FTAdviser.com/Investment Adviser

Pension view - Money for nothing and drinks for free

by Alan Steel

Monday 22 November 2010

Pensions today continually attract bad press, suffering from costly long-term charges, bad investments and interference by governments.

But were pensions really so much better before, as everybody claims?

When I became an IFA in 1973, investors couldn't stick much into any form of pension plan.

Everybody these days goes on about how annuities are pathetic compared to the past. It's really the wrong way to look at it.

The legendary annuity rate of 15% or higher was actually, in the context of history, a flash in the pan. Such giddy heights only occurred a couple of times in the 80s or early 90s - never before, and probably never again.

So let's look at pensions afresh. Let's take the good news. It's still the case today if you are a basic rate taxpayer - thanks to tax relief you get a 25 per cent uplift on the money you invest.

A 40 per cent taxpayer gets 67 per cent uplift, and a 50 per cent taxpayer today putting in £20,000 or less gross, receives 100 per cent uplift - think about it - for every £1 you put in, the government puts in £1 too.

Capital gains tax

Too many forget the growth in a pension fund completely avoids capital gains tax. Much has been made of the drag caused by the tax on dividends inside the plan, but it's not really that much. If you go for low-yielding growth funds, the tax drag is the square root of nothing.

If you die and your plan is in trust, and you haven't drawn any benefits before death, the entire fund is paid out free of taxes, including inheritance tax, as long as the term of the plan is written properly.

So pensions are wrapped around tax reliefs and tax savings unavailable elsewhere.

But apart from the widespread belief that annuity rates are poor, the second main reason people don't like pensions is because they are poor investments.

It's not pensions that are poor investments, it's what's been put inside them by indifferent advisers that makes returns so bad.

That, and heavy charges applying to old plans still festering away today. Charges are much lower today, or certainly should be.

The way I like to look at it is that pensions, especially for higher rate taxpayers, is along the lines of money for nothing and drinks for free (apologies to Dire Straits).

Let's take a simple example: you're 40 years old and you want to stick £10,000 a year into an investment until 60 to provide yourself with a lump sum and hopefully some income.

You're a 40 per cent taxpayer and you stick it in a bank or building society and receive a net 2.5 per cent on average for the next 20 years. You are going to end up with a fund of about £262,000.

Pension plan

Your next-door neighbour decides to do the same but wants to invest £1,000 net of tax relief into a pension plan instead.

He's done some homework and decides to split it between a fund such as Neil Woodford's Invesco Perpetual Income and Graham French's M&G Global Basics.

If the last ten years of the lost decade is anything to go by for these funds, then you can certainly expect at least 10 per cent per annum return, and that over 20 years in this example creates a fund of £1,052,000. His tax-free cash sum is more than what you have saved up in total in deposit.

So the annuity rates that everybody today moans about are irrelevant. Because it's provided for nothing. And that's the way I like to look at it.

Article courtesy of FTAdviser.com/Investment Adviser
Monday 22 November 2010