Reply to: Pensions or savings?

[IR35 Avoider]

with an ISA there is always a risk of your money running out, but with an annuity the capital is never diminished, so there's no such risk.

I thought I'd just explain what I mean by this, in case anyone's interested. When you use savings to directly fund retirement income, it's very difficult to calculate what rate of withdrawal to use. The Efficient Frontier site I linked to earlier in this thread suggests that if you want to be sure of not running out of money, the most you can take from an investment in shares is about 3.3% per year. Of course, if you are this conservative, you will have a very low retirement income and probably leave a large estate, i.e. fail in your goal to use all of this chunk of money to give yourself the maximum retirement income.

If you have a unit-linked annuity invested in exactly the same portfolio of shares, there is virtually no risk of running out of money. That is because your income is actually of a completely different character. Whereas the non-annuity route is funded by income and capital from your pot, with an annuity all the income and capital stays in existence until you die. (Actually there are small deductions each year for Insurance company charges, but except in extreme cases that is not significant.) An annuity is life insurance in reverse; you in effect sell the insurance company insurance on your life. In exchange for getting the whole of your pot, plus any investment growth on it that happens between the annuity start date and your death, the insurance company pays you life insurance premiums. The premiums rise and fall in proportion to the underlying investment, because the pot the insurance company is destined to gain is varying.

When you are living directly off savings, even if over the decades of retirement the stock-market does well, if the worse years happen to turn out to be crowded nearer the beginning of the retirement period, your savings will be very quickly wiped out. The other site I provided a link to previously points out that if you have a need to take a certain amount of income, then you will suffer from negative pound-cost averaging; you will have to sell more shares when the stock-market is down and fewer when it is up. An annuity income from a pot of exactly the same size invested in exactly the same assets doesn't have these problems, and safely gives you a much higher income. In my spreadsheet mentioned above, the after-tax income at the start of the retirement period was 7.3% of the size of the ISA pot, with no risk of running out, when it was coming from the annuity.

[IR35 Avoider]

As a 55 yr old farmer, who is pretty computer illiterate, you may take this with a large pinch of salt, but I have made a simple spreadsheet to compare ISAs v Pensions using the following assumptions
1. The internal tax treatment of Isa & pension invested mainly in international and UK stocks, are the same-------are they?
2. Wherever possible, I have used index linking. Eg the pension taken is rpi linked.
3 I have assumed a continuous REAL rate of return from now until my death of from 1 to 4%
4 I retire at 65, and take for the pension, the 25% cash sum. I also withdraw the same amount from the equivalent ISA.
5 the remainder of the Isa continues to be invested , at the same real rate of return as before, but an amount equivalent to the pension payment is deducted each year.
6 And this probably does'nt apply in your industry, I pay 22% tax on this portion of my income both now, and in retirement. The same would apply if it were 40% in both.

THE RESULTS For a cost to me of £1000 for this year only.

real return...........................1%..............2 %..............3%.............4%
lump sum at present value..354...............391..............431..... .......474
Yearly after tax income
at present value................42.58............46.99....... .....51.81..........57.06
Age at which the Pension
becomes preferable..............85................87...... ..........91...............97

Nb the average life expectancy of a male at 65 is I believe, to 81.
Thus if everything in a calculation is kept as similar as possible, the breakeven point is determined by the age that you die, and for most rates of return and all positive ones, this shows that for most of us, the ISA route gives the better return, unless you anticipate lower retirement tax rates.
So having now looked at this in some detail, I have come to the conclusion that I should stop putting all my eggs in this particular basket (I am a farmer!) and will now start taking up my non cash ISA allowance, which will also give me more flexibility at retirement. But do I trust the future Government?

Before I saw your post, I'd spend the day constructing exactly the same spreadsheet. I only explored real rates of return from 4% to 6%. I wanted to prove that an annuity was safer, in that (oversimplifying only slightly) with an ISA there is always a risk of your money running out, but with an annuity the capital is never diminished, so there's no such risk.

I assumed 30 years of saving to age 65, then looked at what happened over the next 35 years to age 100.

I did prove the annuity was safer, and came to exactly the conclusion you did. With an ISA, the money almost always runs out at age 95, sometimes a little later (depending on the actual pattern of simulated stock-market returns) whereas the annuity never ran out. (It is theoretically possible to make a unit-linked annuity decrease to zero, if you choose a very high Anticipated Growth Rate and get actual returns of less than that for decade after decade - but if you set the AGR to 0 you can avoid the risk completely.)

However, looking back, I realised that some would regard this as a pyrrhic victory. If like me you place zero value on what happens to this chunk of money after you die, and a very high value on knowing you will never run out of income from it, then you will prefer the annuity route. Of course some people will value the pounds left to their estate on death at more than zero, value them to the extent that they are willing to bet on themselves dieing before 95. In short, if you want the maximum mathematical return, and do not differentiate hugely between the utility of pounds you spend while alive and that of pounds spent by beneficiaries of your estate after your death, then the non-annuity route is more suitable.

The non-annuity route has a further advantage - if you are able to anticipate your demise, you can step up your spending rate in order to make the most of your money. To put it bluntly, care of a terminal geriatric is bloody expensive, and the thought of receiving budget-quality care somewhat alarming, so the option to blow the remainder of capital on raising the quality is quite valuable.

Edit: I've discovered that my assertion that the ISA money runs out at 95 is extremely sensitive to the annuity rate the company uses as a baseline. (Remember we are assuming a withdrawal strategy from the ISA of taking exactly what an annuity would have paid.) I initially assumed 6%, changing this to the median of the FSA tables of 6.9% and the ISA money runs out at 89. (By the way, I built an Anticipated Growth Rate of 4.3% into my model, as my guess of what the annuity companies are using as the gilt yield when they quote £577 per month for a standard annuity.)

[boar278]

Oh I do wish that you computer whizzes would make doing tables on a forum more user friendly. I even checked and changed it on 'preview' before posting!

[boar278]

55 yr old Farmer

As a 55 yr old farmer, who is pretty computer illiterate, you may take this with a large pinch of salt, but I have made a simple spreadsheet to compare ISAs v Pensions using the following assumptions
1. The internal tax treatment of Isa & pension invested mainly in international and UK stocks, are the same-------are they?
2. Wherever possible, I have used index linking. Eg the pension taken is rpi linked.
3 I have assumed a continuous REAL rate of return from now until my death of from 1 to 4%
4 I retire at 65, and take for the pension, the 25% cash sum. I also withdraw the same amount from the equivalent ISA.
5 the remainder of the Isa continues to be invested , at the same real rate of return as before, but an amount equivalent to the pension payment is deducted each year.
6 And this probably does'nt apply in your industry, I pay 22% tax on this portion of my income both now, and in retirement. The same would apply if it were 40% in both.

THE RESULTS For a cost to me of £1000 for this year only.

real return...........................1%..............2 %..............3%.............4%
lump sum at present value..354...............391..............431..... .......474
Yearly after tax income
at present value................42.58............46.99....... .....51.81..........57.06
Age at which the Pension
becomes preferable..............85................87...... ..........91...............97

Nb the average life expectancy of a male at 65 is I believe, to 81.
Thus if everything in a calculation is kept as similar as possible, the breakeven point is determined by the age that you die, and for most rates of return and all positive ones, this shows that for most of us, the ISA route gives the better return, unless you anticipate lower retirement tax rates.
So having now looked at this in some detail, I have come to the conclusion that I should stop putting all my eggs in this particular basket (I am a farmer!) and will now start taking up my non cash ISA allowance, which will also give me more flexibility at retirement. But do I trust the future Government?

[ASB]

All I'm saying is that the lump sum of £6633 from the pension, once taken out of it as a tax-free lump sum and put into your own hands, produces the same income going forward as the same size chunk in the ISA, so for the purposes of comparing the two scenarios we can eliminate that amount from both. The difference in income produced by the remaining amounts is then also the difference between the whole amounts (before we subtracted from both sides.) In other word's, it's just a calculation trick - I'm not actually disappearing the money from either scenario.

I am probably just being thicker than normal

Not sure what you are thinking here, ISAs and pensions get exactly the same reliefs on investment income.

Yes, they do now. Ooops....

Not really sure what you are on about here - there's no need to bring voluntary annuities into the picture. To make a fair comparison you must assume that all of the ISA and pension capital are invested in exactly the same way, though you can reduce the returns on the non-lump sum portion of the pension capital by 22% to reflect the tax due. Since it gives the same result, I chose to treat the relevant portion of the pension capital as reduced by 22%, then there was no need to reduce the income from it by 22%.

The bottom line is that you get £796 income from the ISA and £1107 (after tax) income from the pension. A massive difference. The pension route produces 39% more income overall - much more than "a few percent."

I'll recap because I think I have got there...

With 25.5k in the pension you have 2 basic returns available with an assumed annuity rate of 5%.

Either: 25.5k x 5% less 22% tax = 1275 = 995
Or reduced by 25% = 746 - but with 6.5k going forward as well

Now, in the 16k case you will get a better annuity rase (if you are chosing to buy one). Never understood why, but you do. Also since most of it is a return of capital the tax treatment is better. However I will assume the rates are the same - because they do now seem to have narrowed and I can't find any tables. Also this doesn't allow me to make any real estimate of the tax, but it is subtantially lower.

So 16k x 5% = 800 less a little tax
Or 9.5k x 5% = 475 less a little tax and still with the 6.5k going forward.

So yes, you have persuaded me that if you are a 40% taxpayer then the benefits are far more substantial than I initially believed.

But, if you were a basic rate taxpayer from the pension view it is still a gross 10k contribution. You still have the 25.k pension fund, the yield on the annuity is still as above.

However in the ISA type scenario you start from 7,800 not 6,000. This becomes 21k not 16k.

So 21k x 5% = 1100 less a little tax
Or 14.5k x 5% = 725 less a little tax and still with the 6.5k going forward.

So, here the position is that it is still basically equal. This is the premise I started from - that for most people paying contributions from salary the tax benefits are largely illusory. It's only really deferment.

However, taking the cash sum does tilt the balance towards the pension - but at the cost of less flexibilty at the end.

[IR35 Avoider]

But surely that ceases to be a valid comparison? The basic 2 choices are to use the same chunk of income to build a pot.

All I'm saying is that the lump sum of £6633 from the pension, once taken out of it as a tax-free lump sum and put into your own hands, produces the same income going forward as the same size chunk in the ISA, so for the purposes of comparing the two scenarios we can eliminate that amount from both. The difference in income produced by the remaining amounts is then also the difference between the whole amounts (before we subtracted from both sides.) In other word's, it's just a calculation trick - I'm not actually disappearing the money from either scenario.

(In actuality the ISA type route might be more favourable due to the fact that the pension doesn't get any relief on it's investment income).

Not sure what you are thinking here, ISAs and pensions get exactly the same reliefs on investment income.

So, this means the pension can produce approx 800 net, against the 960 from the volunatary annuity. However there is the 6.k cash lying around which evens it up - probably put the pension slightly ahead of the game - but only by a few %.

Not really sure what you are on about here - there's no need to bring voluntary annuities into the picture. To make a fair comparison you must assume that all of the ISA and pension capital are invested in exactly the same way, though you can reduce the returns on the non-lump sum portion of the pension capital by 22% to reflect the tax due. Since it gives the same result, I chose to treat the relevant portion of the pension capital as reduced by 22%, then there was no need to reduce the income from it by 22%.

The bottom line is that you get £796 income from the ISA and £1107 (after tax) income from the pension. A massive difference. The pension route produces 39% more income overall - much more than "a few percent."

Re-read what I said - I don't think you followed my line of thought. (Maybe the way I put it was a bit convoluted.) (Or if I have made any mistakes, then you haven't shown them to me yet.)

1) Company contributions - pension wins hands down due to the CT and NI regime.

Pension wins by an even huger amount than you think, because the effect of the tax-free lump sum is massive.

2) Basic rate tax payer in work and in retimerment - a modest but noticable amount behind if personal contributions are made

Maybe I didn't read your post closely enough, but even if you ignore the tax free lump-sum, I can still see no way that the ISA route can return more than the pension route. The best it can do is be equal. (Was it the assumption of more tax relief on investment income that led you to this conclusion? If so, I've already disputed this.)

Of course you cannot ignore the lump-sum, as it makes a big difference in favour of the pension.

3) Higher rate taxpayer in work, normal in retirement - a modest but slightly less noticiable advantage to the pension route

A 39% advantage - absolutely huge.

4) normal in work becoming a higher rate payer in retirement bad news.

Not a scenario worth worrying about. You could simply stop paying into the pension at the appropriate time to avoid this.

I've noticed in your original example you assumed different rates of return for the ISA and pension capital - you can't do this if you want to make a fair comparison. I haven't used annuity rates anywhere. To make a fair comparison I've assumed that the money in the pension annuity is invested in exactly the same assets as the pension lump sum and the whole of the ISA. Other factors such as mortality bonus/penalties from the annuity and constraints on withdrawal rates may affect the actual income one gets, but these are all swings and roundabout modifications which don't affect the big picture.

[ASB]

Let's subtract 25% x £26,532 = £6,633 from both amounts to take the lump sum out of the equation. (An amount equivalent to lump sum is invested and taxed the same way in both scenarios. A basic-rate taxpayer investing in shares need pay no more tax than if his money were in an ISA, in any case most of the average persons lump sum could be transferred into an ISA in very few years.)

But surely that ceases to be a valid comparison? The basic 2 choices are to use the same chunk of income to build a pot.

This gives a starting pot of 6k or 10k depending on whethert it is gross or net. The resultant is then 16k or 25.5k. This conveniently assumes that the net yield on the investment is the same. (In actuality the ISA type route might be more favourable due to the fact that the pension doesn't get any relief on it's investment income).

Now if we take the 6.5k cash we are left in a position where there is either 16k in a non tax regime or 19k + 6.5k cash.

So, this means the pension can produce approx 800 net, against the 960 from the volunatary annuity. However there is the 6.k cash lying around which evens it up - probably put the pension slightly ahead of the game - but only by a few %.

The problem with this is that if you are a basic rate tax payer in work then the fund is going to be broadly 20% smaller to start with, so then you will definitely be behind.

So in summary my belief is slightly modifed:-

1) Company contributions - pension wins hands down due to the CT and NI regime.
2) Basic rate tax payer in work and in retimerment - a modest but noticable amount behind if personal contributions are made
3) Higher rate taxpayer in work, normal in retirement - a modest but slightly less noticiable advantage to the pension route
4) normal in work becoming a higher rate payer in retirement bad news.

But 2-4 do can become improved due to things like being able to get relief on 3600 even if there is no appropriate income available to support the contribution - which could make a big difference depending on individual circumstances.

From my own arrangements I always did 1 whilst contracting. Now I'm an employee I make contributions from salary - but that is only really because my employer kindly matches them 2 for 1.

I'm yet to be convinced that for most circumstances the tax regime is any real advantage.

[expat]

...NOT individual shares, trust me you are too far from the market to do this well)

Trust me.... so are fund managers and they take a rake-off too. Darts thrown at the market pages have a better record than most fund managers. And the top quartile of funds over the last 5 years consistently underperforms the market in the next year.

Funds have average management fees of 1.6%. If you add on an entry fee of 1%, portfolio turnover costs (fund managers need to sell and buy, you don't), and lost opportunity cost of not being fully invested, then you have turned, say, a relatively good 8% return into a poor 4% or so. The difference between the two, compunded over a few years, is stunnning. 100.00 compunded at 8% over 15 years is 317. At 4% it's only 180.

I don't try to beat the market or time the market or have special knowledge or pretend. Just invest in safe paying companies that I understand and that have a good record.

[lukemg]

Answer for me is both.
I chuck 3600 in a stakeholder with Standard Life (thanks for all the shares). In addition, in a good year I chuck up to 7k in an ISA through Hargreaves Lansdowne (they offer low initial purchase and annual commision terms). I invest this in a range of unit trusts (mostly uk but also european, small amounts in far east and US + a tracker).
Starting next April (just to keep it simple) I am going to setup a SIPP with HL and invest in unit trusts of my choosing (NOT individual shares, trust me you are too far from the market to do this well). My ISA's and PEP's average out at 12% a year since 97 (all through the crash etc) best is up around 28%, lowest around 2% (bought during the downturn, still trying to catch up). Although it's tempting to keep swapping them around, often last years dog is up the league the following year so I let them ride mostly.
I have got various occupational and private pensions which are 'paid-up'. I don't mind if this means my pension will be coming in in small amounts each day of the month, I will quite like that.
Also, I am out of this work lark at 60 (if I can stay in it till then). Whatever cash I have got at that stage will have to be enough, I expect it will, I will have lower expenses, no mortgage etc I reckon I will be comfortable on current projections.

[IR35 Avoider]

Normal person. One off payment of 6k into an ISA wrapper:-

6,000 @ 1.05 ^^ 20 = 15999

Normal Person. Same payment into pension including relief

10,000 @ 1.05 ^^ 20 = 26532

My calculations.
Isa
6,000 @ 1.05 ^^ 20 = £15,919

Pension
10,000 @ 1.05 ^^ 20 = £26,532

I assume no tax on investment income from money held in one's own name, and 22% on money in a pension annuity.

Let's subtract 25% x £26,532 = £6,633 from both amounts to take the lump sum out of the equation. (An amount equivalent to lump sum is invested and taxed the same way in both scenarios. A basic-rate taxpayer investing in shares need pay no more tax than if his money were in an ISA, in any case most of the average persons lump sum could be transferred into an ISA in very few years.)

Then we are looking at ISA £9,287 versus pension 78% x £19,898 = £15,521. So the extra after-tax money at work in the pension is £15,521 - £9,287 = £6,234.

If we assume all amounts earn 5% before tax, then the ISA route gives us 5% x £15,919 = £796 income, but the pension route gives us 5% x £6,234 = £311 extra income, i.e £311/£796 = 39% higher income.

(In my case, if I were 30 years older and buying an annuity now, I would invest all money in my own name in commercial property funds, and invest the residual pension pot in a unit-linked annuity in a property fund. Commercial property yields roughly 5% at the moment. So my assumptions that all money can be invested for the same return, and that return is about 5%, are not that unreasonable.)

[bobhope]

One point to take into consideration re: pension vs. ISAs, is the range of allowed investments.

You can put pretty much anything into pensions including short term bonds, AIM stocks, near cash equivalent instruments, etc.

All of which are restricted in ISAs.

[ASB]

Very off the cuff answer:-

I think I get something like 48% tax relief on the first few tens of thousands of pounds my company puts into a pension each year.

As long as I keep my pension pot below (very approximately) £1 million, tax on the way out will be 75%*22% = 16.5%.

It's quite a big difference.

(£1 million yields £250K tax free lump sum plus 750K into an annuity paying 5% per year yields £37K per year income.)

Agree, but that wasn't the point. This was:-

Normal person. One off payment of 6k into an ISA wrapper:-

6,000 @ 1.05 ^^ 20 = 15999

Normal Person. Same payment into pension including relief

10,000 @ 1.05 ^^ 20 = 26532

Now I can't find annuity rate but the 15999 is all tax free. Or it could be used to buy an annuity at approx 6% of which only a little would be taxed, giving a bteer net return. Equally it could be put into an immediate vesting arrangement to get relief + 25% tax free cash plus tax relief on the contribution.

But, lets just buy a volunatry annuity yielding 6% of which only the income is taxed. This yields 960 - less very little tax because most of the return is the initial capital.

With the 26532 about the only thing you can do (conveniently ignoring the 25%) is to buy a compulsory annuity. This will yield approx 5%. But it's all taxable and nil rate band is used by the state pension. This 1326.50 - but then suffers tax on it all, so we get a net yied of just over 1000.

If you were a basic rate taxpayer then the fund would have been smaller and you would be behind the game.

Pensions are often sold on the tax benefits. But for most people these are largely neutral (unless the qualified guy can adequate refute my possibly incorrect analysis).

From a point of view of your average contractor strategic use of company income to make gross contributions into a pension can yield substantial savings - even allowing for the fact that the output is taxed.

Edit: I am perfectly prepared to accept this may be wrong. However I have never had anybody able to refute it. Using the alleged tax savings to sell a pension to individuals making contributions out of their net incomes is a disgrace. Unfortunalte all discussions I have had with people who should really know just cause this topic to be studiously avoided. This make me suspect I am not wrong.

There are lots of reasons for planning round a formal pension vehicle, especially if reasonably high contribution levels are required - but for most poeple I do not believe tax treatment is one of them.

[IR35 Avoider]

Very off the cuff answer:-

I think I get something like 48% tax relief on the first few tens of thousands of pounds my company puts into a pension each year.

As long as I keep my pension pot below (very approximately) £1 million, tax on the way out will be 75%*22% = 16.5%.

It's quite a big difference.

(£1 million yields £250K tax free lump sum plus 750K into an annuity paying 5% per year yields £37K per year income.)

[ASB]

The government will give you a large amount of tax relief. If you are a high rate tax payer, as I assume most IT contractors will fall into this bracket, the Government will put in 40% of what you do, hence a payment of £60 into your pension will result in the Gvt paying £40 and so forth.

Perhaps you can clear something up for me re tax relief??

Place 60 p after tax in something yielding say 5% for 40 years. Pop it in a freindly tax wrapper and the pot is tax free. [Use this pot to buy a voluntary annuity and this would give a better yield than a compulsory purchase one too due to the taxation treatment of the capital return].

Place 100 before tax in the same then pay 40% on the pot.

I rather think these yield the same results. Thus tax tax relief is a bit of a red herring in a number of ways.

However I will happily concede that the advantages are not by definition illusory if:-

- You are likely to be 40% tax payer during work and base rate in retimement (god help you in the unlikely event it goes the other way).
- The 25% cash sum clouds it
- You can make company rather than personal contributions so the NI releif also kicks in

For most people making thier own contributions out of net incomes a pension only really amounts to tax deferment.

I am not advocating don't do pensions because of this, only that the apparent tax advantages are not necessarily a good reason to do it.

[expat]

Hi expat,

I work as a Financial Consultant and while I do not want this post to be taken as spam, from my clients perspective pensions are still very attractive for a number of reasons, the main reason in my mind being:

The government will give you a large amount of tax relief. If you are a high rate tax payer, as I assume most IT contractors will fall into this bracket, the Government will put in 40% of what you do, hence a payment of £60 into your pension will result in the Gvt paying £40 and so forth.

Obviously this does differ between person to person depending on their tax status but the relief is always there.

ISA’s are of course an excellent way of maintaining short to medium term savings, though pensions still come out on top unless you have hit an age where it is a toss up between them. (the closer you are to retirement the more one needs to put into a pension etc, sometimes its not worth the effort)

Hello,

1. Don't worry, it's not Spam if you don't even tell me how I can pay you money
2. There are indeed 2 normal tax positions to think of:
a) expected lower tax band when retired than when working.
b) expected same tax band when retired as when working.
But there is another aspect to a contractor's pension:
c) the possibility of one's Ltd Co paying the pension contributions.

The attraction of not now paying employer's or employee's NICs and not paying 40% tax, in return for later paying 22% tax, is a substantial one.

I am not sure, however, that the choice between Pension and ISAs ever changes with age: yes, "the closer you are to retirement the more one needs to put into a pension" but equally the more one needs to put into any savings vehicle. As for a SIPP not being worthwhile until you have 30k or so, the same goes for retirement savings as a whole.

The real choice IMHO depends on:
- returns
- taxation
- flexibility/choice/control
- risk (including risk of tax-rule change)

Pensions seem to win on taxation, and on risk (less tax risk, you take the tax break today).
ISAs and other vehicles seem to win on choice (you don't have to buy an annuity; more generally, you haven't made a deal with the Govt that this is your pension) and on returns (more choice of investments, and crucially lower charges if you do it right).

I hate giving up control to the Chancellor.