Is a Pension Policy a Good Investment?
When asked about plans for retirement, most people will immediately think about pension plan savings. Although there are many other ways of saving toward retirement, including ISA savings and investing, investment bonds, the use of property, etc. there are certain benefits that investing in a pension policy gives that other forms of savings do not. However, there are also disadvantages, too.
Why save toward your retirement?
Most people will benefit from a state pension, or perhaps be able to claim other state benefits, when they hit the state retirement age. However, the maximum state pension payable to a single person is less than £110 per week (2012). That’s around £5600 per year. If you believe you could live on this amount, in today’s terms, then there will be no need to consider extra retirement planning. However, the majority will be hard pressed to live on such a miserly sum.
In addition to this, the government has admitted that pension payments in the future may be unsustainable. An aging population will increasingly rely on the tax payments of a relative decreasing number of employed workers. This is a major reason why the state pensions system is being reformed, and automatic registration into company pension schemes is being introduced.
So, the government, as well as individuals, have acknowledged the need for individuals to take greater responsibility for retirement planning, and the largest part of retirement planning is saving into a pension scheme. But is doing so a good idea?
Saving in a pension fund means your money is locked up
Any money saved in a pension scheme cannot be accessed until you take the retirement benefits associated with the scheme. Many people consider this a disadvantage. After all, what if an emergency comes along? You may have saved thousands into your scheme, but will not be able to use any of it to meet an emergency expense. However, others consider this to be an advantage. Locking your money away guarantees that it will be available for use when you really need it: in retirement.
Private pensions have a minimum age for accessing benefits of 55 years old. An investment into such a scheme is probably the longest term investment that any individual will make.
You will be limited as to how you can use your pension savings
When you decide to retire and take your funds, there are a limited number of options open to you. You must create an income from your fund at some time, and this will necessitate the purchase of an annuity before the maximum age of 77.
However, you can take a tax free cash lump sum of up to 25% of your total pension fund value, and this can be used for any purpose: perhaps to buy a property to create rental income, or investment into an investment bond (though the effect on the age allowance may be an issue).
Income from your pension will be taxable
The income created from an annuity is classed as taxable income. It will be added to all other income and taxed at an appropriate rate. In this way it is not accurate to say that saving into a pension scheme is a tax free investment, it is just that any tax payable may be so on income created from the fund in the future. Many see this as a big disadvantage: you are forced to create an income, on which tax may be liable, though when saving you don’t know how much tax you may have to pay when you take the income.
If you die, your pension savings die with you
Dependent upon the type of annuity you purchase with your funds, then it is certainly true that should you die soon after you take retirement your annuity fund bought with your pension fund will be swallowed up by the life company. However, there are various conditions, and different types of annuity – such as a joint life annuity – you can purchase to protect you from this event. But these protection clauses will mean a lower level of income at the outset of your annuity payments.
Saving into a pension scheme is tax efficient
All payments into a pension scheme up to the annual limit attract tax relief of 20%. This means that, in practice, for every £100 you save, the government adds £25. It’s like being given a 25% investment boost from day one. Higher rate tax payers can claim tax back at their marginal rate.
Any capital gain made within the pension fund is free of capital gains tax, and other income inside the fund may be tax free.
Could ISAs be an alternative to pension investment?
Cash and Stocks and Shares ISA are tax efficient savings/ investment schemes. They allow access to funds at any time (though there may be penalties on early withdrawal, depending upon the type of ISA and any conditions attached), but do not attract tax relief on payments in.
However, Stocks and Shares ISAs grow free of capital gains taxes, and Cash ISAs receive interest free of savings tax.
The amount that can be paid into an ISA is far more limited than for pensions.
The big disadvantage with saving for retirement through the use of ISAs is that contributions do not attract tax relief. You pay in £100, and to match the amount paid into a pension fund your ISA would need to see 25% growth.
However, using ISAs as part of your retirement planning allows you to have access to your savings whilst at the same time saving tax efficiently. Nearing retirement it may be possible to use ISA savings to invest lump sums into a pension scheme and attract tax relief at that time.
How about property?
Investing in property is also considered as a viable alternative to saving in a pension fund. Buy-to-let property is popular for this purpose, though it should be remembered that any income by way of rental may be taxable and if no tenant is found the mortgage will still need to be paid.
Also property does not attract the tax relief of pension savings, or the tax efficiency of ISAs. A property that is not your main residence, should you wish to sell, may be hard to sell and take time, and any capital gain will be subject to capital gains tax.
In summary
A pension scheme as a way of saving toward retirement is not only tax efficient, but also tax advantageous. For the tax advantage of relief on payments into a pension scheme, you forego the access that other methods of saving and investing may give.
For those that will require emergency cash on a regular basis, pension savings may not be ideal. However, once an emergency fund has been acquired, then serious consideration should be given to longer term savings, particularly toward retirement in a world in which state pensions are likely to come under increasing pressure.