Why pensions are better than an ISA
Many people loathe pensions as a way to save for retirement, but pensions have a couple of advantages over ISAs.
I enjoyed reading Six steps that will treble your pension this week. Our article outlines some sensible ways you can boost your pension, and is based on a report by the Pensions Policy Institute (PPI) called Closing the gap.
However, there’s one suggestion that I strongly disagree with. That’s Annuitise your entire pension.
If that makes no sense, let me explain. Basically, if you’ve built up a pension pot via a defined contribution pension, you’re allowed to withdraw a quarter of that pot as a tax-free lump sum when you’re 55 or older.
You must then use the rest of your pension pot to provide a retirement income. You can either do that by buying an annuity or by going into income drawdown.
The PPI is suggesting that a new retiree should consider not taking the lump sum and should use the whole pot to buy an annuity. In my view, that’s crazy!
Let’s compare the tax treatment of a pension and an ISA.
The nice thing about an ISA is that you don’t pay any tax when you withdraw cash. Imagine you pay £3000 a year into an ISA every year for 20 years. Your investments perform reasonably well and at the end of 20 years, you have a £160,000 ISA savings pot.
You can then take out £10,000 a year for the following 16 years, and you won’t have to pay any tax on that income. However, when you saved money into your ISA, your savings came from taxed income.
Pensions, however, work the other way round. When you save money into a pension, your savings immediately get a 25% boost when you pay the money in – assuming that you’re a basic rate taxpayer. In other words, you’re getting your income tax back. And if you pay a higher rate of income tax, you’ll get a bigger boost.
However, when you receive an income from your pension, you will pay tax on that income - unless your total income is below the personal allowance for income tax. So with a pension, you gain at the beginning of the process, but lose at the end. With an ISA, you lose at the beginning, but gain at the end.
But with the tax-free lump sum, it’s a win-win. You gain at the beginning because you get a tax boost, and you gain at the end because you’re getting some tax-free income. So when I come to retire, I will definitely withdraw a 25% tax-free lump sum from my pension pot (unless the law has changed).
I’ll do this even if my pension pot is small and the total size of my potential annuity is small too. Not only will I not pay any tax on the lump sum, I’ll also get control. I could stick the money in a savings account and use it when I needed it. Or if I felt brave, I could stick it in the stock market and hope to get some growth over five years.
The other big advantage of pensions is that many employers make contributions into employees’ pension pots – as long as an employee contributes too. What’s more, the Government’s auto-enrolment scheme means that all employers will be legally obliged to start making such contributions by 2017 at the latest.
If an employee doesn’t contribute, he is effectively turning down free money from his employer.
Where pensions lose
I do admit that pensions have two significant downsides. ISAs are much more flexible and give more control. If you’re faced by an emergency when you’re 45, you can pull money out of your ISA, but you can’t get anything from your pension.
And then there’s the whole annuities disaster. If you’re trying to buy an annuity now, the rates on offer are far lower than most people would have expected 20 years ago. I’m currently 44 and it’s impossible to predict what annuity rates will be when I reach 65.
But overall, I still think that pensions are a better bet than ISAs for most people. Employer contributions are too good to turn down. So is a tax-free lump sum.
And even if I’m wrong about the respective merits of pensions and ISAs, I definitely don’t think that annuitizing your whole pension is a sensible way to boost your retirement income.