What is the best way to save for retirement? Part 3

This is the third post in the series “what is the best way to save for retirement?”

So what are the alternatives to a pension?

As we have discovered, a pension, at least in the way the financial services industry use the term is a savings plan. Its has two main advantaged over other forms of savings plans. The first is that an employer or business can pay into the savings plan for you. The other a more obvious is that contributions attract tax relief. These are both massive advantages and could be described as “money for nothing”. Under the new auto enrolment rules your 4% payment to a pension is essentially doubled, with 3% from your employer an 1% from HMRC. However be aware that as with all things, today’s rules are no predictors of the future, one that I may remind you is shaped by economic realities and the politicians that attempt to pretend otherwise.

So what are the alternatives? Well they are almost infinite, but lets narrow this down to three simple ideas.

Investments
Property
A Business

As a pension is simply a pot of money to take income from for the rest of your life (with the option of buying an annuity if you want to). Then any form of investment can do this job, including a bank account (if indeed we can call holding a cash deposit account an “investment”). Today I will only focus on the investment option.

An Investment Portfolio

Investing is fraught with possible mistakes, almost every investment promises “out-performance”. This is largely hot air. Apart from selecting suitable investments and constructing a portfolio, investing has costs and any income from an investment, for example a dividend payment is liable to tax. Gains are also subject to capital gains tax. There are “tax free” investment products such as ISAs, but for many people the amount that can be put each year into an ISA is unlikely to be enough for your retirement (though many will find it more than they can actually save).

Are investments more risky than a pension?

No, you could have identical holdings in a pension and a “regular” portfolio. The issue is understanding how the portfolio is constructed, why and what returns over the long-term are likely to be achieved. Anyone that promises guaranteed results is being less than honest with you. Everyone has a different idea about which assets or markets will perform best – that’s kind of the point of a market – where people agree a price on something when they disagree what direction that price is heading. Its true that there are other tax efficient ways to invest, using EIS, VCTs and such like, but be warned, the term venture or enterprise is used sensibly and most people are neither.

So let’s take an example and agree lots of assumptions

Suppose you need an income of £20,000 a year and inflation-linked at 3% a year (yes we are guessing). If you only expect to live 10 years from retirement at 65 and are happy with this assumption (that the money runs out, all gone, nothing left!) then the income (actual cash) you take will be nearly £230,000 over 10 years to age 75. If we assume that the portfolio grows at 5% a year during this time (which may be ambitious as you are probably keen to have certainty that the money will pay out for 10 years) then you need a fund of about £175,000 at 65. If you expect to live for 20 years and then the fund runs dry… well you would take out total income of nearly £540,000 and need a pot of £320,000 at 65 to provide this.

What would an annuity give me?

If you were to buy an inflation linked annuity at 3%pa as a 65 year old, you would probably need about £500,000 at 65. This is based on a 4% annuity rate (4% of £500,000 being £20,000pa) The advantage of the pension route is that if you live longer than 20 years (85) it continues to pay a rising income until you die. The investment pot has run out. Both have the same assumptions about inflation (which will be wrong in practice, unless you are going to credit me with mystic powers).

Pension or ISA?

So here’s the hard numbers. The pension pot needs to reach £500,000 and the ISA investment portfolio, well let’s go for £320,000 and assume we can predict death at 85. Lets suppose we start saving at 35, giving us 30 years to grow the money by the time we are 65. Let’s also assume the pension and investment portfolio hold the same stuff and perform identically, with the same charges, let’s assume that over 30 years the funds grow at 7% for the sake of simplicity. We will also assume that you increase what you save by inflation (3%) each year so that the amount you pay is proportionally the same each month. This is now virtually a GCSE maths question (if only they’d taught us the maths that was important in life right!).

So to build £320,000 in the ISA investment portfolio, you need to invest £195.64 a month rising by 3% a year, a total outlay of £113,220 over 30 years. As you may imagine to achieve £500,000 in the pension over the same time with the same returns, you need to invest £305.69 a month initially, increasing by 3% a year. A total outlay of £176,906 over 30 years. So the pension costs you £63,686 more (about 36% more). However, with the pension you had 20% tax relief, so you really paid 80% of £176,906 or £141,524, still more than the ISA, but not that much more.

£500,000 Pension pot actual cost for basic rate taxpayer £141,524
£320,000 ISA pot actual cost for basic or higher rate taxpayer £113,220

Your employer can make payments too

Now imagine that your employer was also paying into your pension pot (which they cannot do with an ISA). Suppose that they are paying 3% of your salary – as they will be under auto enrolment, let’s assume you want £20,000 a year because you reckon that’s what you need to support your equivalent lifestyle today, so let’s just assume you earn £30,000 at the moment, so 3% is £75 a month. So if your salary rises at 3% a year in the same way, over 30 years, that’s £43,404 of employer payments in total. You can therefore reduce your own payments from £305.69 a month by £75 to £230.69 a month, which in practice is £184.55 a month net of basic rate tax relief…. Which is marginally less than the £195.64 you need to save into an ISA.

£500,000 Pension pot with 3% employer contribution £106,804 net of 20% tax relief
£320,000 ISA pot £113,220

Of course the more your employer pays the better, but I hope that I have demonstrated that tax relief and employer contributions make a big difference. Don’t forget that the annuity dies with you (unless you build in benefits for your spouse) but anything left in the ISA portfolio is merely added to your estate and subject to inheritance tax. The big gamble is predicting your life expectancy.

Tomorrow I turn to property as an investment. I hope that it evident that this is not advice, I am merely outlining an example and doing the sums. You should get specific advice to suit your circumstances.

Dominic Thomas: Solomons IFA

What is the best way to save for retirement? Part 3Dominic2023-12-01T12:38:52+00:00

What’s the row over pension charges now?

You may have been listening to Radio 4 or perhaps seen the TV news, Steve Webb the pensions Minister is doing the media rounds having announced that charges on pensions should be capped at 0.75% which he announced yesterday and has been plugging his cause since. There is no doubt that there are many very expensive pensions and I would go as far to say that there have been lots of “rip off” pensions. There are too many vested interests, this has broken out in a row over pension charges.

Is there any such thing as a free lunch?

We now have various think tanks and Providers all taking the opportunity to price to the bottom and distance themselves from “rip off pensions” as quickly as possible. An assortment of spurious views about the impact on the final value of a pension fund is now doing the rounds. The vast majority of this is utter drivel. We are all to blame for this (advisers, providers, investors, regulators and Governments) why? Well because over the years we have colluded in the deceit that anything to do with financial services is free. It isn’t. I had hoped that this delusion would have been put to bed by the introduction of RDR, yet AE (auto enrolment) exposes the deep resistance to a shift in mindset.

Can a pension have low charges?

It is perfectly possible to use a pension that has low investment charges and by low I mean less than 0.30%. However this is merely one element of the piece. The administration costs are high due to well intentioned regulation. The “sales costs” are high due to well intended regulation. The regulation is designed to protect the investor and the wider market.

Why does AE have unique charging problems?

The unique problem that AE brings is that there are some very tiny premiums. Suppose you earn £10,000 a year and in several years time you will have contributions of 8% a year (£800) a cap of 0.75% on this would be £6… ok its based on the value of your fund, but given that most will not be more than £4,000 that’s £30 to cover the investment and administration for the year (and by the way you can opt in and out, switch funds, vary the payments creating more administration). It’s a nightmare for pension providers. Some have come up with some low cost solutions (hardly any investment choice) and some have a fixed monthly fee. Well even at £1.50 a month (£18 a year) that’s a higher proportional charge on a small fund of £1,000 (1.80% to be precise). The Government backed (taxpayer funded) NEST is loss making and will be for many years. This is typical of Whitehall delusion that they then expect commercial enterprise to replicate. We all know Governments are not good at maths… don’t we?

The solution is right under their noses

Stakeholder pensions (with low charges) failed because there were other better alternatives at a lesser or more competitive price. The Government (this one and the previous one) believe compulsory membership isn’t quite ok, so we have a “difficult not to join” approach. However, I would argue that today employers and employees already have a proper pension system. It’s called National Insurance and the State pension. We know it’s not good enough, so why not simply make it better for everyone? It has no investment risk and is already set up. For those that want (and need) more than the State pension (most of us) then there are plenty of very good pensions around, any decent adviser can structure a sensible plan – but it is not free… neither should it be. If we want to create a society of that is independent of the State, we all need to face some adult truths.

Dominic Thomas: Solomons IFA

What’s the row over pension charges now?Dominic2023-12-01T12:38:33+00:00

When does Auto Enrolment start?

I have had a number of queries about auto-enrolment, in particular when does auto enrolment start? The short answer is that it already has started – at least for large firms with upwards of 800 staff. Next month (November 2013) the next tier of employers must implement their schemes – those with 500-799 staff. Small firms, which generally means those with fewer than 50 staff have a staged launching date beginning in June 2015. All firms have a “staging date” and this can be found on the pension regulators website, all you need is your PAYE reference number (as the employer).

However small firms should not be under the impression that time is on your side. Setting up a scheme involves certain processes and assessments to be completed. This takes time. Whilst the Government have sensibly staggered the start dates, the reality is that most firms in the UK are small and there will be a rush and backlog. Given the prospect of fines and the amount of advanced warning, I don’t think it wise to hang around on this. I’ve been advised by various pension companies offering a scheme that they are already struggling to cope… and we’ve only just begun. So the time to begin to act on this is now. Here’s a good little video about auto-enrolment.

Dominic Thomas: Solomons IFA

When does Auto Enrolment start?Dominic2023-12-01T12:38:30+00:00

Auto enrolment – fools rush in?

If you are not drawing your State pension, then by now you should have picked up that pensions are changing – again! This time rather than making employers set up a pension that nobody might use, they have decided to force employers to set up a pension that everyone in that firm will use (unless they have an exemption or opt out). This will include mandatory contributions, which will be 3% from the employer and 5% from the employee (eventually). Whilst the employee can opt, he or she will be opted back in after 3 years (with the option to opt out again) – the ideal being that eventually you will forget and naturally begin building up a pension. Auto-enrolment is the path of least resistance.

Employers have begun (well some months ago) asking about AE. To say that there have been teething problems for the first of the large schemes would be an understatement. So today Steve Webb has intimated that SMEs will have a more simplified approach – now please note that AE is already meant to be a “no brainer” with no question asked other that “do you want in or out?”. I am left perplexed at what other new idea could be so simple… perhaps reforming NI and collecting payments directly would be sensible? I suspect that such “radical thinking” would be rather unwelcome. Anyhow when any Government uses terms like “simplified” or “simplistic” my cynicism really kicks in, as invariably this is code for “we have no idea of the consequences” but someone at a think tank thought this would work.

I am attending another presentation on AE next week, I am hoping that this will provide better insight into the latest “alteration”. I freely confess that it is better to change and adapt based upon experience, but for once, it would be nice to have some firm guidelines so that we all know where we stand..

Auto enrolment – fools rush in?Dominic2023-12-01T12:23:27+00:00

Auto Enrolment – Defining the Worker

Auto enrolment – defining the worker

Financial Planning has not yet seen the day when pension schemes are compulsory, but that day is surely closer as auto-enrolment outlines some of the hurdles that employers must jump. As an IFA, my role is to help both employers and employees to make best use of pension arrangements.

The new auto-enrolment pension rules come into effect at the end of October. There are three categories of employee that must be automatically enrolled into a pension scheme by their employer. I draw your attention to use of the word “must” – which means must. The first and easiest group to identify are those that are eligible, this means aged between 22 and State retirement age, working in the UK and earning more than £7,475 a tax year. Note though that this sum will probably be revised (upwards) by the Government and is likely to be linked to national insurance levels or the personal allowance. The second category is what might be described as “keen savers” – employees that fall outside of the automatic criteria, earn between £5,035 and £7,475 but want to join the scheme and have a right to do so. Employers must make it easy for these people to opt in and must also contribute along the same lines. Finally a group that the Pensions Regulator call “Entitled Workers” who earn below £5,035 and don’t qualify for auto-enrolment. The employer doesn’t have to make payments and can offer a different pension scheme. Confused? well here’s a diagram from the regulators website.

Thoughts – the limits will be revised annually, so in reality employers have to keep an eye of eligibility rules. The easiest solution is to simply make the scheme available to all under the same terms, this should prevent breaching any rules.

Dominic Thomas: Solomons IFA

Auto Enrolment – Defining the WorkerDominic2017-01-06T14:40:08+00:00

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