The Lifetime ISA heralds a radical shake-up of the savings market, but before taking the plunge savers need to be wary of the risks.
When it launches next April, the Lifetime ISA is expected to be a popular savings vehicle, especially among younger people – although anyone under the age of 40 can apply. The Government is offering a 25% bonus on savings up to £4,000 a year, meaning that for every £4 saved, it chips in £1, up to a total of £1,000.
Money that is saved can be used to purchase a first home worth up to £450,000 or accessed after 60 to fund retirement. Those taking out their savings before age 60 without purchasing a property will face a 5% penalty, lose their Government bonus and any interest on the bonus.
Penalties are steep because the Government wants people to save, but being hit with a 5% charge isn’t the only potential pitfall Lifetime ISA savers need to watch out for.
Losing out on free money
There are no plans as yet for the Lifetime ISA to be offered to employees as an alternative to their workplace pension – which all employers have to offer staff under auto-enrolment rules.
The auto-enrolment rules also state that employers have to contribute to their employees’ pensions, as long as the worker contributes to the pension too.
There are concerns that workers will opt for a Lifetime ISA, and the flexibility offered by it, over a workplace pension and lose out on valuable employer contributions.
[SPOTLIGHT]Daniela Silcock, head of policy research at the Pension Policy Institute (PPI), said: “[The Lifetime ISA] has been framed as a way to save for retirement but there is no plans for it to fall under the same regulatory regime as pensions or fall into auto-enrolment.
“The key factor is…it will not qualify for employer contributions…The lack of employer contribution could reduce the pension pot by a third. We do not know if the Lifetime ISA will be made qualifying [for auto-enrolment].”
No default investment fund
A survey by insurer Aviva revealed that 1.5 million people did not know where their workplace pension was invested, but the good news is pension savings are invested by default.
Almost all (99%) of those saving into the Government-backed pension scheme, the National Employment Savings Trust (Nest), are in the default fund.
Unfortunately, the Lifetime ISA will not automatically invest savers into a default fund because these funds are run with long-term savings in mind and a high allocation to equities. As the Lifetime ISA can be used for short-term saving, by those who want to buy a home, and long-term saving by those wanting to fund their retirement, there can be no default fund.
Add to this, the propensity for those saving into ISA to put their money in cash, and it could be a disastrous outcome for those wanting to use the Lifetime ISA to save for retirement.
“The issue of saving into a Lifetime ISA is: what are you investing in?” said Steve Webb, former pensions minister and director of policy at Royal London.
“Young people who have ISAs overwhelmingly invest in cash…it is an easy access but lower return asset. Based on that, young people could be biased to cash….If you use the Lifetime ISA as a long-term product then the danger is your will miss out on [investment] returns.”
Those saving into a Lifetime ISA are hit with a penalty when they access funds outside of the allowed times but they could also be stung by other charges.
For a start, they will not benefit from the 0.75% default fund charge cap that pensions have to abide by or the 1% exit charge cap on pensions.
The PPI has warned about the impact costs have on savings and higher charges erode the value of a savings pot by around 13% when pension charges of 0.3% are compared against those of between 1% and 1.5%.
Unfortunately, Lifetime ISA savers could face even higher charges than 1.5% as Silcock said her research showed investment ISA charges were between 1% and 3% a year.
“The average charge on an ISA is between 1% and 3% which is a huge charge compared to private pensions. If the Lifetime ISA charges in the same way as an ISA, it could have a huge impact on retirement savings,” she said.
No access to retirement income products
When a person reaches retirement they have the option to turn their pension savings into income by buying an annuity or going into drawdown, the latter of which also lets them take lump sums of cash.
With both of these structures there is the barrier of tax to prevent people from running down their pension savings too quickly, which is not the case with Lifetime ISAs, which are tax-free on withdrawal.
Furthermore, there is no mechanism for turning the ISA savings into a steady income automatically.
“With the Lifetime ISA there is not the same incentive to draw [the savings] in a phased way in retirement,” said Silcock.
“Taxing the income that is withdrawn [from a pension] encourages people not to breach the tax barrier but the Lifetime ISA is not a pension so you can take the money as you like and possibly deplete the money more quickly than you would have done if it was in a pension.”
Silcock added that annuities and drawdown were designed for pensions as they automatically took Income Tax from payments, whereas none is due from withdrawal from a Lifetime ISA, making them unsuitable for use with the ISA.
“It is not clear whether products will be made for Lifetime ISA users and if there are not it means people will have to manage their money to make sure it lasts,” she said.