ISA or a pension? The choice is yours

Many people putting money into ISAs this month will be viewing their investment as a possible way of saving for retirement. Individuals savings accounts appear to be winning the battle for hearts and minds while pension products are seen as becoming more confusing and inflexible.

"There is more of a demand for the flexibility of ISAs," says Bath-based Patrick Connolly at the financial adviser AWD Chase de Vere. "Pensions have a fairly negative perception."

Graeme Currie, a financial consultant at Alan Steel Asset Management, sees a similar trend. "There is a move away from pensions," he says. "There is a lack of trust. There have been so many changes in legislation that people are wondering what is going to happen next."

Contributions into personal pensions have been falling since 2007, according to data from the Association of British Insurers. ISA contributions have been far more volatile, according to the Investment Management Association, yo-yoing up and down in this period. But in 2010, net retail sales of ISAs were £4.2bn, half of what went into personal pensions that year. It would be no surprise to many advisers if the ISA comes closer to parity with personal pensions in the years to come.

Although there are particular attractions of ISAs, no one should write off pensions. And most advisers will urge people who can do so to invest in both.

"Having the balance between the two is the best option," says Ben Yearsley, an investment manager at Hargreaves Lansdown.

But, for those who can accept the disadvantages of pensions, there are some weighty plus points. Tax relief at 40 or 50 per cent of the contributions paid in makes them extremely attractive for many high earners.

Similarly, employees in company pension schemes essentially miss out on free money if they forgo the attractive contributions that employers often make on their behalf.

This will be reinforced from October when a new scheme, the National Employment Savings Trust (NEST), provides a pension scheme for workers who currently do not get offered one by their employers. The scheme will require employers to contribute 1 per cent of an employee's salary, rising to 3 per cent by 2017, into each individual worker's NEST pension plan.

Another advantage is that a quarter of the value of the pension fund can be taken tax-free on retirement.

Adrian Walker, the head of retirement planning at financial services group Skandia, sees tax-planning opportunities in pensions for wealthier people, but these are the kind of cases which need specialist advice. By way of example Mr Walker says: "ISA savings fall into a person's estate when they die, but money in pensions is free of an inheritance tax liability on death."

Many of those most strongly drawn to ISAs now are basic-rate taxpayers and/or people in their 20s and 30s.

"ISAs are becoming the default vehicle for retirement savings," Mr Connolly says. "Younger people are keener on the ISA's flexibility, especially if they are saving for a mortgage deposit."

The fact that pensions cannot be touched, in most circumstances, until age 55 at the earliest, is a big drawback for those who want a multi-purpose fund that could be used for emergencies or a house as well as for retirement.

Although there is famously no tax relief on contributions made into an ISA, there is no tax to pay on capital gains or on the income. (In theory, there is the 10 per cent tax credit which is assumed to be paid on all dividends paid out by companies. But Mr Yearsley says this is a notional issue which applies to all dividends, whether inside an ISA or not, and should not be seen as a disadvantage of ISAs.)

Some of the most diligent investors in ISAs have accumulated funds of more than £1m in the 26 years since Margaret Thatcher's government introduced the forerunner of the ISA, the PEP (personal equity plan). If they receive an income of 5 per cent of that amount, they are earning £50,000 without paying income tax on it. Only a small minority will achieve that level of income, but there could be many receiving £10,000 or so a year.

Dark clouds are certainly looming over the pensions sector right now.

"The rumour is that they might take away higher-rate tax relief" in the 21 March Budget, Mr Currie says.

Mr Connolly says: "I'd be very surprised it that happened this year, but, at some point, it might well happen."

He thinks the chances of an attack on ISAs are much more remote. "The Government has been putting a lot of emphasis on ISAs. It has even created the Junior ISA [allowing up to £3,600 to be put into similar accounts for the under 18s, from last November]. It would be a massive U-turn if they changed the tax relief on ISAs."

Another problem area is that personal pensions need either to be converted into an annuity or accessed through an income-drawdown plan.

The second of these is quite complicated, but it does allow individuals to stay invested in the market with that part of their pension fund they have not touched.

The first option – buying an annuity – is looking distinctively unattractive as the UK seems firmly lodged in a low-interest-rate environment.

"Use ISAs for now and hope that pensions sort themselves out before you need one," suggests actuary Henry Tapper of First Actuarial. He believes pensions should have a big role to play, but that the system is currently flawed in the area of annuities.

Someone taking out an annuity – a monthly payment plan bought with the proceeds of a pension – would receive 25 per cent less today than someone who took one three years ago. The Bank of England is firmly committed to keeping interest rates down, even though this hits everyone buying an annuity.

So, while some people – mainly higher-rate taxpayers, other well-off individuals and those in good company schemes – may prefer pensions to ISAs, the vast majority of those with some spare cash to invest will also want to consider ISAs.

"A 50-50 split is probably a good starting point," Mr Connolly says.

Finally, more investors seem to have a warm feeling about their ISA that they do not have for their pension.

"More people are engaged with their ISAs than with their pensions," says Mr Walker of Skandia.

This even extends to how they choose their funds and monitor their investments. Few members of pension schemes or owners of personal pension plans make active decisions about where their money should go. But ISA investors tend to be more involved.

At Hargreaves Lansdown, for instance, ISA clients who make their own investment decisions, rather than consulting the firm's advisers, tend to be "relatively frequent traders" who often switch from one ISA fund to another.

ISAs provide flexibility and free choice

Each month Alison Kingston invests £890 into anIndividual Savings Accountwith Skandia.

Her husband does the same, and her household has amassed £21,360 in this tax-free investment during the past12 months.

It is several years now since the Newcastle-based couple have been investing the maximum they can in ISAs.

But even though ISAs have been through five years of volatility during the economic crisis, Alison has no regrets at all about investing her moneyin them.

"When your investment goes down, your payments in are buying more units," she says. "When the good times come back, you reap the benefits."

For Alison, the national sales manager at a pharmaceuticals company, her ISA is one part of her savings strategy.

She also has a company pension, and withdrew some money from her ISA to put into an investment property.

Part of the plan for Alison, who "recently turned 50",and her husband may beto take early retirement.The ISA gives them theliberty to do so.

"It's up to us," she says.

Links

DirectGov on ISAs: www.direct.gov.uk/en/MoneyTaxAndBenefits/ManagingMoney/Savings AndInvestments/index.htm

DirectGov on pensions: www.direct.gov.uk/en/Pensionsand retirementplanning/index.htm

Association of British Insurers: www.abi.org.uk

Investment Management Association: www.investmentfunds.org.uk