With poor annuity rates taking their toll, some basic-rate taxpayers are
looking at Isas instead of pensions for a decent retirement income
As the current Isa season draws to a close, figures prepared for The Observer show that some basic-rate taxpayers, investing £10,000 into an Isa left for 30 years, could be around £200 better off annually than if they had put the same money into a pension.
A basic-rate taxpayer saving £10,000 into an equity Isa, and leaving this to grow for 30 years – assuming investment growth of 5% a year after charges – would receive an annual income of £2,161, compared with £1,972 from a pension pot based on current annuity rates, according to the figures from advisory firm AWD Chase de Vere.
However, the greatest impact is seen on death, as the Isa saver would leave a hefty £43,219 to be passed on to surviving family compared to just £13,506 from the pension – or the 25% tax-free cash sum that can be drawn when an annuity, or income for life, is bought.
"The merits of basic-rate taxpayers saving into a pension are significantly reduced at present because of a combination of poor annuity rates, pension income being taxed and annuities bought without guarantees having no value on death," says Patrick Connolly, financial planner at AWD Chase de Vere.
"Also, while remaining invested in Isas after retirement may be riskier than buying a pension annuity, it gives scope for further investment growth."
Philippa Gee, of Philippa Gee Wealth Management, adds: "Isas are a serious component for retirement planning and most investors would be mad not to consider them.
"Pensions do have certain advantages, particularly with tax relief on contributions and the ability for employers to save on your behalf. However, Isas are more flexible, as you don't lock your money up and can have a longer period of tax efficiency with greater death benefits."
Tumbling annuity rates have added to the overall growing disillusionment with pensions. In February 2003 a man with a pension fund of £50,000 could have bought an annuity with a five-year guarantee of around £3,500 a year, according to JLT Annuity Bureau.
A decade later, in February 2013, the same fund would buy an income 26% lower, at £2,590 a year.
"It's a sobering fact that, based on prevailing annuity rates, even those able to accumulate a pension fund of £1.25m, will only be able to buy an annuity that will pay just under £40,000 a year," says Jason Hollands, from IFA Bestinvest.
Some savers, such as Mark Fisher, 53, from Wolverhampton, have turned their back on pensions in favour of Isas to benefit from greater control over their savings pot.
Mark, who works as baggage handler in Birmingham Airport, decided around six years ago to cancel his company pension contributions and put his money into a Nationwide cash Isa.
"My father died before he was 65, and he had a good pension," says Mark. "But thanks to the small print, my mother lost out on up to £68,000 because it said that if he died before this age, there were no death benefits."
Mark had a couple of old company pensions from his time working in a distribution warehouse. "But I won't contribute any more to a pension, as I want instant access to my money and to ensure it isn't lost in the same way as my father's," he says.
Others, such as Jacqui Cleaver, 32, director of Dorset-based New You Boot Camp, are also shunning pensions in favour of property. "I know pensions are tax efficient, but being self-employed you see all sorts of avenues open up when it comes to saving for later life."
She owns three flats in Poole and Bournemouth, buying the first when she was just 23. "Then I started investing the company earnings when I was 25.
"All the properties are rented out, with mortgages that are gradually being paid off, so by the time I'm 45 I'll own them outright and hopefully the property market will rise again. I hope to retire before 55 and don't want my savings locked in a pension I can't access. With income from property, along with cash and equity Isas, I have more control over my funds, without my money being locked away for decades."
Stories like those of Mark Fisher and Jacqui Cleaver are not uncommon as public faith in pensions continues to dwindle. Less than half of employees, at 46%, were paying into a workplace pension scheme last year, the lowest since records began in 1997, according to the Office for National Statistics (ONS).
However, savers should be very careful before dismissing pensions. There are two main reasons why they still form the basis of retirement planning, say experts – tax relief and employer contributions.
In terms of the tax benefits, pensions are a clear winner over Isas for higher-rate taxpayers. If someone age 55, paying income tax at 40%, pays £8,000 into a pension, the government increases that to £10,000 with basic-rate relief, with a further 20% tax rebate given on completing a tax return.
They are allowed to withdraw 25% of the pot as a tax-free lump sum. Allowing for this £2,500 withdrawal, and the £2,000 tax rebate, they then have a sum of £7,500 in the pension for a net contribution of £3,500. And the clear drawback of Isas is, of course, the temptation to fritter away the fund before retirement. A pension can only be drawn after the age of 55, whereas withdrawals can be made at any time from an Isa.
Tom McPhail, head of pensions research at Hargreaves Lansdown, says: "The tax advantages of pensions have never been more important, given the uncertain investment climate.
"While investment returns, interest rates and inflation are unpredictable, the tax breaks on a pension are given up front.
"What's more, there is now no compulsion to buy an annuity, so when you do get to retirement, you can just draw an income from the fund until you decide to buy an annuity – or until you die."
However, Ray Black from IFA Money Minder, adds: "Most people with pension pots of £100,000 or less will buy an annuity – so the drawdown option to produce an income and take on investment risk won't be a consideration for people without substantial funds."
There are further benefits to come for employees who don't currently have access to a company pension.
Under auto-enrolment, over the next few years every employee aged 22 up to state pension age, earning more than £9,440, will automatically become a member of a workplace pension, meaning they will benefit from an employer contribution.
Stan Russell, retirement expert at Prudential, said: "For a typical employee on low-rate tax, every pound invested in their pension will be matched by the employer and they will also receive 25% tax relief on their personal contributions. This means that every pound is immediately boosted by 125%, which will not be matched by many other savings vehicle. For higher-rate taxpayers, the effect is even greater."
While deciding how to save for retirement can be difficult, there is little doubt that the vast majority of us simply need to save more. People finishing work this year can expect an average income £3,400 less than those who retired five years ago in 2008, according to figures from Prudential.
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