Darling, please take all my money (Personal Pension Schemes in general)

Member Name: AndrewPo

Product:	Personal Pension Schemes in general
Date:	12/08/08 (949 review reads)
Rating:

Advantages: Apparently an excellent deal for the rich

Disadvantages: Your money is tied up for a long time

Pensions are very boring and tend to be neglected until it is too late, so I thought I would write down my thoughts on the subject.

I have read quite a few articles in Sunday newspapers that would have you believe that middle-class life has a few simple rules: you should pay X% of your earnings into a pension, from an early age, whether it is a personal one or a company one; most of your salary goes towards your mortgage and the rest goes into a cash ISA. This should continue until you are 65, then you can live off the pension. Finance is simple and compartmentalised. I disagree with some of what these standard articles say, with the exception of one thing, which is that you do need to invest quite a lot for retirement and the earlier the better, but you do not have to exclusively put this in to a pension, unless you don't have any will-power and will end up spending it otherwise.

If your employer already pays into a pension or if you pay into a work scheme then you would only need to have a personal pension as well if you thought that scheme was inadequate for your needs.

What is a Personal Pension?

Personal pensions are provided by a huge number financial organisations and I won't recommend any one in particular, but they can be a very wide range of types of investment account, depending on your requirement. They can range from an active share trading account to effectively just a very safe, deposit account (or money market fund) but typically it might consist of a pension fund or a selection of pension funds, which are similar to unit trusts investing in a balanced safe portfolio or shares and bonds. The difference is, with a pension, in exchange for signing away your right to access the money at will, you will receive an income tax rebate on all of the money going into the account at your marginal rate of tax and the option to take 25% of the money as a tax-free lump sum at retirement. So that sounds pretty good? If you pay tax at 40% a £60 net investment results in you having £100 in your pension almost straight away. Obviously if you pay 20% tax you would need to pay in £80 for the same £100 (and if you include National Insurance you are not really getting all of your "income" tax back from the government) So personal pensions appear to be very good for higher-rate taxpayers and pretty good for basic rate tax payers.

I am not saying that these assumptions are incorrect. With the exception of the fact they obviously are far more generous to the rich than the poor in terms of tax rebate, there does appear to be a very positive reason for putting all of your retirement fund into a personal pension, but there are a few negative things to consider.

Pensions are not tax free.

Pensions and ISAs when launched were claimed to be tax-free. In the case of the ISA, this was true in that no tax was taken from capital gains nor dividends or interest and all of the money could be taken out tax free at any time. The personal pension was similar, except for the tax rebate described above, but only 25% of the fund could be taken out tax free and only on retirement and the rest had to be used for a pension which would be taxed. This is a simplification, because you can actually wait until the age of 75 before buying an annuity, but even so you don't have full access to all of you money. The tax-free status has also been changed by Gordon Brown, since their launch, in a complicated way involving tax-credits designed to be obscure enough for most not to understand or notice, but the result is that ISAs and personal pensions are effectively taxed at 10% on equity dividends, which means they are not much better for a basic rate tax payer than just holding the investments outside of the pension "wrapper". This only applies to the dividends on shares in an equity ISA and not to income from bond funds in an Equity ISA, nor to interest on cash in a Cash ISA which are both still tax free.

Capital Gains Tax

The government is being very generous by not charging capital gains tax on your investment inside the pension, but you are allowed £9,600 of tax free capital gains per year anyway, which most people don't use, so holding investments outside a pension only becomes an issue when you are are regularly disposing of gains of more than this. Capital gains are taxed at just 18% above £9,600 per year. You can also invest up to £7,200 a year into an equity ISA in very similar range of funds available through pensions, also completely capital gains tax free.

Income tax on Pension

One big argument for personal pensions is that you will probably earn less in retirement than while working, so you will pay tax at a lower rate, either because a bigger percentage of your salary is now in the income tax free personal allowance band (which is also larger for pensioners) or you are paying far less, or no tax at the 40% level. The best candidate, for whom pensions almost certainly beat ISAs, is someone paying 40% tax, but who is not extremely well paid, who on retirement will be just below the 40% tax limit. Tax rebates received while working will be in a higher band than tax paid while retired, but what will happen to the taxation system between now and then. The rules can change and it might not be in your favour. ISA's are not taxed when you take an income from them, nor when you take the money out, which you can do whenever you want e.g. if the ISA rules change, or if you retire early or need the money for something important.

Other Investments

There are several possible investments that could be used for retirement instead of a pension and I'm not referring to buy-to-let property, which has gone out of fashion for some reason. I am referring to other balanced investment portfolios that have different restrictions and tax treatment. Equity ISAs are my favourite and give very good tax incentives as described before, with extra flexibility, but in addition to these, and Cash ISAs there are National Savings and Investments Index Linked Savings Certificates, which are tax free and protect you against inflation and of course the best tax free investment of the lot: your mortgage. If you can pay chunks of your mortgage off without penalty the result is similar to have a really good rate of tax free interest on your savings.

Cheating the system

Recently the rules have changed so you can pay in up to £235,000 in one year, so you can save your money somewhere else until just before retirement, pay it into a pension collect your tax rebate, then shortly afterwards take your 25% tax-free lump sum. This way there is little chance of the government changing the rules and you have the flexibility of being able to do whatever you want with your money.

I have a personal pension into which my employer paid a large chunk of my salary for many years (rather than set up their own company pension) When this started personal pensions really were tax free (no 10% tax on dividends) I really was getting all of my income tax back on the money put in and I was allowed to choose and manage the investments, or get a fund manager to do it for me. In addition to that I could take the tax-free lump sum and pension at the age of fifty and sail off into the sunset. Fifty sounded like a good target in my industry which is full of youngsters. Unfortunately Gordon changed the rules and now I can't have the money until I am 55 and I actually semi-retired this year at 41 and I have to wait for 14 years for my money and what's to stop Darling from extending the pension age to 60 before I get to 55? Good job I put money in other investments too.

Pros

Income tax rebate (especially for higher rate tax payers)
Capital Gains Tax free
Good range of investment possibilities
25% tax free lump-sum at retirement
You will probably effectively be in a lower tax band in retirement

Cons

Can't take the money out until retirement age
Dividends taxed at 10%
Governement can change the rules and the minimum pension age
Pension will be taxed and the rate could be much higher
ISA tax rules are nearly as good, and they are far more flexible than pensions

Paying off credit card debt and loans is a better bet than either ISAs or Pensions and paying off the mortgage is a good alternative to a pension too.

In Conclusion there is a very good compelling argument for putting money into a personal pension, if you don't already have adequate cover from a company pension, and especially if you are a higher-rate tax payer, but you will have your money tied up until pension age, which, along with other pensions rules, might change to your disadvantage. If you want life to be simple and predictable, or if you don't have the discipline not to spend your money put lots of money into a pension, otherwise spread it around a bit just in case, and use your equity ISA allowance as well and pay off all expensive debt before any investment.

Summary: The rules could change