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
The tax levied on the total value of your estate after you die. IHT has to be paid by the beneficiaries of your estate before they can receive any of the money from it. The money can’t be taken from the value of the estate _– it has to be paid before any money can be released. There is an IHT threshold – known as the “nil-rate band” – below which no tax is levied (£325,000 in 2011/12). Any amount above the nil-rate band is subject to tax at 40%. If your estate totals £600,000, there is no tax on the first £325,000; however your estate will pay 40% tax on the remaining £275,000, a total of £110,000. Prudent tax planning can reduce your IHT liability, so always consult a specialist solicitor.
Tax-free lump sum
An inelegant phrase that is nonetheless accurate in what it describes: a one-off payment to a beneficiary that is free of any form of taxation. Usually received when using a pension fund to purchase an annuity, as 25% of the overall fund can be taken as a tax-free lump sum.
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
The catch-all term applied to investors who buy properties with the sole intention of letting them to tenants rather than living in them themselves, with the proceeds from the let usually used for the repayment of the mortgage. Buy-to-let investors have to take out specialised mortgages that carry higher interest rates and require a much bigger deposit than a standard mortgage. Other expenditure can include legal fees, income tax (on the rental profits you make), capital gains tax (if you sell the property) and “void” periods when the property is unlet.
Everything you own: all your assets (property, cars, investments, savings, insurance payouts, artwork, furniture etc) minus any liabilities (debts, current bills, payments still owed on assets like cars and houses, credit card balances and other outstanding loans). When you’re alive this is called your wealth; when you’re dead, it becomes your estate.
In exchange for any lump sum – usually your pension fund – an annuity is “bought” from an insurance company and provides an income for life. When you die, the income stops. Annuity rates fluctuate daily and depend on your sex (although from 21 December 2012 insurers will no longer be able to use gender as a factor when calculating annuities), age, health and a number of other factors, so you have to pick the right one and, once bought, its terms cannot be altered, so seek financial advice.
An alternative to an annuity, income drawdown (also known as an unsecured pension) allows you to take income from your pension fund while the fund remains invested and so continues to benefit from any fund growth. The drawdown of income has to be calculated carefully as taking too much income could exhaust the pension fund so experts say the annual drawdown must not exceed what the assets would normally yield in an average year. The invested pension fund could also be hit by market turbulence and the value of the assets could fall.