You may need to rethink your pension strategy completely. Next year's changes in the tax and investment rules have changed everything.
A-Day is April 6th 2006, when the investment and tax rules for company and personal pensions change. So far, the boffins have concentrated on the minutiae of the rule changes and on the 'property in your pension' story, which we've already covered in MoneyMaker.
But there's a much bigger implication of the new rules that means you need to rethink the way you save for retirement. Strangely, it means you may be better off putting LESS into pension plans now and MORE in later, in the years just before retirement.
The relevant change is to the rules on the tax relief you collect when you put money into a pension plan. I won't go into the details of the current rules, suffice it to say they are complex and they restrict the amount you can put into a plan in any one year and get tax relief. The rules caused particular problems to the self-employed and anyone with fluctuating earnings. But from next April it is quite simple. Each year you can put into a company, personal or stakeholder pension the larger of
* £3,600 (if you have low or no earnings)
* your gross salary/earnings up to a limit of £215,000.
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Lump sum payments have more scope
Why is this so important? Well, the conventional idea on pensions was that you signed up for a regular savings plan. You were entering a commitment to a long-term plan with penalties, so you only wanted to commit to what you could afford, and also what you could be sure of getting tax relief on. But now, this just isn't so important.
Imagine you're a few years off retirement. You know you haven't got enough in your pension plans to give the income you want. So each year for several years you whack in big lump sums - maybe as much as your salary - from other savings, and collect tax relief on the lot.
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Get a lot more bang for your buck
The tax relief is worth most to you over the shorter term. Say you put £1,000 into a pension plan and get basic rate tax relief, so £282 of tax relief is collected and £1,282 is actually invested. Say you get a return of 6% on the investment. At the end of year one your plan is worth £1,359. That means the tax relief has boosted your return from the 6% you'd have got on £1,000 in another type of plan to a whopping 35.9%.
But now assume you leave the money invested: at the end of 10 years the original £1,282 in the pension plan will have grown to £2,332. That is a net annual return on of 8.5% on your starting sum of £1,000. The longer the savings period, the less of a boost the tax relief provides to the net rate of return you get.
So tax relief gives you most bang for your buck over the short term. And the new pension rules enable you to max out on that by accumulating capital and whacking it in when it suits you.
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Save flexibly, then get tax relief
Now don't think for a minute this gets you off the hook of saving for retirement. On the contrary! What I'm suggesting is that by saving up capital in whatever other ways you like - buy-to-let, shares, ISAs - you create the opportunity to use pension plans more effectively and maximise the value of the tax relief available.
My own view, supported by over 100 years of history, is that over any period of ten years or more, you will get the biggest return from stock market-linked savings schemes. Through a fund supermarket you can effectively set up your own DIY regular savings scheme and put it into the funds you choose - and you won't go far wrong, I suggest, if you stick with funds from my Best Buy tables.
The main thing is to choose a form of saving you like and pile money into it. Over a 15 or 20-year period you will get almost as high a net rate of return as if you put money into a pension plan. Then, as retirement approaches, use tax relief to maximise the sums you put towards the provision of pension income.
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Flexibility is important
The advantage of this method of savings for retirement is that you retain the flexibility to use the funds you save in non-pension form for other purposes, as of course you may need to do if your circumstance change. I often think the theoreticians who go on about pensions fail to realise just how important it is to most people to have access to the capital they save up.
Like Donald Rumsfeld with his 'known unknowns', we know we may need the money for things we know we can't foresee. And we know that once the money is in a pension fund we can't get at it.
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Not what the experts ordered
So there's the outline. Save as much as you can in whatever you like best: houses, shares, ISAs etc - and put lump sums into pension plans in the years immediately before retirement. Sounds like it makes sense and for once the experts got it right?
Funnily enough - though perhaps not surprisingly - this consequence of the new pension rules wasn't even thought of by any of the experts. Even when I now point it out to them they frown and try to brush it off as something that won't actually affect people's behaviour - because they believe people ought to save in pension plans. Whereas I believe people ought to save for retirement, and am glad the new rules give most of us scope to do so more effectively without tying our capital up for ever in plans where we can't get access to it if we need it.
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Check out our SIPP centre here
