Are pensions a good retirement planning tool? (Full text)

Where is the best place to put your money for retirement? Ask a lot of people and the automatic response is that you should put your money in a pension to get a bigger retirement pot which comes from the tax advantages given by HMRC. I however am not convinced and in fact believe the government and the pensions industry is actually close to misleading the public as to the advantages of pensions.

For some people they seem to provide big advantages which in my opinion outweigh many of the negatives and risks with pensions. Personally I use a pension as part of my retirement investing strategy however I don’t have all my eggs in one basket and have about 34% of my total assets within a pension tax wrapper. However I believe that for many people the benefits could be marginal (maybe even negative in some instances) and if I was in that position I would not touch a pension.

To me the advantages of a pension are really quite simple as it’s essentially nothing more than a tax deferral scheme. The theory is that you contribute to the pension today, tax free, and then some day in the future you withdraw the money and are then taxed on it. The only other carrot I think of is that when it comes time to withdraw at some distant date you can currently take 25% of the pension pot saved tax free.

The current disadvantages seem many and include but are certainly not limited to:

- At retirement I won’t get access to my pension pot but instead can only purchase an annuity or an unsecured pension (USP). The only exception I can think of is if you plan well in advance and don’t intend to retire in the United Kingdom you may be able to transfer your pension pot to a Qualifying Recognised Overseas Pension Scheme (QROPS). QROPS is something that is highly likely to be used by me.

- To me the rules seem complex and can be changed at anytime by the government. The government have also proven that they will not leave pensions alone and will be constantly tinkering.

- I have no idea what tax rates will be in the future.

- Governments can change the allowable retirement date. If I’m targeting a particular date and only save in a pension then I could be very disappointed.

- I will be very limited as to what you can pass down to future generations. For example if I bought a standard annuity at retirement and died the next day nothing could be passed down.

I think the best way to demonstrate if a pension might suitable for someone is for the individual to sit down (with independent advice of course) and carry out some analysis looking at different options. I can very easily imagine that every single person in the UK being different. Today I’m going to demonstrate how I look at pensions with 2 examples as I understand the rules.

The first is Average Joe who is very similar to me. He is a 40% tax payer whose employer allows him to salary sacrifice. He also gets some advantages from his employer for contributing to a pension. The second person is average Bob who is a 20% tax payer who contributes to his pension out of net pay and gets no advantages from his employer for contributing to a pension.

Firstly, some general assumptions used in the examples:

- I am going to assume that that the investments are made into a balanced type of asset allocation. I will therefore assume the nominal average returns that can be expected will be 8.6% per annum.

- For consistency I am going to assume the pensions are both Stakeholder Pensions (rather than for example a Self Invested Personal Pensions – SIPP’s) where the government allows the provider to charge fees of 1.5% for the first 10 years and 1% thereafter. I will assume the provider is ‘generous’ and only charges annual fees of 1% over the life of the pension.

- It was very easy for me to get a Stocks and Shares ISA (S&S ISA) that has zero annual fees for providing the tax wrapper. It is also very easy to buy a series of Exchange Traded Funds (ETF’s) and build a balanced asset allocation for fees of less than 0.5% per annum. Therefore I will assume 0.5% in the examples below.

Average Joe (Maths in the image above)

Let’s assume average Joe earns £50,000 and his employer allows him to salary sacrifice £2,000 of his pre tax earnings annually into his pension pot. Were he to take this £2,000 as salary (and later invest into an ISA) he would pay tax at 40%, national insurance at 1% plus his employer would pay national insurance at 12.8%.

Joe’s company is generous and agrees to match his commitment of £2,000 every year. They also offer a Salary Sacrifice arrangement allowing Joe to reduce his salary and in exchange his company will invest into his pension on his behalf. This means he doesn’t pay tax on the contribution but also importantly he doesn’t pay national insurance either. Finally as his employer hasn’t had to pay the 12.8% employers national insurance they generously agree to contribute this to Joe’s pension also.

Running the maths means that if Joe chooses to commit £2,000 of his before tax earnings into his pension pot annually he actually ends up with £4,256 going into the pension. On the other hand if he chooses to contribute to an ISA he pays tax and national insurance and ends up with £1,180 going into the ISA. That is a very significant difference.

Now Joe continues his contributions, lets compound interest go to work and in 30 years looks to retire.

Joe has been very careful to ensure that he is only a 20% tax payer in his retirement as he already owns his house and can live relatively frugally. He has also not put all his eggs in one basket and so has invested outside of his pension and receives enough earnings from other investments plus the state pension (he made enough NI contributions) to use up all his tax free allowance. Joe’s pension pot has compounded to £482,205. He chooses to take the maximum tax free that he can which is £120,551. With the remainder he can then choose either an annuity or a USP however whatever choice he makes he has already used up his tax free allowance and so his pension will be taxed at 20%. He won’t have to pay national insurance on his pension.

So allowing for this 20% tax rate on all his subsequent USP or annuity payments his effective total available pension pot is £409,874 compared with £147,179 if he had have saved in an ISA. That’s an increase of 178% which for me makes it worth using for part of your retirement investing strategy and compensates for the negatives of pensions.

Average Bob (Maths in the image above)

Let’s assume average Bob earns £30,000 and intends to also invest £2,000 of his pre tax earnings annually into his pension pot. Were he to take this £2,000 as salary (and later invest into an ISA) he would pay tax at 20%, national insurance at 11% plus his employer would pay national insurance at 12.8%.

Joe’s company is not generous and does not help him with his pension arrangements. He therefore has to pay tax and national insurance at the full rate (£620), make the pension contribution and then let the pension company gross up the contribution (effectively claim back the tax) by 20% or £345.

Running the maths means that if Joe chooses to contribute £2,000 of his before tax earnings into his pension pot annually he actually ends up with £1,725 going into the pension as he still has to pay the national insurance of 11%. On the other hand if he chooses to contribute to an ISA he pays tax and national insurance and ends up with £1,380 going into the ISA.

Now Bob continues his contributions, lets compound interest go to work and in 30 years also looks to retire.

Bob has also been very careful to ensure that he is only a 20% tax payer in his retirement. He has also not put all his eggs in one basket and so has invested outside of his pension and receives enough earnings from other investments plus the state pension (he made enough NI contributions) to use up all his tax free allowance. Joe’s pension pot has compounded to £195,443. He chooses to take the maximum tax free that he can which is £48,861. With the remainder he can then choose either an annuity or a USP however whatever choice he makes he has also already used up his tax free allowance and so his pension will be taxed at 20%. He also won’t have to pay national insurance on his pension.

So allowing for this 20% tax rate on all his subsequent USP or annuity payments his effective total available pension pot is £166,126. What is really surprising however is that he would actually be better off if he had of just invested in ISA’s where he would have investments totalling £172,125 which he could withdraw tax free when and how he likes. By having the pension he is worse off plus he also still has all the negatives of pensions as explained previously.

So my personal thoughts in summary:

- A key element of my retirement investing strategy is to minimise fees and tax which erode the effect of compound interest. As with any of my investments I’m watching both.

- In my experience stakeholder pensions tend to charge higher fees on the investments within the wrapper than equivalents (exchange traded funds – ETF’s etc) that can be bought in an ISA or outside of any pension wrapper.

- A pension doesn’t automatically appear the best vehicle to save for retirement.

- Always, always, do your own research. One size does not fit all.

- If you do want to save into a pension it seems worthwhile to explore whether getting your employer to set up a salary sacrifice scheme to save the national insurance could benefit you. However with every complex investment there are things to watch every step of the way. For example with salary sacrifice schemes there also seem to be some negatives. It looks like statutory benefits could be affected because taxable pay is reduced. Also, the state second pension could be affected if you earn between the Lower and Upper Earnings Limits. Also it doesn’t seem beneficial to set one up if paid below the National Minimum Wage or the Lower Earnings Limit.

Finally, pensions are very complex things. I personally use them and I have tried to demonstrate why they suit me based on my research only (remember I am not a financial adviser, only an average Joe). However, as they are very complex I may have misunderstood an element resulting in an incorrect calculation in the long example above. If you do spot an error please post a comment so that I can correct it.

I also would also encourage readers to post general comments as I was quite surprised with what I saw once I ran the numbers.

And as always DYOR.