At MoneyWeek, we’re pretty suspicious about pensions. But not everyone thinks they’re a bad way to save. Here, IFA Robin Algar explains why he thinks that everyone should have one.
Pensions have had a rough time of it lately. Occupational schemes are not what they once were and final salary schemes have become a dying breed; mis-selling scandals have shaken confidence; and the miserable performance of the stockmarket has compounded the problem. At the same time, layer upon layer of successive pension legislation has been imposed by politicians, creating an environment of staggering complexity. According to The Scotsman, a special commission led by Adair Turner revealed that the Government only contributes about 6% of GDP to pensions; around £57bn less than the 11% invested by the rest of Europe (go to https://www.pensioncalculator.org.uk/ to help calculate your own shortfall). No wonder the population is increasingly suspicious of pensions in general and sceptical regarding their worth. And no wonder we aren’t saving.
So what’s the solution?
The answer is the same as it has always been – pensions. If you don’t want to rely on the State (which currently offers a maximum pension of £79.60 per week for a single person, or £127.25 for a couple), you have to save more and you should probably do so via a pension. Here’s why.
Pensions are cheap
Personal pensions are cheap. If you buy via a Stakeholder, you will pay a single charge that is not allowed to exceed 1% of the fund’s value every year – and that’s it. If your fund is large, you may pay even less. There are other low-cost options too. Many so called ‘mono-charged’ schemes cost no more than a Stakeholder, but give a much wider investment choice, sometimes offering externally managed funds or a ‘fund of funds’ approach (which takes much of the burden of portfolio management away from the individual). By contrast, if you save via an Individual Savings Account (ISA), you can often find yourself paying initial charges of 3%-5% on each contribution, in addition to an annual management charge that may be as much as 1.5%.
Pensions give you tax relief
The second reason for using pensions is well known – tax relief. Most of us know that the maximum relief that can be obtained on contributions is 40% – the higher rate. Or is it? Well, actually, it’s not. It is, in fact, possible to achieve 59% tax relief. This is possible for a basic-rate taxpayer, or non-taxpayer, who is within the income band in which Working Tax Credits are tapered at 37p for each £1 of income. Effectively, in certain circumstances, a pension contribution could attract 22% basic-rate relief, given by deduction from the pension payment, plus an additional tax credit equal to 37% of the gross payment, giving a total of 59%. Similarly, a higher-rate taxpayer could achieve relief of 46.67% if their income falls within the band in which the family element of Child Tax Credit is tapered. And it doesn’t end there. If the appropriate structure is in place, it is also possible to avoid National Insurance on personal pension contributions, which are levied at up to 11% of an employee’s earnings.
Compounding makes all the difference
Most people save towards retirement over a number of years, and it definitely pays to start as early as possible. Why? Because of the effect of compounding. Consider two savers, Mr Smith and Mr Brown, both aged 35 and higher-rate taxpayers, and assume – for simplicity’s sake – that the only relief available is 40% income-tax relief, and that at the end of each year both have achieved 5% growth net of charges. Mr Smith starts putting £6,000 a year into an ISA. At the end of the year, his ISA is now worth £6,300. He adds another £6,000 and the following year he achieves another 5% growth on the sum of £12,300, and so on for 30 years.Mr Brown, on the other hand, puts his £6,000 into a pension. Immediately that becomes £10,000, and assuming 5% net growth he has £10,500 at the end of the year. The same thing happens for 30 years. At the end of 30 years, both have contributed £180,000.
So, Mr Brown will have 40% more than Mr Smith, right? Wrong. Mr Smith’s ISA has grown to £398,300, but Mr Brown’s pension totals £664,000. Both have paid in the same amount, but Mr Brown has £265,700 more. Because of the compound growth, he doesn’t just have the extra 40% in tax relief; he has an extra 67%. Mr Brown can now take 25% tax-free cash totalling £166,000. If Mr Smith were to do the same, he’d be taking out over 40% of his fund. Let’s say he does. If Mr Brown purchases an annuity with the balance at 7%, he will get an income of £34,860 per annum (p/a). If Mr Smith does the same, he’ll receive £16,261 p/a – less than half as much (although his capital remains intact). If Mr Smith then draws down capital to boost his income to £34,860 p/a, it will be gone in 12 years. Mr Brown’s income, on the other hand, will continue to roll in, no matter how long he lives. (These figures are for illustrative purposes only).
Pensions offer freedom
A fourth reason to consider pensions is the ability to manage one’s own investments, a facility available with either a Self Invested Personal Pension (SIPP) or its occupational cousin, the Small Self Administered Scheme (SSAS). Investors can choose from a variety of asset classes, including managed funds, stocks and shares, derivatives and commercial property. Milk and fishing quotas are not allowed, although why anyone would invest in these is a mystery. But from 2006 you will be allowed to include residential property in your SIPP.
Many pension rules are soon to change, but in general this will make pensions a better investment. The upshot is that they are cheap, tax efficient and very necessary. On the other hand, they are also confusing, so most of us could probably benefit from good advice – particularly with A-Day fast approaching. As with life in general, the biggest mistake you can make with your pension arrangements is to do nothing.
Robin Algar is an Independent Financial Adviser with Millfield Partnership.He provides specialist investment, tax planning and retirement advice tohigh net-worth individuals. He can be contacted at ralgar@millfield-partnership.co.uk, or 01608-810985.
The information in this article is based upon our understanding of current and proposed legislation, and Inland Revenue practice, both of which are subject to change. Millfield Partnership Ltd is authorised and regulated by the Financial Services Authority.