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02 Dec 2010 | 08:00

Alan Steel, chairman of Alan Steel Asset Management, on why investors should ignore all the puff surrounding pensions

Pensions are a bit like teenage prima donnas: nobody seems to understand them. But with a little bit of effort, getting the best out of a pension is not difficult, and despite the bad press they receive, pensions have a huge amount to give.

Let's not beat about the bush: pensions are not perfect, and over the years they have deserved some of the stick they have got. But to simply label them as useless and kick them into the long grass is madness.

When I became an IFA in 1973, there were tight rules about what people could stick into their pension. For the self-employed, tax relief was granted only on contributions equating to something like a sixth of their earnings, with maximum limits in place on total contributions.

This was hardly the sort of approach that led to people building up decent funds - but before anyone shouts from the galleries that annuity rates more than made up for smaller pension pots, that is not the case.

There were undoubtedly some very lucky people who got on to the annuity bus at bumper rates of about 15%, but the reality is such pricing was genuinely a once in a lifetime offer that was available only on a few occasions in the 1980s and early 1990s. We had never seen these sorts of annuity rates before and it is a sure bet we will never see their like again.

Tax relief

All of this belies the benefits that pensions offer and the tax relief and tax savings available are dramatic. The first thing to remember is that pension contributions attract tax relief. This means a basic rate taxpayer gets an immediate 25% uplift on their investment.

For those paying tax at 40%, the uplift is 67%, and for those in the 50% bracket, the uplift is a staggering 100%, as long as they do not put more than a gross figure of £20,000 into their pension.

Not only do investments get a pat on the back as they go into the pension, but once in there they are not liable to capital gains tax. Despite all of the hoo-ha about the tax on dividends inside a pension plan, this is largely avoidable by picking low-yield growth funds. If the dividends payable are minimal, the tax will hardly be punitive.

If you die, it is also possible to make sure that any of the cash in your pension is passed on without being subject to inheritance tax. As long as the plan is written in trust, you have not taken any benefits and the term of the plan has been written appropriately, the entire fund will be paid to beneficiaries free of tax.

The truth of the matter is that pensions are fantastic: it is the rubbish that so often gets shoved into them that gives them a bad name. Numerous well-heeled and intelligent clients have walked through my door and told me from the start that they are not interested in pension planning because pensions are rubbish, offering poor value and paltry returns.

However, when I speak to them about their ISAs, they reel off their favourite fund managers, talk about the fantastic returns they enjoy and bemoan the fact they cannot have these same star performers in their pension.

When they find out they can, the immediate delight soon turns to fury as they realise just how much they have missed out on because of the shabby advice they have been given.

Picking investments run by the best fund managers makes a massive difference to the size of the pension that investors can accrue. For those who do not believe me, just look at the numbers in the following example.

If a 30-year-old decides to give pensions a miss and instead stick £500 a month into a building society, earning a steady 3%, by the time they are 60, the account will have grown to just under £295,000. Not bad, until you consider that if they had funded a pension with the same amount of money, net of tax relief, and invested it in a solid selection of funds returning 10% annually, they would be sitting on funds of over £1.8m. This would give him a tax-free sum of £450,000 with £1.35m still left in the pension.

And for anyone who thinks an annual return of 10% is unreasonable, just have a look at the historic performance. Over this so-called lost decade, we have 'endured' the likes of: Angus Tulloch (First State), Graham French (M&G) or Ian Henderson (JPM). There are many managers delivering these sorts of performances, and not having them in your pension is a costly mistake that is too often driven by ignorance and poor advice.

There is a lot of puff spouted about pensions, but when you pick away the pastry, they are a very meaty product. Investors should waste no time in tucking in.

Article courtesy of ifaonline.co.uk
Thursday 2 December 2010