If you are a high earner and you want to put money into a pension, you are about to find that it isn’t as easy as it once was. Unless the new government changes anything, from next year you will start to lose pension relief on your contributions if you earn over £130,000. Still, what is bad news for the saver is often good news for the financial industry: it tends to give them an opportunity to find more complicated products to sell. Which is why offshore bonds are suddenly being promoted as an alternative to pensions.
They work like this: you buy a ‘wrapper’ from a life assurance firm, into which you can then place a range of investment funds. The wrapper protects your assets from tax for as long as you hold it. Then when you cash in, you pay tax on the accumulated gains. You may wonder what the point is given that you end up paying the tax in the end. The answer is you are effectively arbitraging your tax rates.
If you’re a higher-rate payer now but expect to be a lower-rate payer when you retire, you can buy and hold now and sell when you retire. That cuts your tax rate in half. The other benefit of an offshore bond is that you can withdraw 5% of your initial capital investment tax-free every year for 20 years. However, there are drawbacks. Charges are high, usually between 0.3%-1% upfront, plus £400 or up to 0.25% a year on top of that, says Elizabeth Colman in The Sunday Times. And that’s on the wrapper alone. Advisers often take another 1.5% a year and you’ll pay for the funds too.
If you’re looking for a pension alternative, offshore bonds aren’t necessarily the answer. Say you put £80,000 in an offshore bond and leave it there for 20 years. Assume charges of 1% and returns of 5.5% – a tad optimistic, admittedly – and you end up with £192,937. If you wanted to take an income, the 5% rule would then give you £4,000 a year – not enough to manage on without cashing in the bond and taking the tax liability. Do that and you’ll have £170,350 after basic-rate tax, which you could use to buy an annuity giving you around £13,727 before tax, according to Find.co.uk.
You can do better with a pension, even with only 20% tax relief. An £80,000 pension investment increased to £100,000 using basic-rate tax relief equates to a £241,171 pension pot 20 years later, as-suming the same interest rate and charges. Once you’ve taken your 25% tax-free lump sum of £60,293 you could buy an annuity of around £14,218 before tax, says Find.co.uk. That makes it the better option.