The best retirement option for you

In recent years, many people have steered clear of pension schemes, disillusioned by the bad press they have had, as well as personal experience of poor performance and inflexibility.

Many have chosen alternative routes instead, such as ISAs or buy-to-let property.

However, recent developments, such as the easier availability of self-invested personal pensions (SIPPs), which have given investors greater investment flexibility, and the government's current proposal to relax the need to buy an annuity at age 75, are helping to make pensions more attractive again.

Pension vs ISA

The strongest argument in favour of using a pension as your main method of building up a retirement pot is that your contributions are eligible for tax relief at your highest marginal rate of income tax, which means they are boosted by 20% if you are a basic-rate taxpayer, or 40 or 50% if you pay higher-rate tax.

So your savings in a pension are automatically worth more even without any investment growth.

Even non-taxpayers benefit from a 20% subsidy when they save via a pension, up to a maximum contribution of £3,600 gross.

Other attractive tax breaks are that investments grow virtually tax-free in a pension fund and that at retirement a quarter of the fund can be taken as a tax-free lump sum. But, thereafter, your regular pension income is subject to income tax.

By contrast, there is no tax relief on ISA contributions but the investments grow in a tax-sheltered environment, any capital gains generated are tax-free and when income is taken there is no further tax liability.

In some circumstances, contributing to a pension is a 'no-brainer'. Any employee offered membership of a company-based scheme to which an employer also contributes would generally be foolish not to join as it would be the same as turning down part of their pay.

Making extra contributions is also attractive when an employer offers to match them.

But when it comes to making voluntary contributions, savers face a conundrum. Once savings are put in a pension, they cannot be accessed until age 55 at the earliest. For younger people, tying up money for so long is often a disincentive.

Even at retirement, accessibility is limited. Once the tax-free lump sum has been taken, the remaining fund must be used to provide an income.

Although today it is easier to leave the fund invested and take income drawdown (known as an 'unsecured' pension), most people end up with an annuity.

Annuities have become increasingly unpopular as a result of falling interest rates which, combined with rising life expectancies, have resulted in them producing significantly lower incomes.

At the same time, their inflexibility and the fact that, on death, any outstanding capital goes into the insurance companies' coffers has made them even less favoured by the general public.

These factors have helped encourage people to turn increasingly to alternative forms of retirement saving. ISAs have proved particularly popular because they are not only tax efficient, but very flexible.

It is now possible to invest up to £10,200 a year in an ISA, which can be linked to a wide variety of investments while at the same time your money remains completely accessible.

Indeed it has often been debated whether ISAs are not a better choice than pensions for retirement savings, particularly because of their accessibility. But now that the government is proposing relaxing the annuity rules at age 75, is the pendulum swinging back in the other direction?

Financial advisers divided

Jason Witcombe of independent advisory firm Evolve Financial Planning believes the argument hasn't really changed, bearing in mind that most people will still have to go down the annuity route.

"I think the matter is pretty straightforward, it is solely down to tax relief," he says.

"For higher-rate payers who expect to pay a lower rate of tax in retirement, and will therefore gain more than they lose, there is a clear tax advantage," he says.
"But for basic-rate taxpayers, unless they are joining an occupational scheme, I don't think pensions are the place they should be. For younger people, who need to be able to access their savings, and for basic-rate taxpayers, I am more in favour of ISAs."
Matt Pitcher, senior wealth adviser at independent financial advisers Towry, feels that the proposed age 75 changes will make pensions more attractive, particularly for higher-rate taxpayers.

However, for basic-rate taxpayers, he believes it is a more finely balanced decision from a tax point of view.

"All the same, I still think pensions should be the starting point when you are saving for retirement. They give people a savings discipline and the fact that the money cannot be accessed can actually be an advantage because otherwise there can be a temptation to take money out of ISAs early.

"ISAs, on the other hand, are a good way of building up the capital you may want to use in the early years of your retirement for travelling and so on."

Andy Merricks, head of investment at independent advisers Skerritt Consultants, believes there is no clear winner between pensions and ISAs.
"It is a difficult one to call and it therefore makes sense to have a foot in both camps," he says. "With pensions, the tax relief you get helps to build up your retirement fund, and in return your access is restricted.

"However, I don't think this should stop people feeding their pension plan with a relatively high level of regular contributions."
However Merricks says the image of pensions has been tarnished. "I find far more people are disappointed with pensions than with ISAs," he reveals.

"They get to retirement and are extremely disappointed with the amount of pension their funds can buy. Although the inaccessibility of pensions is seen as a negative, it can also be a positive – you are not tempted to dip into your money.

"I think it is best to spread savings between a combination of pensions and ISAs to get the best of both worlds. The worst thing is not to do anything at all for your retirement."

Skerritt Consultants suggests a balanced portfolio, that can be apportioned across ISA and pension tax wrappers.

Tom McPhail, head of pensions research at Hargreaves Lansdown, argues that in terms of tax efficiency pensions are still best, even for basic-rate taxpayers.

He says: Besides the tax-free lump sum from their pension, it's worth bearing in mind that the over 65s also get a higher personal tax allowance of nearly £9,500 so quite a lot of their income will be tax-free, meaning even basic-rate taxpayers can make a net gain.

"Also if someone dies before retirement, their entire pension fund can be passed on tax-free, whereas their ISAs will become part of their estate and could be subject to inheritance tax. So in tax terms, I believe pensions are more attractive.

"Post retirement, ISAs are more flexible – you can invest your money where you want and leave the entire fund to your beneficiaries on death.

"However, when you buy an annuity you are guaranteed a risk-free return for life, which is important although many people tend to underestimate their life expectancy."

McPhail also points out that it is currently possible for a 65-year-old man to buy a level, non-inflation protected annuity yielding 6.4%, whereas to get a similar yield from ISAs it would probably be necessary to invest in a high-yield bond fund.

He believes many people underestimate the potential to get it wrong with their investments and suffer a capital loss. He hopes government pension reform will encourage people to put more into pensions.

He also believes there is a role for both forms of savings: "Pensions are good for replacing your core salary in retirement but you still need to be able to dip into savings from time to time which is where ISAs come in handy."

McPhail expects more employers to start introducing ISA schemes for their employees, offering to deduct regular contributions from salaries.

"Although employees can easily set up their own ISAs, many really appreciate the simplicity and convenience of payroll deduction."

It would appear that while some experts believe the government's annuity proposals might help to improve the acceptability of pensions, most believe that ISAs will still continue to play an important role in retirement planning.


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