Pensions are second best for retirement savings

A basic rate taxpayer accrues benefits in a personal pension plan 8% greater than using an ISA, according to recent research by Hargreaves Lansdown. HL argues that this makes pensions better value. The facts show that most people don’t agree.

The vast bulk of the £18.8 billion lump sum personal contributions to pension plans in 2006 was paid by higher rate taxpayers. Though standard rate taxpayers could pay lump sums into pension plans, they generally don’t do this but choose to save in other ways.

The reason, says EveryInvestor’s Chris Gilchrist, is simple: people value flexibility in their savings plans and dislike three aspects of pension plans: restrictions on access, loss of inheritability, and payment of tax on their income.

HL’s research assumes that tax rules remain the same, but when planning for a 20- or 30-year investment this is unrealistic. From next April, tax relief will fall along with the basic rate of income tax, and the effect is to reduce the enhancement to a £1,000 lump sum contribution from £282 to £250. There have been major changes in the tax rules on pensions over the past decade and it is far more likely that they will change than that the simple tax treatment of the ISA will alter. Savers can easily avoid any adverse change in the ISA rules in future by withdrawing their capital.

‘Rich people with plenty of capital can afford to give up access and flexibility on some of their money,’ says Gilchrist, ‘So it is quite rational for them to invest lump sums in pension plans. But exactly the same logic explains why most standard rate taxpayers don’t put lump sums into pensions and in general are right not to do so.’

The conclusion, says Gilchrist, is simple. ‘People should contribute to occupational schemes to the extent that they benefit from employer contributions. But standard rate taxpayers should make personal savings into an ISA until they have used up their annual savings allowance before considering further personal pension contributions, unless they are very close to retirement.’

Adds Gilchrist: ‘Advisers often wheel out the argument that pension savings are good because you don’t have access to your cash and can’t spend it. This is the same paternalism that creates rigid rules governing the conversion of pension fund capital into income through annuities. If people can be trusted to make investment choices with SIPPs, they can surely be trusted to decide whether to use their capital for retirement income or for other purposes.’