Psst! Anyone want to buy a second hand Lamborghini?
Following the Budget Speech on 19 March, Steve Webb, the Pensions Minister said “If people do buy a Lamborghini but know that they’ll end up just living on the state pension that becomes their choice”. What was the actual pension announcement made on the 19 March that elicited such a response?
When it comes to retirement wealth planning, saving is only half the picture. The tricky bit comes when you want to draw an income once you’ve retired and doing it in the most tax advantageous way. The skills needed to blend income from various sources, including pensions, ISAs, general investment accounts and cash savings when in retirement is akin to the fine tuning required to be done to the engine of a top of the range sports car.
For durability the starting point needs to be the power unit and transmission – aka pension – and contrary to a lot of financial press comments focusing on the downsides of pensions they remain the cornerstone of good retirement planning because of the opportunities a pension affords as part of a holistic financial plan. ISAs, on the other hand, are increasingly seen as an alternative to pensions. This is not only simplistic but also dangerous.
If we presume you are a higher rate taxpayer (HRT) and you save a net amount of £100 per month (£166.67 gross for the HRT in the pension), then after 40 years you get the following saving’s pots as shown in the table. The rate of compound growth is assumed to be 5% gross per annum (including in retirement).
This example clearly illustrates a major advantage of pensions over the other two options, a return of almost £100,000 more than the ISA and £156,000 more than the bank account. The counter argument is that under the ISA and bank account, you are able to access as much of your capital as you want, when you want, whereas with a pension you can only access it from age 55 and are restricted to the 25% tax free lump sum and associated pension. Additionally, with the ISA, all the ‘drawings’ are free of tax, but the pension income is taxed at the individual’s highest marginal rate.
At first glance it seems difficult to argue in favour of pensions against the latter two favourable treatments of ISAs. However, the ultimate goal is to have a sufficiently comfortable standard of living in later life. So, if we consider the options at retirement, and presume you take 25% of your respective fund to clear debts and then draw £7,200 as income, increasing by 3% per annum (£9,000 gross from the pension, as a basic rate taxpayer in retirement), then in our opinion the pension option looks even more attractive.
After 18 years the ISA pot is almost exhausted with only about £7,000 remaining, whereas there is still over £120,000 left in the pension pot. In both instances, you will have had a total ‘net’ income of £161,000. Even on death, the pension option is potentially more tax favourable. If you were to die after 18 years and assuming your estate was liable to inheritance tax at 40%, then only about £4,000 would pass to your beneficiaries from the ISA, while the remaining pension fund, which currently would be subject to a special tax charge at the rate of 55%, but not inheritance tax, would result in £54,144 being left to beneficiaries. Even allowing for income tax and the special tax charge in this scenario, albeit it is only one example, you and your beneficiaries would have enjoyed £75,000 more under the pension than the ISA.
The proposals in the Budget, which all being well will come into effect in the tax year 2015/16, imply that from age 55 you will be able to access as much of your defined contribution pension pot as and when you want, which immediately overcomes one of the perceived downsides of a pension. For example, if you had not previously taken your benefits, you would be able to take 25% of the fund as a tax free lump sum and then as much as you want from the remaining pot, paying only income tax at the marginal rate on the latter amount.
The concern some commentators have in respect of this flexibility and freedom of choice is that people might fully strip out their pension pot over a very short period of time, enjoying life to the full, and then become reliant on the state. This fails to give credit to you for carefully managing your finances and diligently saving into a pension in the first place. And even if you were to adopt this hedonistic lifestyle, you could always sell the Lamborghini to continue to finance it!
This blog first appeared in What Investment