Changing face of retirement planning

When it comes to tax- incentivised saving schemes, personal pensions - in particular Sipps - can often be portrayed as the ugly sister and somehow ‘broken’. Issues such as failed esoteric investments, pension liberation and ongoing legislative changes, the reduction in lifetime allowance have all contributed to a sense of pensions somehow failing.

Since their ‘birth’ in 1999, Isas, on the other hand, have been blessed with their Cinderella status - helped in no small part by not being at the mercy of election cycles and a revolving door of ministers charged with their care.

Without doubt the pension system can be improved. Leaving it be for longer than any one term in government would be a good start - for a long-term investment it seems to bear the brunt of short-sighted political ‘fixes’.

It nonetheless remains a key tool in the retirement planning kit. True, saving for retirement no longer begins and ends with a pension. People can take advantage of Isa allowance, capital gains tax allowance and their pension saving - both to grow funds for income in retirement and tax-efficiently manage drawing an income from the funds once retired.

How best to support saving for retirement and how income is taken throughout retirement is a complex issue - not just for savers but for the Exchequer, too.

Striking the right balance of tax wrappers and where to draw income from to get the most from savings in all their forms could make all the difference when realising your ambition of a comfortable retirement and being able to leave money to dependents.

And here’s why.

Don’t pay now, pay later - the benefits of deferred taxation

The cost to the Exchequer of providing pension tax relief in 2011/12 was estimated to be £34.9bn, around 20 times higher than the cost of funding the tax benefits available on Isas. Although this is perceived to add fuel to the fire for those who wish to see pension contributions lose higher rate tax relief, it ignores the potential cost to the government in the longer term if individuals are not incentivised to save for retirement; not only with respect to future tax take, but also the cost of care for those who have made little or no provision.

The impact of higher rate relief on contributions, with regard to the overall return on savings can be quite substantial. For example, Table 1 shows the value of a person’s pension fund at the end of 40 years. For every £100 of net income saved monthly, the gross amount saved per month will be £166.67 for a higher rate taxpayer. The rate of growth is assumed to be

5 per cent gross per annum and is calculated on a compound basis, capitalised annually.

As is clearly demonstrated by this simple example for a higher rate taxpayer, the difference in return of almost £100,000 between money saved in an Isa to that saved in a pension, may make them more likely to consider the benefit of contributing to a pension.

So what happens when the individual retires? Taking income from an Isa is tax free, however pension income is taxable, although figures from HM Revenue and Customs (HMRC) indicate that six out of seven individuals who were higher rate taxpayers during their working lives will be basic rate taxpayers in retirement.

Looking at the example in a bit more detail and presuming on retirement the individual took 25 per cent of their Isa fund and the 25 per cent tax-free pension commencement lump sum to pay off debts and then took a net income of £7,200 pa (£9,000 pa gross from pension), increasing by 3 per cent pa from the remaining funds, we see in Chart 1 and Chart 2 that after 18 years the individual has received just short of £161,000 net income from both the Isa and personal pension. However, the Isa fund is almost exhausted with only £6,689 left, while the pension fund has over £120,000 remaining. This could be used to continue to provide a drawdown pension or buy an annuity, if appropriate.

An alternative scenario is if the individual had died after 18 years, and assuming their estate was liable to inheritance tax at the rate of 40 per cent, then £4,013 would pass to their beneficiaries from the Isa. The remaining pension fund, although not subject to inheritance tax, would be subject to the special lump sum death benefit charge at the rate of 55 per cent leaving £54,144 to pass to their beneficiaries.

A summary of the overall position is shown in Table 2.

Even after income tax on pension income, and the lump sum death benefit charge on the remaining pension fund, the individual and his beneficiaries will have benefited from around £75,000 more from the pension than the Isa.

It has to be emphasised that this is only one example. How best to save for retirement and, of even more importance, how income is taken throughout retirement is a complex issue. It should not be assumed that taking the maximum income from your pension is the best option; more than likely it may come from blending income from a combination of pension, Isa and other investments. What this example does illustrate though, is that the ability to defer any taxes until retirement is a benefit not to be ignored.

Neil MacGillivray, head of technical support unit, James Hay Partnership