Is a pension the best option for your retirement savings?

Politicians of all colours, regulators, insurance companies and financial advisers all agree on one thing: we need to save more for our retirement.

Yet a growing number of experts think that pensions may no longer be the best way to save for your retirement.

Ros Altmann, an independent pensions consultant, warned three years ago: "The real danger lurking in the future is that state pension policy is undermining private incentives to save and has rendered pensions an unsuitable investment for the majority of lower- and middle-income groups."

Two recent legislative changes make it more likely that she will be proved right: the restriction on relief for pension tax contributions for higher earners and the rise in the limits for individual savings account contributions to £10,200 a year, which will now rise in line with inflation.
Killik & Co, the stockbroker, reports that ISA contributions by its clients have been rising sharply while pension contributions have been falling.

Statistics from the Investment Management Association, which show that ISA sales are the strongest since 2002, suggest other advisers are experiencing similar trends.

Venture capital trusts (VCTs) and enterprise investment schemes - both tax-efficient investment vehicles - are also enjoying bumper sales.

Pension schemes
On the face of it though, pension schemes look attractive. First and foremost is the tax relief on contributions, which make pensions one of the few ways in which ordinary savers can shelter income from tax.

Second, pensions can provide a guaranteed level of income in retirement that can be index-linked and left to your spouse.

The advent of self-invested personal pensions (SIPPs) means investors are no longer restricted to poorly performing insurance-based funds, while stakeholder pensions have also helped drive down costs across the entire pensions market.

But these are also some of the things which are making pensions look increasingly less attractive. Take tax relief.

Last year, the then chancellor Alistair Darling announced that high earners would receive much-reduced pensions tax relief in 2011-12, which also affects those earning more than £130,000 in this tax year.

"It is a signal even for those who are not affected that the goalposts can move," says Malcolm Small, senior adviser on pensions at the Institute of Directors.

If tax relief has been cut for one class of pension investors, it makes it easier to cut for others. And with the UK's budget deficit running at £167 billion, the pressure to find savings from somewhere can only rise.

Tom McPhail, pensions adviser at Hargreaves Lansdown, says the Tories are already hinting that higher-rate tax relief could go.

The relief on pension contributions is clawed back by making income from pensions taxable, subject to the ability to take up to a quarter of the fund tax-free.

That is the opposite of ISAs, where most people make contributions from taxed income, but where benefits are free of tax.

That already makes pensions less attractive for those who expect to accumulate a sum large enough to attract income tax. Any further restrictions on tax relief will undermine pensions still further.

Then there is the secure pension income. Most people drawing a pension have to buy an annuity that guarantees to pay a pension until death and, if you opt to include a spouse's pension, beyond.

But the advantages of security of income are increasingly outweighed by their inflexibility and unattractive annuity rates.

Falling interest rates have meant lower annuity rates: a £50,000 pension pot would buy a 65-year old man a pension of just £3,600 a year, and much less if he wanted index-linking or to give his wife the benefits if he died.
Annuity rates are also both unpredictable and volatile. Pensions expert Ned Cazalet of Cazalet Consulting points out that during the early 2000s a fall in the stockmarket, a fall in the yield on government bonds – a crucial determinant of annuity rates – and an increase in life expectancy meant annuity rates dropped by a quarter.

"Taking these three factors together, someone who had been invested in a unit-linked retirement fund in the run up to retirement could have found that the combined effect was to reduce their annual retirement income by 50% during the space of a few short years."

Of course, ISAs and other investments were also affected by the stockmarket crash, but they did not also have to contend with changes in long-term interest rates and life expectancy.

And unless you have opted for a spouse's pension, annuities – unlike ISAs – die with you.

Small says that under current rates on a £100,000 annuity, it will take a 65-year-old man around 18 years to get back the value of his investment – just one year less than his average life expectancy at 65.

Bob Bullivant, chief executive of Annuity Direct, points out that means that half of 65-year-olds are still alive after 18 years. However, by the same token half will be dead.

Pensioners who have a SIPP can avoid buying an annuity using income drawdown, which means simply taking the income from the fund.

Yet even here the amount of income you can take is restricted; up to the age of 75 you can draw up to 120% of the relevant annuity rate, which has to be recalculated every five years.

Most pensioners would end up buying an annuity by age 75 because the drawdown rules, or alternatively secured pension, at that age are so restrictive as to make it unrealistic.
With drawdown, the pension fund can be passed on as part of the estate, subject to a tax charge.

And it does mean you can choose the best time to buy an annuity, deferring the purchase if rates are very low, but predicting what rates will do is hardly straightforward.

There has been pressure for years to ease the rules requiring the purchase of an annuity and most experts expect that it will eventually happen.

Drawdown is the most likely alternative, but it is unrealistic for pension funds of less than £100,000 as the costs are so high.
The third black mark against pensions is their interaction with state benefits. Small says the average pension pot in 2009 was £25,000; enough to buy an annual pension of around £1,600.

That, says Small, is enough to deprive pensioners of some of their means-tested benefits.
He adds: "So there are problems at the top end, where higher relief is being reduced if you earn more than £130,000. And at the bottom end there is a question mark over the economics of saving through a pension."

The experts views on pension freedom

Malcolm Small says pensions should no longer be the default vehicle for retirement savings.

His research suggests many investors do not understand the tax advantages, and when the procedures for paying in to, and drawing down, a pension are explained they find it unattractive.

He says: "I did consumer research in 2006 and 2007. When I explained how an annuity works, and that it gives a guaranteed income for life, they thought it was great.

"When I explained what happened if you did not live very long, they described it as 'legalised theft'."

He thinks ISAs and the options outlined below give more flexibility. "In an emergency, for example if your boiler blows up, you can draw on your Isa or leave it alone. And you will get what you get. A pension is inflexible and does not reflect the way we live our lives now."

But that inflexibility means other experts insist pensions are best. Marcus Carlton, a director of wealth managers HFM Columbus, says: "Everyone needs a pension. As a discipline for savings that you can't rob when you have a mid-life crisis, it is an excellent vehicle.

But the attack geared to the higher-rate taxpayer has had a knock-on effect and left a degree of uncertainty among consumers."

The fact it is impossible to touch a pension until the age of 55, and many schemes require regular contributions, is a discipline not shared by most alternatives. And statistics show that many of those taking out personal pensions give up.

He calculates that, among personal pensions taken out through IFAs, one in five stop contributing within a year, one in three within two years, and six out of 10 after four years.

The high costs of starting a pension means many of these investors will not get their original investment back when they retire.

"For most investors, pensions are still, and will continue to be, the first port of call to build an income in retirement," says Tom McPhail. ‘If you can afford an Isa as well, use it with a pension to provide flexibility."

But he admits the picture is changing: "It is far from immutable and will continue to change".

Which pensions are best?

If you are in a company scheme, it is probably worth staying in it. That is especially true if you still have a scheme that guarantees to pay a particular proportion of your earnings at retirement – a defined benefit scheme – but these are becoming rare outside the public sector.
But defined contribution schemes, where the pension is based on the amount in the fund at retirement, can be worthwhile if the employer makes a decent contribution.

The average contribution, according to the Pensions Policy Institute, is 6.1% compared with 16.6% for defined benefit schemes.

The government is planning to ensure that all employees are enrolled in a company pension scheme with its proposal for Nest, which everyone who does not have a pension will have to join in 2012.

But it has been attacked for its high charges: a 2% upfront fee and annual charges of 0.3%, which is higher than stakeholder schemes and more than would be expected in what is likely to end up as a large scheme.

The minimum contribution required from employers is just 3% and, while employees are expected to put in 4%, there is no compulsion to do so.

Pension experts fear that the introduction of Nest will encourage employees to close more generous schemes and trade down to this meaner scheme.

This article was originally published in Money Observer - Moneywise's sister publication - in May 2010

Your Comments

That's a lot of words! Lets do the maths (and use the easy numbers)...,
ISA or SIPP the money can be invested into the same cash or shares..,

The ISA:
If I pay 50% tax and can afford to put £10K cash into an ISA.., it costs me £10K.
If the value neither rises nor falls I'm left with £10K. (I'm no better off)
If the value of the ISA doubles (£10K x2) I'm left with £20K. (So I'm £10K up)

If I put the same £10K cash into a SIPP it gets a £10K tax relief boost to £20K.
If the value neither rises nor falls, I commute 25% on retirement, pocketing £5K (of the £20K) and I'm still left with a £15K pension, which effectively cost me £5K (the original £10K minus the £5K which I took on retirement)
BUT if the value of the SIPP doubles (£20K x2) I'm left with a £40K SIPP, I commute 25% on retirement, pocketing £10K (of the £40K) and I'm left with a £30K pension, which effectively cost nothing!

If the original investments quadruple in value the SIPP investment returns the same cash as the ISA.., AND provides a £120K pension as well!

If my calculations are correct..., would someone please move me to the 50% tax band! It's SIPPs all the way for me.

50% of £10000 is £5000 simples

So how do you figure out that you "double your money" in a tax relielf boost. Putting £10,000 into a SIPP isn't going to give you 100% tax relief to double your money? It'll surely only give you a max of 40% if you are a high rate tax payer? It's okay if you don't want the money until 55 but anything taken before then must come from the ISA so its only good if you have any spare cash!

Though pension schemes look attractive i don't think it's a good way to save for retirement.

Dear Guest (of 18/05/2010), Top rate tax is now 50%, and if I were paying at that rate I would certainly have a few pennies spare!

Tax can be reclaimed on earnings at the higher rate. So if a top rate taxpayer (50%) wants to put £10K into a pension..., they pay £8K in. The pension fund reclaim 2K (basic rate tax) boosting it to £10K and the taxpayer can also reclaim £3K from the taxman, therefore they pay £5K to invest £10K. So yes, the way I understand it..., if you pay top rate tax you get a 100% boost to your savings (although there is a cap on the amount you can save) if you tie them up in a SIPP.

That boost is reduced accordingly if you pay tax at a lower rate. Only as a 20% taxpayer I would stick to an ISA.

If there is an accountant or tax inspector out there, I would be happy to be enlightened if my understanding is incorrect!

Tax efficiency aside- Pensions also offer a level of enforced discipline because you can't get at the money. ISA's, Savings Accounts, Investments can all be liquidated in relatively little time. This can be either an advantage or disadvantage. If you need a fluid investment a pension is not the way forward. If you can afford Pension Contributions, and know that you are an ill-disciplined saver, a pension can be a useful tool.