Pension savers miss out on £720 million

Research recently published by Unbiased has revealed that UK pension savers are missing out on £720 Million in tax relief by failing to top-up their employers' pension schemes. Higher rate tax payers who make additional contributions are entitled to tax relief at up to 40% on contributions, which they make to improve their retirement income. These can be to the employer's scheme or to a private arrangement.

With many schemes under pressure and reducing the rate at which future benefits build up, or even ceasing to provide future benefits, it has never been more important for people to take personal responsibility for their retirement planning. Tax breaks are available for pension contributions as well as for other forms of saving. Unbiased have provided a tax waste calculator to help you find out whether you are making full use of the relief available to you. Find out how much tax you are wasting here

Half of all UK adults are making no retirement savings

A recent survey commissioned by the BBC suggests that half of all UK adults have made no pension savings. Only 36% of under 30's make any contributions and only 45% of 41 to 65 year olds contribute. Most cite lack of affordability but others expressed concerns about pensions given recent stock market falls and the well publicised failure of companies such as Equitable Life.

This is not as straight forward as it seems. For many on low earnings it is arguable that they are quite right in not making private pension contributions as this is simply likely to tip them over the threshold for state benefits of far greater value than the pension which they will receive. The UK government has tried to remedy this effect by introducing Pension Credits. You can find our more about Pension Credits here If you know what your expected private and state pensions are, you can can obtain an estimate of your entitlement, if any. It would be sensible for anyone on low earnings who is considering making private contributions to check whether they will actually be better off.

The FSA consumer website Moneymadeclear also provides a great deal of useful information, not only on pensions but other aspects of financial planning.

Whilst I recognise only too well that younger people can only afford very limited contributions, it is worthwhile mentioning that if an early start can be made with retirement planning a respectable level of retirement income can be built up at an affordable contribution rate. The opposite is also true. If contributions are left too late, it will be nearly impossible to make them up. In this table the FSA have shown estimates of the levels of pension which can be expected given different levels of contributions and starting ages.

For example, a 20 year old contributing £50 per month could expect a pension of £238 per month when they retire at 65. They would need to live just under 8 1/2 years after retirement (i.e. to age 72 1/2) which is within most people's life expectancy, i.e. they are likely to get their money back.

Of course, other assets can be used such as properties and business sale proceeds. These need to be factored into retirement planning. The key word here is 'Planning'. In order to ensure that you are able to achieve the level of income in retirement which is needed to maintain your standard of living, you need to have a plan which is updated regularly. The plan should be based on cash flow modelling as this is the only effective means of analysing the impact of different types of assets as well as changing levels of requirement.

Government Restricts Higher Rate Relief on Pension Contributions

In today's Budget the Chancellor has restricted higher rate tax relief on employee contributions to pensions where the employee earns £150,000 or more and makes annual contributions of £20,000 or more.

For further details see this

Good news ISA allowances have been immediately increased to £10,500 for the over 50's and for everyone from 6th April 2010.

Is Higher Rate Tax Relief On Pensions Under Threat?

A number of commentators have suggested that The Chancellor will abolish higher rate tax relief on pension contribution in The Budget on 22nd April.

Financial Times

Yahoo Finance

These could just be 'buy now while stocks last' rumours but there may be some truth in them, given the financial pressure, which the government is under.

If in doubt, it would make sense to bring forward contributions to prior to the Budget. It is unlikely that any changes will be retrospective but this can not be ruled out.

If tax relief is removed, this should not be a reason to stop making savings for retirement. After all, at some stage, like it or not, employment and the earnings associated with it will cease. When that day comes, there needs to be a replacement source of income. This does not just need to be provided by way of a pension but as long as there is some tax relief on contributions they probably have the edge on other methods of saving. See my last blog for more information on this.

Are Pensions Not Fit for Purpose?

In this Article published on Citywire Lucien Camp argues that pensions are not fit for purpose. He suggests that there is a birth date lottery, which affects the level of income, which you can expect when you retire. He implies that a tax free savings vehicle such as an Individual Savings Account (ISA) would be a more effective method of retirement saving. He also suggests that their annual contribution limits are more than enough to cater for most people’s funding needs. Let us examine whether either of these propositions is actually true.

Before doing so, it is worthwhile comparing the two types of arrangement:

Pension Contributions: Paid net of basic rate tax relief at source. Higher rate tax relief is also available. This means that basic rate taxpayers pay 80p for every £1 invested. Higher rate taxpayers only effectively pay 60p for every £1 invested. Respectively they have immediately made a 20% and 40% return on their contributions.

ISA Contributions: No tax relief is granted. Contributions are paid out of income on which tax and National Insurance have already been paid.

Pension Income: Taxable. Paid net of tax at your highest rate.

ISA Income: Tax Free.

Access to capital: Pensions – 25%; ISAs – 100%

Which will provide the better retirement income?

Let us consider, given the same cash outlay by a basic rate taxpayer, which of the two is likely to provide the greatest income on retirement at age 65. For this purpose, I have assumed that the full value of the pension or ISA fund would be used to provide an income. In both cases the fund has been assumed to grow at the same rate (a conservative 5% pa), since the same investment choices are available to each. Contributions of £7200 (in terms of the cash paid out by the pensioner) have been assumed to be made for 20 years. This means that the pension contributions will be increased by tax relief to £9,000 per annum. The ISA investments will be £7200 per annum, as they do not benefit from any tax relief.

In the case of the pension fund, I have assumed that a level single life annuity payable for a minimum of 5 years (even if the pensioner dies) is purchased. For the ISA I have assumed that the fund would be run down over 25 years (i.e. until the pensioner is aged 90, by when most people have probably died).

When the pensioner is aged 65, he/she will have a pension fund of £297,593 or an ISA fund of £238,074. This represents a difference in the accumulated fund of £59,518.

The pension income would be £21,027 per annum gross, based on current rates. After tax, a basic rate taxpayer would receive £16,821 per annum. The ISA fund would provide a tax-free income of £16,087 per annum. The pension income would be guaranteed for the life of the pensioner, however long they live and would not be dependent on future investment returns. The ISA income would be dependent on both the future growth of fund and the life expectancy of the pensioner. If investment returns are less than I have assumed or, should the pensioner live more that 25 years after retirement, the ISA income may be reduced or stopped.

In this example the pension income, which is payable for life would exceed the ISA income by over £700 per annum. If the pensioner were a higher rate taxpayer whilst they worked and a basic rate taxpayer in retirement, the difference would be £1847 in favour of the pension fund. This assumes that they make pension contributions, which ultimately net down to £7200 per annum.

Note that non-taxpayers still benefit from basic rate tax relief at source on pension contributions although they may only pay £3600 per annum (equivalent to £2880). It is also possible to provide for a fully inflation proofed retirement income or draw an income from the pension fund (i.e. similar to that assumed for the ISA) instead of buying an annuity.

The conclusion as to which can provide the best level of retirement income, all other things being equal is that a pension fund is likely to beat an ISA in most scenarios. This is without taking into account the fact the pension funds sit outside your estate for inheritance tax purposes and are not accessible to creditors, should you become bankrupt. Bear in mind, despite the adverse and ignorant press to which they have been subjected, that pensions are designed to provide a retirement income. Their tax breaks give them the edge over ISAs. This is not to say that ISAs are not useful. They are more suitable for medium to long-term savings, perhaps to meet a specific objective, such as education funding. In reality the perceived flexibility of full access to the capital is somewhat illusory because if fully encashed and spent early on in retirement, there will be nothing left to live off later on.

Are ISA maximum contribution limits sufficient for most people’s needs?

In order to examine this it is necessary to factor in the effects of inflation. If inflation of say 3% per year is deducted from the assumed investment return of 5% per annum, this gives a ‘real’ return of 2% in round terms. On retirement, the ISA would generate an income in today’s terms of £8478 per annum. The average wage in the UK to April 2008 equated to £24,908. This means that the prospective ISA income amounts to just over 35% of pre-retirement income. It also assumes that on the above level of earnings the pensioner was able to fund ISA contributions of £7200 per annum, equivalent to 28.91% of earnings.

Assuming that the same person instead pays £7200 net into a pension fund, on retirement they could expect a real income of £9884 if they are a basic rate taxpayer whilst working and in retirement. If they were a higher rate taxpayer, obviously earning more than average earnings, their real income in retirement would be £13178 per annum.

It is obviously somewhat improbable that a person on average earnings will be able to afford maximum annual ISA contributions. However, this illustration has shown that for a person on average earnings they are unlikely to provide a pension that is anywhere near previous earnings.

Summary

In both of the above examples (where the same investment return assumptions have been used for both pensions and ISAs), pension arrangements appeared to be the most effective method of retirement funding. On balance, if funding for retirement, a pension should be used. If funding for a medium to long term financial objective an ISA would probably be more suitable since all of the proceeds can be accessed.

Accessing cash in hard times

Many commentators are predicting that we are about to enter into a recession, as a consequence of which unemployment is likely to rise. With the housing market still in decline and credit being in short supply alternative sources of funds need to be found.

For the over 50’s there is a source of funds in the form of the tax free cash sum from accumulated pension funds. Most private pensions allow policyholders to draw a lump sum of up to 25% of the value of the fund. This can currently be taken from age 50 although from 5th April 2010 the minimum age will rise to 55.

It is not always necessary to draw a pension at the time when the tax free cash lump sum is taken. Instead the remainder of the fund can be allowed to continue to be invested according to the level of risk that the policyholder wishes to take. If an income is required this can be taken from the fund subject an upper limit, which is reviewed every five years, or in the form of an annuity which can provide a guaranteed income for life. The income is normally paid net of UK tax although expats can arrange for it to be paid without deduction of UK taxes but subject to tax where they reside. If the policyholder is trying to maximise the amount of cash in the short term they could take their entire first year’s entitlement to income from the fund as a single payment at the beginning of the year.

Potential funds from which benefits may be taken early include personal pensions, stakeholder pensions, retirement annuities, final salary (defined benefit) schemes and additional voluntary contributions (AVCs and FSAVs). In the case of final salary schemes and AVCs the policyholder needs to have left the service of the employer with which they built up the benefits. The proceeds from several different pensions of all varieties can be brought together in a single arrangement in order to allow the withdrawal of tax free cash.

Take a case where funds of say £80,000 have been accumulated in a variety of plans. Once they have been transferred, £20,000 can be paid out as a tax free lump sum. In addition a further £3880 gross (£3104 net of basic rate tax) could be paid as an upfront income payment from the fund.

This facility is not just useful to help clear debts. The capital released in this way can be used towards new business ventures or even as a deposit for people wanting to take advantage of the drop in house prices by investing in properties which they will rent out.

This article, of necessity, has been abbreviated in order to keep things simple. One should not forget that the primary purpose of pension funds is to provide an income when the policyholder or member no longer works. If benefits are taken early this will be at the expense of later income in retirement. Some private pensions provide guaranteed annuities, which can be forfeited if the policy is transferred elsewhere. Where benefits are transferred from a final salary pension scheme this could result in a smaller longer term retirement income and guarantees could be lost. These are just some of the issues that may need to be considered. Due to the complexities involved it is most important that advice is sought from a properly qualified pensions specialist before entering into any transactions.

In these times of financial stress, how well protected are your investments?

Given the current turmoil in the world markets with banks going bust and insurance companies needing emergency loans to keep afloat you could be forgiven for worrying about the security of your money. However, all is not lost.

In the UK when an insurance company, bank or broker goes bust there is an organisation called the Financial Services Compensation Scheme (FSCS) which provides compensation to investors and policyholders who have lost out. The FSCS is funded by levies on the companies authorised to trade in the market place. The levels of compensation that it can pay depend on the type of arrangement that you hold and have been set out below:

Deposits: £35,000 per person (for claims against firms declared in default from 1 October 2007). 100% of the first £35,000.*

Investments: £48,000 per person.
100% of the first £30,000 and 90% of the next £20,000.

Mortgage advice and arranging: £48,000 per person (for business conducted on or after 31 October 2004).
100% of the first £30,000 and 90% of the next £20,000.

Long-term insurance (e.g. pensions and life assurance): unlimited.
100% of the first £2,000 plus 90% of the remainder of the claim.

General insurance: unlimited.
Compulsory insurance (e.g. third party motor): 100% of the claim. Non-compulsory insurance (e.g. home and general): 100% of the first £2,000 plus 90% of the remainder of the claim.

General insurance advice and arranging: unlimited (for business conducted on or after 14 January 2005). 100% of the first £2,000 plus 90% of the remainder of the claim. Compulsory insurance is protected in full.

Summary
In summary, if hold cash with a bank or building society the maximum compensation amount is now £35,000 per customer at each bank. The maximum compensation for insurance policies is effectively 90% of the value of the claim (100% of the first £2000). Whilst insurance companies provide a greater degree of investor protection this relates to the surrender or claim value NOT what you paid for it. If your policy is invested in the markets it will certainky have reduced in value. If it is held in back deposits and the underlying banks go bust - you loose your money. The above levels of compensation relate to individual investors and policyholders - not institutions.

Whether you are worried about the solvency of the insitutions with which you hold money or about the effect of the markets on your investments you should not act in haste as this could trigger penalties or merely crytalise investment losses. Seek professional advice from an independent financial adviser who can provide you with impartial professional advice.

If you would like further information on the FSCS click here