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Pensions vs ISAs

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      07.03.2009 23:17
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      Investing in a mixture of pensions and ISAs would seem to be a good bet, although research is key

      *Disclaimer*

      In this review I've tried hard to consider in depth the different options, benefits and risks involved with planning for your retirement using pensions, ISAs or a combination of both. I am *not* a qualified financial advisor. Feel free to dip in and browse general themes and concepts but be sure to get advice from an IFA or suitably qualified professional before taking any financial decisions.

      The review is written relying upon the basic premises that your pension fund will buy an annuity, while your ISA fund will be depleted to fund living costs over time.

      *Pensions vs ISAs*

      Like all good contests (bear vs shark, spy vs spy etc.), pensions vs ISAs is an epic conflict that looks fantastic on paper, but ends in a complex stalemate with numerous complications and variables to consider that mean it is nigh on impossible to say that either investment vehicle wins on points! Like all investments and life in general, a balanced selection of both is probably the way to go.

      As the government has legislated us all into pensions penury from 2012 anyway under the new national pension plan, it seems as good a time as any to discuss it. That is, unless you opt out and refuse to take a pension.

      *This conflict will be fought with unusual weapons*

      When considering retirement investments in general, it is worthwhile keeping in mind the fact that the government makes various allowances and provides tax benefits that make long-term investments of this nature of particular value. In addition to this, to compare pensions and ISAs we must think of our access to capital, growth of our investments, security, charges and whether or not we are able to pass on said investments to dependants or loved ones when we ultimately shuffle off this mortal coil.

      *Swings and roundabouts*

      Simplifying things for a moment - the tax benefits of investing in a pension or investing in an ISA are much the same but kick in at different points in our investing cycle. Pension payments are deducted from your gross earnings, meaning that you get relief on tax when you make the payments. You will still typically have tax deducted as and when you receive pension income in future. With ISAs it works in reverse. You make payments towards your ISA with monies that have already been taxed (salary) but will not be charged tax on any interest accrued on your ISA. In addition to this, your ISA is not considered for Capital Gains Tax (CGT) purposes.

      Two things to consider that may stand in the favour of pensions are the fact that you can currently take a tax-free lump sum of 25% from your pension when you retire and that you may receive a further tax 'break' if you are likely to drop a tax band due to having lower income during retirement. This would seem to provide additional tax benefits that are well worth considering.

      As stated, there are various different tax combinations to be considered and the link to the Telegraph article by Faith Archer at the bottom of the page will take you to a useful table that considers some different permutations of tax benefits now and at retirement.

      *Charges*

      Both pension schemes and stocks and shares ISAs will usually attract charges. Schemes with punitively high charges can obviously affect the value of your investment and you should make sure that you are aware of these before taking up any investment.

      *Additional benefits of a pension*

      Pensions also offer some other benefits that should be considered carefully.

      1.If you lose your job you will be able to claim benefits faster if you don't have lots of cash in savings and ISAs. If you have large amounts of cash in an ISA this will be factored into any means testing for benefits.
      2.If you are declared bankrupt your pension benefits are protected and cannot be taken by your creditors.
      3.If you are in a work pension scheme it is very likely that your employer will make substantial contributions into your pension pot. For example, in the job I just left my employer doubled my contributions up to a maximum contribution of 10% of my monthly salary. Even if the value of your investments fall sharply, these contributions will offset that and provide a real safety cushion.
      4.Many occupational pensions come bundled with free enhanced life insurance.
      5.If you die before retirement, there is a good chance that your dependants/spouse will be able to claim much of the value of your pot without inheritance tax. This probably won't be the case if you've retired already and purchased an annuity.
      6.The possibility of a hefty tax-free lump sum at retirement.
      7.You can make overpayments within fairly relaxed guidelines, subject to a maximum typical pension pot of ~£1.6 million.

      *Additional benefits of an ISA*

      1.Enhanced control over your investments compared to most pension schemes (unless you have a SIPP pension).
      2.Ability to split your investments between cash and stocks and shares. You are allowed two ISAs in a tax year (one for cash, one for stocks and shares). You are, however, bound by the £7,200 limit for investments and no more than half of this amount can be in cash.
      3.Your ISA can be passed on to your dependants when you die, albeit it will be ravaged by inheritance tax.
      4.You can have access to your capital a lot quicker than with a pension. That said, I'm trying to compare the benefits of both pensions and ISAs for retirement and this is a bit pointless if you plan on using ISA monies before you retire..

      *Shuffle, shuffle*

      As mentioned previously, we all have to die and it may be worthwhile considering what happens to our investments when we do so.

      Pension = You will typically buy an annuity with your pension pot, which perishes with you (unless you have bought a product which allows for some of the money to be passed on to named beneficiaries).
      ISA = Your ISA will be included along with the other investments in your will and the rest of your estate. Inheritance Tax can take a massive chunk out of the value of the ISA.

      In my opinion, neither is particularly great and you will be getting done by either the banks or the government! While the pension route may not seem ideal I think it would probably be my preferred option, as your annuity will give you income security. With ISAs, on the other hand, you may run out of funds long before you die and there's not really much you can do about this unless you have supplementary investments elsewhere. Phillip Scot covers the subject of what happens with retirement investments when you die in an article linked to at the bottom of the page.

      *Security*

      I for one don't believe that the capitalist system is falling and it's now time to stock up on tinned food and guns. Granted, the global economy is taking a battering, but I think investments based on stocks and shares will be around for quite a while yet.

      The cardinal rule to remember is that *the value of your investment can fall!* This is natural and is simply an example of the stock market reacting to larger macroeconomic conditions. The theory is that in time you'll go up more than you go down, but nobody can predict the future.

      There are a variety of rules regulating who gets what in the event of the failure of a pension provider and there have been some very high profile examples of people losing everything that make people question the safety of their pension plans (and rightly so!) In addition to this, the rules differ between occupational pension schemes and personal pension schemes. Some schemes are almost entirely covered, while others offer very little cover for the size of the investments involved.

      The Pensions Advisory Service are the experts on this sort of thing and there is a link to information that they offer on the subject at the bottom of this review. Also, take a look at the page provided for the Financial Services Compensation (FSC) scheme.

      ISAs, on the other hand, vary wildly in what protection is offered and you should check with the provider before signing anything. For example, a cash ISA will typically only be covered up to the value of £50,000 under the FSC scheme. In theory, you could lose any value over this figure held in a cash ISA. A nightmare scenario, but consider this:

      You pay £3,600 into a cash ISA for 30 years = £108,000 + interest. If your bank goes bust you could lose £58,000.

      The same could apply with a stocks and shares ISA and not all of these schemes would appear to be covered to an unlimited amount (although I have seen some that appear to be so).

      Put simply, it's bloody confusing.

      *Caution and future-proofing - my personal choices*

      For the many benefits listed and the varying levels of protection offered, I'll be principally utilising an occupational pension scheme to fund my retirement. I will, however, also be taking advantage of my ISA allowances for any 'spare' money that I want to put away for a rainy {or old} day. I will be making sure that I know exactly what is protected by what rules, as life is hard enough without bankers and global financial crises ruining an old age that many of us plan for decades in advance.

      *Errors and omissions*

      I've made it clear from the outset that this is an opinion piece and not financial advice. If you see any omissions, errors or points that just don't make sense - *please* let me know. I'd hate to mislead anyone unintentionally!

      *Links*

      Please note, Dooyoo don't allow words of 80+ characters. I've had to split some of my links by inserting the word (space). If you see any of these, fix them like this:

      www.abit (space) complicated.com - will become www.abitcomplicated.com, making sure to delete the word space in brackets and any spaces. A URL/address will never have a space in it and they won't work if they're left in.

      1. www.unbiased.co.uk - I am not qualified to give financial advice and am not trying to. Find an IFA here!
      2. www.moneymadeclear.fsa.gov.uk/pensions - Official pension advice from the government.
      3. http://www.fool.co.uk/Pensions/guides/Pensions-vs-ISAs.aspx - Useful article from the Motley Fool website, well worth a look.
      4. http://www.thisismoney.co.uk/retirement/article.html? (space) in_article_id=426738&in_page_id=6 - A similar article, deals well with benefits upon death.
      5. http://www.telegraph.co.uk/finance/personalfinance/pensions/2820533/ (space) Pensions-vs-Isas-new-rules-affect-best-route-to-a-prosperous-retirement.html - This article by Faith Archer discusses different tax liabilities well, with various permutations covered. It also has a handy ready reckoner produced by Hargreaves Lansdown.
      6. http://www.pensionsadvisoryservice.org.uk/miscellaneous/security_of_pensions/ - Advice from the Pensions Advisory Service - a great resource.
      7. http://www.fscs.org.uk/consumer/key_facts/limitations_of_the_scheme/ (space) compensation_limits/ - Official figures showing what you may be due if your financial provider is unable to meet their obligations.
      8. http://news.bbc.co.uk/1/hi/business/7414108.stm - Good short article introducing the new Personal Accounts scheme.

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