The way pensions work at the moment most people will be better off with money in ISAs because it’ll be tax-free forever.
The policy wonks sit around bewailing the fact that we don’t save enough for retirement and coming up with reasons why. The Consumers Association blames greedy product providers and high sales commissions. The Pensions Policy Institute says it’s because of over-complex rules and means testing. The Opposition parties blame inconsistent government policies.
Actually, they’re all missing the point. I know why I don’t want to have a big chunk of my own money in pension funds and I bet when I explain why, you will agree with me. This explains why I believe everyone should pump the maximum they can into ISAs, which the government has said will be tax-exempt forever under rules to be introduced in this year’s Budget.
Arrange a free SIPP consultation todayDo as you’re told with your pensionUnder the current rules, when I reach the age of 75 I must convert any money I have in my pension fund into an annuity that pays a fixed income for life. I can buy an annuity that pays for a set period, or one that pays a reduced pension to my dependants, so I can ensure that my wife and dependants do get something from the capital I’ve accumulated.
But I can’t leave them the capital. And they’ll pay tax on all the income they get. So will I. I can take 25% of the capital in my fund as a tax-free cash sum, but every penny I take out after that will bear income tax.
Do you find that an attractive proposition? I don’t. Even though I like the idea of collecting tax relief on money I put into the fund now, I hate the idea of not being able to do what I want with it later.
See my Self Select ISA recommendations here.
Pensions only make sense for the richNow stay with me for one more paragraph and you will understand why we have a problem. Economists use the term ‘utility’ to measure the value of things. The utility of something to someone depends on their circumstances.
Food has high utility to someone who’s starving and low utility to a millionaire. Now think about pension funds. If you already have a lot of capital in various forms - a big home, your own business, inherited wealth - then you will feel relaxed about bunging a chunk of it into pension funds where your access to it is restricted and you can’t leave it to your heirs.
See my SIPP recommendations here.
But suppose, like most of us, you don’t have lots of capital. Then access to that capital, the ability to do what you want with it and leave it to whomever you like, has high utility and you will rate this way above the tax advantages of pension plans. So you won’t put any free money you have into pension funds.
Wow. Talk about a statement of the bleeding obvious. And the facts bear this out: almost all the money being put into pension funds on a voluntary basis comes from very well-off people. But have the policy wonks or anyone in the Treasury given this serious thought? No. The Treasury has turned down flat any proposals to relax the annuitisation rules, and has recently tightened up the tax on inheritances of capital from pension plans.
Arrange a free SIPP consultation todayYou’re better off in an ISAI’m sure that the Treasury mandarins will be forced to change their minds and their policies within the next few years (I’ll spare you the reasons). But while they are behaving like a bunch of dimwits, there are
good arguments why you should save as much as you possibly can in
Individual Savings Accounts (ISAs) rather than in pension funds.
Last autumn Gordon Brown announced that the next Budget would include rules making ISAs permanently tax exempt. That means that even if the money stays in your ISA for 50 years you will never pay a penny of tax on it. You can withdraw income or capital or any mixture or both at any time without penalties.
You can also take money out and put it back again (within the annual contributions allowance of, currently, £7,000 a year). You can put in monthly savings and/or lump sums. You can leave the money to whomever you like when you die. You don’t have to declare your ISA on your tax return.
Order free ISA information here.
Flexible and cheapIn fact, the ISA is the most flexible savings and investment scheme there has ever been. And because the charges are simply those of the funds you buy within the ISA, you can create a plan with rock-bottom costs if you want to. Just buy our Best Buy index-tracking fund,
Fidelity Moneybuilder UK Index, which has annual costs of a mere 0.3%. To put that into context, it’s under half the annual management fee being paid by many pension funds valued at £10 million or more.
Always use a
self-select ISA so that you can spread your capital across different investments and switch them when you need to.
Even better for the poorIf you’re likely to be affected by means testing in retirement, then the last thing you should do is put money into pension plans. The income they generate will all be taken into account and could result in you getting no benefit at all from your pension savings.
Why you could lose out.
Put money into an ISA, though, and if it looks as if you’ll be affected by means testing, you can spend the money before the critical date and lose nothing.
Order free ISA information here.
That may sound as if I’m advocating that people cheat the system, but I’m not. I’m just pointing out what people are incentivised to do by the government’s rules. Governments usually say they believe in incentives. Gordon Brown has said it hundreds of times. Well, here’s an incentive he’s created. Does he really expect people NOT to respond to it?
Pension tax incentives worth just 7%Pensions guru at Hargreaves Lansdown Tom McPhail has worked out (on the basis of the Financial Services Authority’s own figures) that the tax relief incentives on pensions mean that over a term of 25 years, the return to a basic rate taxpayer with money in a pension plan will be just 7% higher than the return in an ISA, assuming exactly the same investment return.
I say this is a no-brainer: a 7% increase in return simply isn’t enough to compensate for the loss of flexibility and inheritability and the likelihood of paying more tax on the pension income. Higher-rate taxpayers reap bigger rewards from the pensions tax breaks, but for basic rate taxpayers, the ISA looks much better value.
Many financial advisers say things to me like: “Well, you may be right, Chris, but I advise my clients to put money into pension plans because then they won’t be tempted to spend it. If they have the cash available in the ISA they might spend it be
