ISAs v Pensions: The Official Retirement Debate

jem16

fairleads wrote: »

Mr. A, a male aged 56, retires with savings of 250,000 invested mainly in bond income, equity and bond income and equity income unit trusts, most of which are held under the Isa wrapperHe invests 125,000 @ 7% bond yield and 125,000 @ 5.5% yield
Drawing 6.9% x 125,000 from the bond portfolio provides a tax-free income of 8,625
and 6.5% x 125,000 from the equity portfolio to give another 8,125 also tax-free
The result is an annual tax-free income of 16,750 P/A which equates to 6.7% of the total portfolio.
This is not excessive because some of the Bond UTs are producing 7% income yields and the balance of the portfolio delivers a tax-free yield of 5.5%. He is therefore, in effect, boosting his income with a bit of capital.

May not be excessive but is still drawing more than the yield so in Year 2 etc, pot is reduced so next year's income has to be reduced or pot falls further.

Mr. B, of a similar age, retires with a larger pot - 312,500 - courtesy of the 20% tax-rebate on contributions.
He takes 25% as a tax-free lump sum and invests that 78,125 in a matching portfolio, and draws 6.5% tax-free as income.
The balance of 234,375 was invested in a similar manner.
However, because Mr. B has invested under SIPP rules his annual draw down is limited by GAD to 5.4% and the income is taxable at 20%. His income is as follows.
234,375 x 5.4% = 12,656 - 7475 PA = 5181 TI x 20% = 1036 tax.
His net annuity income is therefore 12,656 – 1036 =11,620.
Now add tax-free income (78,125 x 6.5%) of 5,078 to give a total net income of 16,698.

Which is fine as he is drawing less than his pot is yielding so his pot will increase whereas Mr A's will decrease.

Unfortunately, at the end of year one, the market takes a knock and values fall by 10%.
So Mr. B now finds that the value of his drawdown in year two is also reduced. Whereas Mr. A's income draw is unrestricted.

However Mr A is now having to use even more of his capital as his pot has also fallen by 10% but he is still drawing the same.

Now let's add in Mr C.

Mr c, of a similar age, retires with a larger pot - £416,666 - courtesy of the 40% tax-rebate on contributions.
He takes 25% as a tax-free lump sum and invests that £104,166 in a matching portfolio, and draws 6.5% tax-free as income.
The balance of £312,500 was invested in a similar manner.
However, because Mr. C has invested under SIPP rules his annual draw down is limited by GAD to 5.4% and the income is taxable at 20%. His income is as follows.
£312,500 x 5.4% = £16,875 - £7475 PA = £9400 TI x 20% = £1880 tax.
His net annuity income is therefore £16,875 - £1880 = £14,995
Now add tax-free income (£104,166 x 6.5%) of £6770.79 to give a total net income of £21,765.79

Now Mr C has £5,015.79pa more than Mr A courtesy of him making use of his higher rate tax relief when he was working. Plus he's still only drawing less than his capital is yielding unlike Mr A.

If however, as I strongly suspect, that SIPP manco costs are greater than those of the ISA wrapper, then this following example is far more representative of the prevailing situation
In this case the deduction of a .5% annual SIPP man- co fee, over the 30 contributing years, reduces the SIPP from 312K to 288K.

Unfortunately the costs for the ISA wrapper and SIPP wrapper can be exactly the same.

Further, if Mr. B has the benefit of the 40% rebate on contributions but suffers manco fees of only 2% even, then it is entirely probable that he will still not be any better off than Mr. A.

Not true though.

Food for thought?

Would that be tripe then?

Thrugelmir

jem16 wrote: »

Mr c, of a similar age, retires with a larger pot - £416,666 - courtesy of the 40% tax-rebate on contributions.

Great post.

One observation. The value of the fund would be larger than the tax relief alone.

As an equity fund ( Foreign & Colonial for example) raises its dividend every year (for 40 years).

So the compounding effect of an increasing reinvested dividend over many years bears a significant additional return.

jem16

Thrugelmir wrote: »

Great post.

One observation. The value of the fund would be larger than the tax relief alone.

As an equity fund ( Foreign & Colonial for example) raises its dividend every year (for 40 years).

So the compounding effect of an increasing reinvested dividend over many years bears a significant additional return.

I was really going along the lines that the two pots would have been built up using identical investments so that the only difference would have been the tax relief.

jamesd

Also worth noting that both Mr. B could have taken pension benefits earlier, at age 55, taken the maximum income and not spent it, allowing a somewhat higher than GAD effective income by spreading the money from that one year over the remaining years until GAD catches up with investment returns.

The lower GAD limit creates a significant incentive to take benefits well before planned retirement date. There was still an incentive at 120% but it was less strong.

fairleads

Tripe
Before addressing the case of the 40% taxpayer, we should at least take into account some demographics. They are as follows. Only 22% of the 27odd Million UK tax- payers fall into the higher tax bracket. Further, most of those 22%, if not all, have not been subject to the higher rate for all their working lives so neither would their pension benefit from a full term of 40% rebates. After all, many recent graduates can’t find employment even, let alone an income of 42K +. However, if we say that those 22% pay tax at 40% for the last 15 of their 35 contributing years, it follows that their pension pot will not in fact grow to 416K but a more probable, but still theoretical, 371K. However, and as Dunstoneh has alluded to, only half of the 40% rebate is credited to the fund on a monthly basis. He said the balance first needs to be claimed on the annual return, and only then is it refunded to the 40% taxpayer. Who are in turn responsible for paying that into their fund. In addition, because this annual payment is made in arrears it impacts negatively on the growth of the pension fund. Thus reducing it further to 328K.
Now we come to the controversial subject of the extra man co fees, the ones I believe are higher than those applied to the Isa funds. And it has been conceded, here on this forum, that SIPP man co costs could be anything from .2 up to .7 % P/A. So if we take a middle ground and apply a .45% fee we find that our SIPP pot is further reduced to a more representative figure of 300K. Thus it follows, all other things being equal that the 5.4% GAD limited and taxable income, plus the income derived from the 25% tax-free lump sum, is a now reduced net annual income of 16,100. Whereas the Isa fund still produces a competitive 16, 750, and wholly, tax free annual income.
Further, the Isa investor still has the added advantage of 100% of their personal allowance. Therefore, it follows that, come the day, even the state pension will be tax-free. Whereas the Sipper’s state pension will be fully taxable. However, come 65 and the Sipper’s GAD income limit has increased to 6.8%. But I have to say that drawing 6.8% of the fund as income will slowly run down the capital value of the fund. And the reason for this is two fold
A) 6.8% drawdown could well be close to the fund’s annual return and
We still have to account for a .45% manco fee.
Therefore, it would be prudent to limit our drawdown to, say, 6.35%
And for brevity’s sake, we assume that from the age of 56 to 65, inflation is 0% and our fund’s values have remained constant.
In which case the final value of the SIPP pot is still 300K with the Isa remaining at 250K
Using the same procedure as used previously, but with the new improved drawdown and including say 6.5K state pension the resulting net incomes will be 23K for the sipper and 23.25K for the Isa investor.


Now I did previously mention that if the stock market takes a knock and the fund value falls by say 10% it follows that so will the GAD limited income. And it was mentioned that the Isa income stream would also take a knock. But this is the interesting part about investing for income; short-term capital volatility more often than not does not automatically reduce the income stream. Reference the mention of an investment / unit trust that has delivered an increasing dividend income every year for more than20 odd years. One of the funds in our portfolio has produced a dividend thats grown for 9 out of past 10 years. So as we can see, the Isa investor - providing they invest in income producing equity, and equity and bond income funds, that is - or individual gilts and shares – can, to a greater degree, isolate themselves from short term market volatility. This has been our case, short- term capital volatility, of minus 25% even, has not led to a material loss of income.

Now we come to the matter of pension fund costs. Please take the time to visit the funds network page on the web site of one of the world's largest fund manager (no names but it does start with an F) and enter as a financial adviser. And see for yourselves the cost structure – the % fee that your adviser can cream off your fund, your retirement investment. And in a bid to further enlighten readers re the question of hidden, or not so obvious, extra manco pension fund costs – here with is a link to an article that provides more info on this controversial subject.
http://www.thisismoney.co.uk/money/investing/article-1726411/Hargreaves-Lansdown-resists-revealing-fund-manager-commission.html

So as we can see, there is even more bad news, because, as the link to HL above alludes to, there can also be another layer of costs debited against your pension fund. This is the fund (unit trust) manager’s kick back to the pension fund provider – the SIPP manager – its called trail commission. So if you choose the wrong combination - of provider, fund manager and financial adviser- your pension pot could well be debited with two more amounts of trail commission. One to the SIPP provider, and the other to your financial adviser.
Now these trail fees are over and above the usual unit trust fund manager’s fee of anything between 1.25 and 2% P/A. - Vested interests indeed.
There is a way to reduce some of these costs, however, and it is to construct your pension fund around a portfolio of individual shares, gilts and investment trusts. But that brings its own problem, because regular dealing costs also impact on your fund.
Before concluding, I’d like to draw your attention to another often-overlooked aspect of taking early retirement from a self-invested pension fund. When still young enough to enjoy and make best use of a decent pension, the Sipper is restricted to 5.4% drawdown. But the irony is that the older they get the, the higher the GAD limit. So they get a higher income when they can least enjoy - or for that matter need - it. Whereas the Isa investor can draw down a higher income+ capital amount when they need it – on retirement. And at a later stage, when their income needs decline, gift some of their money to family rather than HMRC. But the sipper’s fund, even with a final years GAD limit of say 20% will always be at least 80% full and tax at 55% of 80% is a huge loss to the main beneficiary of their estate – their spouse.
So, when taking all of the above into account, and including that with the taxation and loss of control over at least 75% of capital, is it any wonder I am so vehemently opposed to a self invested pension fund - be it stake holder, SIPP or whatever.

dunstonh

Now we come to the controversial subject of the extra man co fees, the ones I believe are higher than those applied to the Isa funds.

Its clear you believe that but you are wrong. So, no point going on about it.

Further, the Isa investor still has the added advantage of 100% of their personal allowance.

But there is no point having a personal allowance that is not being used.

But I have to say that drawing 6.8% of the fund as income will slowly run down the capital value of the fund. And the reason for this is two fold
A) 6.8% drawdown could well be close to the fund’s annual return and
We still have to account for a .45% manco fee.
Therefore, it would be prudent to limit our drawdown to, say, 6.35%

Average return on a medium risk basic fund is around 7.5% p.a. after charges. However, you are right that drawing 6.8% p.a. could easily see erosion. However, that would equally apply to ISA.

fairleads

dunstonh wrote: »

But there is no point having a personal allowance that is not being used.


.

But it is an option that is still available to use. So I have both an option and a choice. Not a bad place to be.

Judwin

fairleads wrote: »

However, and as Dunstoneh has alluded to, only half of the 40% rebate is credited to the fund on a monthly basis. He said the balance first needs to be claimed on the annual return, and only then is it refunded to the 40% taxpayer. Who are in turn responsible for paying that into their fund. In addition, because this annual payment is made in arrears it impacts negatively on the growth of the pension fund. Thus reducing it further to 328K.

This isn't correct. You don't reclaim the extra 20% and pay it into the fund yourself. You make contributions nett of 20% tax regardless of your actual tax band. If a HRT payer wants to put £10K into their plan, they make a cheque out for £8000 and send it to the pension co. The Pension co then claim £2000 tax back from HMRC. The HRT payer then claims the additional £2000 back from the tax man in the self assessment form, or through their tax coding.

Therefore, whenever HMRC refund their 20% into your fund, thats the end of it. There is no payment in arrears.

Judwin

There is also a slight niggle with the Person B and C.

Fairleads states "He takes 25% as a tax-free lump sum and invests that 78,125 in a matching portfolio, and draws 6.5% tax-free as income. " Jem60 states similar for Person C.

The single ISA allowance is less tha £12K p/a so it's going to take 7 years for a single person B to get £78K into an ISA, or 10 years for a single person C to get £100K into an ISA. Sure there are other tax free wrappers - but yielding 6.5% ?

And it's NOT neccessery to pay HRT in orger to get 40% 'tax' relief. If you use salary sacrifice, a 20% tax payer can also save 11% Employees NI, and possibly some/all of the 13.8% Employers NI. This means the 20% tax payer actually recieves almost 45% 'tax' relief.

fairleads

Judwin wrote: »

This isn't correct. You don't reclaim the extra 20% and pay it into the fund yourself. You make contributions nett of 20% tax regardless of your actual tax band. If a HRT payer wants to put £10K into their plan, they make a cheque out for £8000 and send it to the pension co. The Pension co then claim £2000 tax back from HMRC. The HRT payer then claims the additional £2000 back from the tax man in the self assessment form, or through their tax coding.

Therefore, whenever HMRC refund their 20% into your fund, thats the end of it. There is no payment in arrears.

Thanks Judwin but the operative word here is whenever