ISAs v Pensions: The Official Retirement Debate

jamesd

EdInvestor, you probably meant 75% of the pension rather than 75% of the tax relief but either way you're understating the amount of a personal pension that's tax free.

75% of the pension is taxable so you end up with the personal allowance reducing the tax paid on that. For someone getting 8k in state pensions, 16k total income and with a 10k personal allowance that would leave the first 2k of the personal pension income tax free. That's a further 25% of 75% = 18.75% more that's tax free, for a total of 43.75 tax free.

Someone on just 12k total with the same state pension and personal allowance would be ending up with 62.5% of the pension free of tax.

If an employer paid in half of the money then that's just 28% or 18.75% paid by the person getting the pension even if they were only getting basic rate tax relief on their own contributions.

Pensions are the best deal around when it comes to providing the first part of income in retirement. ISAs start to be more and more interesting as the pension income increases.

EdInvestor

The OP already has 40k in a PP and should end up with a big state pension as he is not contracted out and on a good wage.Very likely he has already filled up the 10k tax allowance.

But it's always worth checking, get a state pension forecast after October here:

https://www.thepensionservice.gov.uk

robnoblewarren

Hi fellows, everybody seems to be avoiding mentioning the research on this. So, quoting the FSA, and taken from the DIY Fee-Only course on portfolio and pensions (link if you want it):

"The present approach of giving more generous tax treatment to the pension lump sum at retirement than to pension income is inconsistent with the aim of trying to encourage people to provide themselves with an adequate income in retirement. Yet it is the existence of the tax free lump sum that gives pensions their tax advantage over other products currently available. However, this advantage is often more than offset by charges, especially for basic rate taxpayers who stop contributing early on. Indeed, for basic rate taxpayers the value of the additional tax relief is not very substantial in itself. If there were no differences in charges, basic rate taxpayers would only need to be willing to pay an extra 7% for the very substantial flexibility of a CAT-standard ISA in order to make that the more worthwhile choice. For an average level of contribution, the difference between the charges on the median personal pension and those on an ISA broadly cancel out the tax advantages of the former."

Our own computations for each client usually shows little difference between the two, supporting the above occasional paper 'Saving for Retirement'.

boobbby

EdInvestor wrote: »

The OP already has 40k in a PP and should end up with a big state pension as he is not contracted out and on a good wage.Very likely he has already filled up the 10k tax allowance.

But it's always worth checking, get a state pension forecast after October here:

www.thepensionservice.gov.uk

Your right!! I already have a forces pension and will have used up my £10k tax allowance when I receive my full state pension.
I still think I will get a bigger income from my ISA than from the PP and I will always have the option to receive the cash from the ISA or even leave the fund to my dependants. Although it took less money to build up the PP it took a lot longer (over 20 years) and if I had that amount of time with the ISA I could have saved less each year but with the interest added it could have still given me the same fund as I have now. Over the years I Knew exactly what was in the ISA but never really knew what was in the unit linked PP as it kept going up and down.

dunstonh

the difference between the charges on the median personal pension and those on an ISA broadly cancel out the tax advantages of the former."

Which shows just how out of touch the FSA are with these things at times. Personal pensions investing in funds typically have much lower charges than ISAs investing funds. If you use unit trust funds then you are typically looking at identical charges most of the time.

The FSA comments also mention CAT standard which was abolished some years ago. So, the FSA comments could be pre date the A day changes.

jamesd

Quotes from the Second Report of the Pensions Commission in 2005:

"Saving via a pension attracts significant tax advantages, not only relative to saving in fully taxed vehicles, but also relative to other tax-advantaged routes, such as ISAs. Most people achieve significantly higher rates of return if they make employee contributions into pension policies rather than save via other mechanisms;" page 25.

"for the median earner paying basic rate tax ... their pension is increased by 8% over that which could be obtained by saving out of post-tax earnings into an ISA, and by 17% over that which could obtained if they saved out of post-tax income into accounts subject to the normal rate of tax on investment income. This 17% advantage versus the “normal” tax treatment arises from three effects: the absence of tax on investment income during the accumulation period: the fact that the lump sum is tax free: and the fact that tax relief on contributions will for the average earner be at a marginal rate of 22%, while the pension received will in the case illustrated be taxed at an average rate of 17%. Such a person would however be even better off if she could persuade her employer to make employer pension contributions on her behalf, reducing cash wages but keeping the total labour cost to the employer unchanged. Figure 7.5 illustrates that in this case she is 30% better off saving through a pension than through an ISA, and 40% better off than saving in a non-tax privileged form" page 309.

"for the last 15 years the vast majority of household net financial savings has been via occupational pension funds, and that more than 100% of net financial saving has been in either pension funds or life policies [Figure 1.34]. Outside of pension funds and life policies, the household sector has been a net dissaver of financial assets. This is despite the growth of PEP/ISA accounts." page 82.

robnoblewarren

Dunstonh says "Personal pensions investing in funds typically have much lower charges than ISAs investing funds. If you use unit trust funds then you are typically looking at identical charges most of the time."

Our own figures show total charges of about 3% p.a. on each, whether you are investing in funds or unit trusts, and this is consistent with published reports. We'd like to know where your figures come from, if you think we've got it wrong?

In the meantime, we conclude that we can't justify using funds nor unit trusts.

Jamesd's comments (thanks) seem to support that, since the charges on occupational pensions can be driven down to less than 1% p.a. But not personal pensions, of course, nor FSAVCs.

So we think the FSA has it right (this time:} ).

There is an online procedure to measure the annual charges in your unit trusts and personal pensions, in case you want to verify your own position, at http://www.fee-only.net/course1/course1.asp?article=1073

dunstonh

Dunstonh says "Personal pensions investing in funds typically have much lower charges than ISAs investing funds. If you use unit trust funds then you are typically looking at identical charges most of the time."

Our own figures show total charges of about 3% p.a. on each, whether you are investing in funds or unit trusts, and this is consistent with published reports. We'd like to know where your figures come from, if you think we've got it wrong?

Stakeholder pensions typically have a 1% annual management charge and the typical amc on unit trusts is 1.5%. A number of stakeholders have the TER set at 1%

It is possible if you are young enough to get the RIY down to around 0.4% using funds.

EdInvestor

dunstonh wrote: »

Stakeholder pensions typically have a 1% annual management charge and the typical amc on unit trusts is 1.5%. A number of stakeholders have the TER set at 1%

You have to add on another average 1% in hidden transaction charges, more for funds with a high portfolio turnover, usually less for trackers. The FSA disgracefully does not require these transaction charges to be disclosed.

Neil_Lovatt

stphnstevey wrote: »

"I think the most important difference is that pensions allow you to invest with pre-tax pounds where as ISA's only with post-tax pounds. So for a basic rate tax payer they could receive 22% tax rebate on the entire contribution to a pension. Were as an ISA you receive 22% tax back only on the interest paid on your contribution.

Eg
£100 pension contribution you would need to contribute £78 and receive a £22 tax rebate or for every £78 pounds invested you receive £22 tax break

£78 ISA contribution at say 6% interest you would receive a tax rebate of ((78x6%)x20%=) 93p or for every £78 invested you would receive a 93p tax break

I know in a pension this is tax deffered till when you receive an income, but the point is that the fund starts with considerably more money and that will compound (the power of compound interest!) to a massively larger amount than you could ever achieve with post-tax pounds."

Sorry I meant to pick up on this one some time ago! I think you are not understanding the benefits of compound interest. Tax relief applies as a percentage figure to the sum you invest, therefore it makes no difference WHEN the tax releif is paid.

For example say tax relief has the benefit of adding 50% to your investment (I know it doesn't but it makes everything so much simpler).

You have two investment options £100 in a pension (so £150 after relief) or £100 in an ISA.

In both options you invest in the same tax-free fund which doubles your money.

The ISA now has £200, the pension £300.

BUT you now switch the £200 from the ISA into a pension and you get 50% releif on £200, taking your pot up to £300.

So they are identical - what's the advantage of the ISA THEN Pension route.

Well firstly you are locking your money away in the pension, the ISA THEN Pension route gives you optionality. Also putting money into a pension can be a finely balanced decision - you might end up being better off in retirement outside of a pension given some of the issues over means testing, the point is though it's therefore better to be taking those kind of decisions closer to retirement when you can make that judgement call.

Most importantly of all by using an ISA THEN Pension route you can "time" your contributions into the pension to ensure you maximise your opportunity to get higher rate relief, imagine in the example above if you got 50% releif AND a reduction in your tax bill? Would there be any question of using an ISA over a pension?

As I've noted before everything changed on A-day, the really interesting thing is that IFAs, the industry and journalists still haven't caught up with it and carry on recommending a pension as the best first option. In practice it's probably the last option you should be using.