth. And had they used their full allowances under the pre-Isa regime too, in every year since 1987, that rises to more than £340,000. In fact, says Richard Green at Neptune, a couple could potentially build a lump sum, "which as the investment grows over the years, may be in excess of the pensions lifetime allowance" (£1.8m from next year).
In short, unless you are a very high-earning household (in which case, see below), you can probably save just as much in an Isa as you could in a pension. And Isas have some key advantages over personal pensions. They are more flexible – you can cash them in at any time you like, whereas you can't get at your pension capital until you turn 50 (and that goes up to 55 from 6 April 2010). Of course, if you do this, you'll reduce your overall pension pot and sacrifice future growth as a result. But that comes down to self-discipline. Assuming you resist the urge to splash the cash before you retire, there are other benefits too.
Once you hit 65 your personal allowance – the amount of income you can earn tax free – jumps from £6,475 to £9,490. But if your taxable income from a pension exceeds £22,900, you start to lose £1 of extra personal allowance for every £2 of extra income you earn. But Isa income doesn't count towards this test. Nor does it count towards the means test applied to work out how much pension credit you might be entitled to. Of course, you can't rely on the pension credit system still being around when you retire, so you shouldn't make investment decisions based on that. But it's useful to know that saving in an Isa now won't potentially reduce the amount of state pension you receive in the future.
What's more, anyone cashing in a pension plan must, by the time they're 75 (in the vast majority of cases), buy a contract from an insurer – an annuity – that basically provides you with an income stream. To give you an idea of how poor rates are at the moment, £100,000 would buy a 65-year-old single male around £3,000 a year (that's designed to rise with inflation – a flat annuity would pay £7,000 a year, but you have no inflation protection). An Isa pot, on the other hand, can be used to invest in anything you like, whether equities, cash or bonds.
Tax relief isn't everything
Much is made of the fact that tax relief is given up-front on pension contributions. So if you're a basic-rate taxpayer, the government will turn every 80p you put into a pension into a pound; while a 40%-rate payer need only put in 60p.
But for a basic-rate taxpayer this is less of a draw than you might think. Firstly, as noted above, if your pension income ends up being above the personal allowance, you get taxed on it, which reduces the overall tax benefit compared to an Isa. Secondly, Tony Hazell argues in the Daily Mail that you should be able to get an Isa that charges less than your average pension fund. Invest £200 in an Isa charging 0.55% a year and you could have a fund worth £330,000 after charges, assuming 40 years of stockmarket growth at 7% per year. That could be used to buy, say, corporate bonds yielding 5% a year, giving an annual income of £16,500.
Invest £200 in a personal pension and the amount invested rises to £250 with basic-rate tax relief at 20%. Great, but assume charges are 1.5% a year. With the same 7% growth rate on the funds, your pot after charges would be £328,865. Assume 25% is taken as a lump sum and invested in corporate bonds yielding 5% and the rest is used to buy an annuity, then you'll generate an after-tax income (with no inflation adjustment) of around £16,440. So with a personal pension you may have sacrificed a lot of flexibility for little, or in some cases no, extra return on retirement.
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What about higher-rate taxpayers?
For higher-rate taxpayers (anyone earning more than £43,875 a year), personal pension income-tax relief seems to make more sense. A £250 pension contribution only costs someone who pays 40% income tax £150. The rest comes from the UK Treasury. That's a significant extra investment that has many years to grow to a decent-sized pot. For example, says Paul Inkster of Barclays Stockbrokers in The Daily Telegraph, a higher-rate taxpayer aged 40 who saves £1,000 a year for 20 years into a pension could generate £3,512 a year from buying annuities with both the 25% tax-free lump sum and the rest of the fund. However, had the same investor taken the Isa route, they could expect just £2,558 per year, a 37% difference.
However, the trick is to avoid being a 40% taxpayer when you come to retire. Otherwise you negate a big chunk of the earlier tax relief. You can avoid tax on one quarter of your pension pot by taking the maximum 25% lump sum tax-free. You are free to do with it as you will. Throwing a party is one option, reinvesting it in, say, corporate bonds or equities is another.
The rest then has to be used to buy an annuity. Provided the income generated does not put you over the £22,900 threshold where your extended personal allowance (£9,640 in 2009/2010) starts to be cut, you will suffer much less tax on the way out than the 40% relief you enjoyed on the way in. Even above that threshold, higher-rate tax won't kick in until your retirement income after personal allowances hits £37,400 (for 2009-2010). So you will still benefit from the tax relief you have enjoyed while contributing. But even investors in this situation may want to think twice about saving into a pension as their first choice, says James Brooke, financial architect at Anand Associates. Brooke points out that you can invest in the same assets regardless of whether you use a pension or not. And if you use your Isa allowance for income-generating investments, and your capital-gains tax allowance in full each year (see the box on page 20), then most people can protect their investment returns from tax without using a pension.
Another benefit is that you lock in your tax saving rate right now by saving in an Isa. If you save via a pension, then you don't know just how high income tax might be when you come to take the pension income. For example, the government – via 'fiscal drag', whereby the threshold for becoming a higher-rate taxpayer is frozen even as wages rise – is pulling more people into the higher-rate taxpayer bracket. It's even theoretically possible, if unlikely, that if you're currently a young basic-rate taxpayer, you could end up having to pay higher-rate tax once you start drawing your pension, depending on what happens to rates.
But the key benefit of avoiding a pension, as far as Brooke is concerned, is that you don't have to use your retirement capital to buy an annuity. When you buy an annuity, you are using your capital to pay for an income stream. Once you've done so, the money is gone and can't be passed on to your family. Part of this income stream is your own capital being paid back to you. So to make it worth your while, effectively you have to live longer than it would have taken otherwise to use up your capital.
Assuming the same rate of return on both the pension and Isa options, Brooke calculates that even a higher-rate taxpayer who then goes on to lower-rate tax would have to live for around an extra 25 years to break even on their annuity. If you are a higher-rate payer and end up on the same rate when you retire, the break-even date takes even longer to hit. Obviously, your preference depends partly on how concerned you are about eliminating this 'longevity' risk. But it shows just what poor value annuities are right now – even if you do shop around for the best rates (which you must).
What you should do
Brooke's points go right to the heart of the pensions issue – the uncertainty. The fact is that anyone locking away money in a pension well ahead of retirement is taking a considerable level of political risk. You can't be sure what a present or future government will do. As Gordon Brown has proved again and again, all those pension pots just sitting there waiting to be plundered can be a big temptation for a troubled government looking for an easy tax hike.
The main reasons to invest in a pension, he reckons, are if your employer will only contribute to your pension if you do – it's daft to pass up the extra money. Secondly, salary sacrifice (where you give up part of your salary in exchange for a higher pensions contribution) is an effective way to contribute to a pension, again via your employer, particularly for higher earners. Thirdly, if you need the discipline to force you to lock your money away, a pension can be useful.
In other words, if you have no willpower, or someone else is paying, a pension is worth having. But if you're talking purely about your own money, you'd be better off using up your Isa allowance each year. It's more flexible and it still leaves you with the opportunity to switch to a pension at a later date if it ends up being more tax-efficient to do so.
What to do if you fill up your Isa
What can you do if you're a high earner? From April 2011, assuming the rules don't change before then, those on £150,000 or more (employer pension contributions are counted towards this figure for anyone earning more than £130,000) will gradually lose their higher-rate tax relief on pension contributions. This will be tapered down until those earning £180,000 or more will only get basic-rate tax relief. So a £25,000 pension contribution will cost them £20,000, rather than £15,000.
This has firmly shifted the tax incentives for high earners in favour of Isas, says Justin Modray of Candidmoney.com. "While there's no initial tax relief on Isas, there's no tax on income when taken, a benefit that's likely to become increasingly valuable given that taxes look set to continue rising over coming years."
Even for someone on £150,000 a year, filling up your full £10,200 (from April) Isa allowance each year is a decent achievement savings-wise, particularly if you have a partner whose allowance you can use too. But if you do fill up your Isas, what else should you look at? One of the most obvious things to do is to take advantage of your annual capital-gains allowance of £10,100. As James Brooke points out, using your Isa to house income-producing investments and keeping those focused on capital growth outside should enable most people to avoid paying tax on their investment returns.
Investments that should generate capital gains primarily rather than income would include things such as zero-coupon bonds (bonds that don't pay any income and sell at a discount to par value), zero-dividend preference shares, or simply non-dividend paying stocks, or funds focusing on growth stocks rather than income. And if you go over your CGT allowance, it's taxed at just 18%, but that may not last. So what investments don't incur CGT?
Justin Modray suggests that one option for wealthier investors could be to buy a larger main residence than they need, with plans to downsize when they do retire. That way they benefit from the CGT exemption on the main residence. It's an interesting suggestion that might be useful to some, although it's not one we'd be keen to stake our retirement on.
You are, of course, taking the risk that your property will drop in value, meaning you don't get any capital gains at all. And there's also the risk that you may have no desire to downsize when you reach retirement age, or even that the main residence capital-gains exemption may be scrapped.
Venture capital trusts (VCT) are another option. These offer a 30% income-tax rebate on annual investments of up to £200,000 as long as the VCT is held for at least five years. Capital gains and income are also tax free. But to reap these rewards, you are taking a great deal of risk (VCTs only invest in small companies) – and they are not the most liquid investments in the world either.
'Chattels', such as jewellery, paintings, antiques, and fine wine, are another option – although only up to £6,000-worth. Another option is gold, as long as you buy it in the right form. If you buy gold coins that are considered legal tender – post-1837 British gold sovereigns, according to Mark O'Byrne of Goldcore.com – then any gains aren't subject to capital-gains tax when you come to sell.
• This article was originally published in MoneyWeek magazine issue number 466 on 18 December 2009, and was available exclusively to magazine subscribers. To read more articles like this, ensure you don't miss a thing, and get instant access to all our premium content, subscribe to MoneyWeek magazine now and get your first three issues free.
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