August 2008

The ISA-ing on the cake

Traditionally, pensions are seen as the foundation for a retirement income with ISAs used for medium-term savings and topping up pensions. However, as many people shy away from the prospect of saving into a pension there could be a growing role for ISAs in helping people to accumulate retirement savings.

One obvious point in favour of the use of ISAs is that with most people not saving enough for retirement, using an ISA is a good thing in itself. St James's Place divisional director, pensions, Ian Price commented: "I am a great believer that as long as people are saving somewhere for retirement, that's better than nothing."

According to Price, the average amount held in ISAs and their predecessors, personal equity plans (PEPs), for someone approaching retirement is around £60,000, more than the average pension fund.

Fidelity International head of UK marketing Rob Fisher agrees, saying that he believes ISAs can have an important role to play in complementing pension provision.

"We have researched why people take out ISAs and saving for retirement is always the biggest single use, some way ahead of paying for education for children and grandchildren, with mortgage repayments the third most popular use." It would seem that the ease of access to your money that you get with an ISA makes it a preferable choice for those who find the bad press associated with pensions offputting.

However, despite the benefits of saving into an ISA, there are issues savers need to be wary of. Prudential head of business development, investment, Frank Morton noted: "Market volatility and uncertainty has resulted in a collapse of confidence. Certain areas, such as unit-linked investments, have been hit quite badly."

Deciding factors

While these concerns are affecting attitudes to saving, the tax status of an individual is an important consideration in deciding whether an ISA or a pension should be used. In simple terms, contributions to an ISA do not attract tax relief, whereas pension contributions do. In both, investment growth is tax exempt, while withdrawals from an ISA are free of income and capital gains tax, whereas withdrawals from a pension fund, apart from the 25% tax-free lump sum, attract income tax.

For higher rate tax payers, paying into an ISA is less tax-efficient than contributing to a pension. Tax relief can be obtained at 40% on contributions, while withdrawals will only be taxed at the basic rate, if an individual moves from being a higher rate tax payer when contributing to being a basic tax rate payer in retirement.

The choice is more finely balanced for basic rate tax payers though. IFG Group financial planning strategist Donna Bradshaw commented: "For higher rate tax payers, there is a very obvious benefit from using a pension, rather than an ISA. For basic rate tax payers, there is not a huge difference."

Bradshaw added that recent changes to the income tax system mean that income taken from an ISA could be more tax-efficient than using a pension for pensioners whose incomes are between £21,800 and £28,990.

"There have been a lot of changes to the tax bands this year, including an increase in the age-related personal allowance for those over 65," Bradshaw commented.

She explained that the personal allowance from 65 to 74 is £9,030, with an income limit of £21,800, meaning that for every £2 in income over the limit, £1 of age related personal allowance is lost.

"It is an effective tax rate of 30% and you could have the income tax-free if it was paid from an ISA and kept your age related allowance," Bradshaw added. "There is quite a strong argument for people who are basic rate taxpayers and on more modest pensions to look at an ISA as a top-up to their basic state pension and any company pension, rather than a personal pension."

Since A-Day in 2006, changes to the pension contribution rules mean that an individual could save into an ISA as a basic rate tax payer, perhaps in the early years of their career, then roll over a lump sum into a pension when they are a higher rate tax payer. Abbey head of pension product development, Mike Brown, said: "If I put £6,000 into an ISA, then another £6,000 in a year later and then another £6,000, I've got £18,000 in total. If I put that into a pension and get a 40% tax break, I've put £30,000 into a pension. The argument that you must put money into a pension today because that means you have more money working for you immediately, due to tax relief, doesn't work". However, Brown added that such a strategy requires self-discipline, to avoid touching the capital for, say, a new car.

The accessibility of saving in an ISA can therefore be both a positive and a negative as far as retirement planning is concerned. For younger individuals, Jeremy Woodley, UK director at the Fry Group commented: "An ISA gives individuals the opportunity to pay off student debts or fund a property deposit."

For some, ISAs are attractive as a means of saving for retirement if they do not wish to buy an annuity. However, since 2006, "there is a lot more flexibility on how you take your benefits", Woodley said. He added that the last budget reduced the tax case for ISAs. "If you pay capital gains tax at 18% and have a £9,000 allowance, you have got to make a lot of gains and then you pay tax at a lower rate than income tax. If you are going to use an ISA, it is better if you put cash in it," he added. In fact, a great deal of money, over £100 billion by some estimates, is held in cash ISAs and this can now be transferred into equity ISAs. This could mean a boost to longer term saving, but so far there are few signs of this, due to investor inertia and rocky equity markets.

Investment platforms

The movement of funds between different types of ISA and between different tax wrappers is being facilitated by the greater use of investment platforms, according to Fidelity's Fisher. "An adviser can add value with wrapper allocation, by using different wrappers at different stages of a client's life," he said. This could lead to transfers from ISAs to pensions as individuals go through life, while the platform can also be used at the de-accumulation stage, when an income is taken following retirement.

Chartwell financial planning director Andrew Limb said many people approach retirement income planning on a cash flow basis, making ISAs, which provide an income free of tax, attractive. He added that for many retirees, the main objective is a high level of income, even if this eats into their capital. "As long as people are aware of what's happening it is not the end of the world," he said.

Of her wealthy client base, Bradshaw commented: "Income is taken as required from across all their different investment wrappers, typically from investments that are performing well, leaving other assets to bounce back," she said.

Hargreaves Lansdown has looked at the use of ISAs and pensions for retirement saving and its head of pension research, Tom McPhail has come down firmly on the side of pensions: "Almost irrespective of personal circumstances, pensions are the most effective way to save for retirement income," he said. "ISAs offer some advantages in terms of flexibility, but for retirement planning purposes, this flexibility doesn't outweigh the advantages of a pension."

Another consideration is inheritance tax (IHT) and Aegon Scottish Equitable has warned of potential IHT liabilities on ISAs. IHT is payable at 40% above an individual allowance of £312,000 and Aegon Scottish Equitable said someone using their ISA or Pep allowance every year since their introduction in 1987 could have £360,000 in assets, assuming average unit trust growth rates.

Looking ahead, a possible development is for group ISAs at companies to encourage employee savings. Jelf Group corporate services director David Edwards said: "Employers may wish to provide a facility to run alongside pension, for saving into such an arrangement, which provides flexibility." Abbey's Brown added that this type of facility could enable employers to differentiate between different groups of staff when personal accounts arrive in 2012. "At the moment, employers can't contribute directly to an ISA because it is an individual contract, but it is an interesting area and with a bit of thought it could improve the savings ratio," Brown said.

Whatever changes personal accounts may bring, ISAs are well-established as a pension top-up vehicle and a key part of financial planning. However, there are arguments for and against their use in relation to a pension, so advisers and their clients should proceed on a case-by-case basis.

Matthew Craig
Freelance Journalist and UK Head
CoreData Research