LISA or a pension pot… or both?

Michael Johnson compares a pension pot with a Lifetime ISA from the perspective of a millennial

There are some 14 million millennials in the UK: the generation born between 1981 and 1996 represents a large market. But faced with unaffordable housing, student debts, fragmented careers, earnings stagnation, zero-hours contracts, minimal defined benefit (DB) provision (other than the public sector), a rapidly-retreating state pension age and, perhaps most challenging of all, increasingly having to support an ageing population, many millennials are on the financial rack.

Consequently, few millennials are likely to have multiple retirement savings accounts. So, if choosing between a pension pot and a Lifetime ISA (LISA), which one would best suit their needs?

1.       High earners: some, not all, should take the tax relief

There is one obvious reason to elect for a pension pot rather than a LISA: higher rate tax relief is larger than the LISA’s 25% bonus. But some 92% of millennials are basic rate taxpayers so, on this basis alone, a pension pot is only obviously preferable to 8% of all millennials. But what is less intuitive is that anyone who continues paying tax at 40% in retirement would, purely from a tax perspective, be better off with a LISA (discussed below).

There are two other reasons to favour a pension pot: inheritance tax (IHT) and state welfare benefits. Assets in a pension pot are exempt from IHT, whereas LISA assets are not, and they are also excluded from benefits assessments, whereas LISA assets are included. But how many millennials are concerned about a potential IHT liability sometime in the distant future? And are welfare benefits really a consideration for those choosing between a LISA or a self-invested personal pension, say? Both these considerations are unlikely to have any material impact on influencing savings behaviour in favour of a pension pot.

2.       Neutral considerations

2.1     The upfront incentive to save

The LISA pays a 25% bonus on post-tax contributions, whereas basic rate taxpayers receive 20% tax relief on pension contributions. These incentives are economically identical because the bonus is 25% of a post-tax amount, whereas tax relief is 20% of a gross (pre-tax) amount; unfortunately, this is not intuitive.[1]

2.2     Contributions limit

LISA contributions are limited to £4,000 per year (until reaching the age of 50, and £0 thereafter), whereas pensions tax relief annual allowance is £40,000.[2] However, given that few millennials can afford to save more than £4,000 in a year (out of post-tax income), the LISA limit is unlikely to be an issue. And those who can save more are probably higher rate taxpayers, in which case they should opt for the pensions route.

3.       Reasons to save in a LISA before a pension pot

3.1     Income Tax

Both the LISA’s 25% bonus and pensions’ 20% tax relief effectively reimburses the saver for any basic rate income tax paid prior to saving. However, when it comes to using the savings, LISA withdrawals are tax-free from 60, whereas any form of income derived from a pension pot is taxable at the saver’s marginal rate, once the 25% tax-free lump sum is taken into account. Perhaps more surprisingly, higher rate taxpayers (while working and then in retirement) would also be better off with a LISA than a pension savings vehicle (see below).

Thus, for example, someone whose marginal rate of income tax was 20% both when working and subsequently in retirement would have to contribute a post-tax £80 to a LISA, but £94.10 to a pension pot, to receive a post-tax £100 in retirement.[3] And a higher rate taxpayer (working and in retirement) would have to contribute a post-tax £85.70: they too would be better off with a LISA.[4]

For over 90% of the under-40s population, the LISA is a more tax-efficient retirement savings vehicle than a pension pot. For basic rate taxpayers, LISA savings accessed from 60 are effectively entirely tax-free whereas the effective tax rate on a pension pot is 15%. Remarkably few people appreciate this fundamental LISA attribute, one with which the pensions framework cannot compete. And the LISA’s first home purchase early-access optionality provides additional value.

3.2     Access

Pension savings cannot be accessed until the age of 55 (57 from 2028, i.e. for all of today’s millennials), except on grounds of serious ill-health. Conversely, access to LISA savings is permitted at any age (from one year after the first subscription). From 60, there are no penalties, and pre-60 access is penalty-free if funds are for the purchase of the first UK home (to be lived in, not for rental), up to a value of £450,000.[5] Numerous surveys evidence that home ownership is millennials’ top financial priority so, when it comes to choosing a retirement savings vehicle, home ownership status should be a significant consideration.

Given that roughly 70% of millennials do not own their home, a LISA is the obvious choice. Its ready access to buy the first home, with the bonus retained, is a free option for the saver, with which pension pots cannot compete.

Pre-60 withdrawals for other purposes would require repayment of the bonus and an additional 6.25% penalty.[6] Note that, for many people, the alternative source of funds would be to borrow via a credit or store card at a typical annual percentage rate of at least 18%.

3.3     Workplace saving

The UK’s workforce is approaching a period of dramatic change in composition, and this will occur over a remarkably short timeframe. In 2020 some 50% of the workforce will comprise millennials, but by 2025 this will be nearly 75%.

(a)      Personalisation

It is striking how people refer to “my ISA”, but when talking about workplace saving they depersonalise their membership of “the company scheme”. An extraordinary 39% of auto-enrolled scheme members are unaware that they were a member of a workplace pension scheme, according to 2017 analysis of 938 auto-enrolled scheme members by Decision Technology. Some 95% had never tried to change their fund, 91% did not know where their funds were invested, 80% did not know how much was in their pension pot and 34% did not know who their pension provider was. Very few have identified a beneficiary, should they die. Personalisation is a prerequisite for engagement.

Ideally, savings derived through work should be as personal as a bank account, unencumbered by the jargon and paraphernalia of pensions. Being in control is closely allied to being motived, and therefore engaged.

(b)      LISA as a workplace ISA

Employers have long complained that their pension contributions are undervalued by employees, and therefore represent poor value for shareholders. There are reasons for this, notably millennials’ dislike of pension products’ complexity and inflexible access, and their distrust of the pensions industry. Given this, it is in employers’ interests to offer their millennial employees a choice of workplace benefits that includes a LISA. This could be presented as a workplace ISA bearing the employee’s name, which would help engender a sense of personal ownership, and thereby help to boost employee engagement with saving.

(c)      A workplace ISA alongside a pension pot

A LISA and a pension pot are not mutually exclusive, and could be complementary, particularly for high earners looking to save more than £4,000 per year. In addition, many millennials value the LISA’s penalty-free access, particularly if they have yet to get onto the property ladder. If they also like pension pots’ inaccessibility (i.e. savings are out of reach until at least 57), then accumulating savings in both vehicles would make sense. Salary sacrifice considerations may also play a role in opting for multiple savings vehicles.

Michael Johnson is adviser to Smarterly, the workplace savings platform

 


[1] LISA:         £100 gross – £20 tax = £80, plus 25% bonus of £20 = £100 saved.

Pension:     £100 gross – £20 tax = £80, plus tax relief of £20 = £100 saved.

[2] There is actually no limit to how much may be saved in a pensions vehicle, but there is no incentive in respect of contributions exceeding £40,000 per year. The Lifetime Allowance is £1,030,000.

[3] A post-tax £94.1 contributed to a pension pot would receive £23.52 in tax relief, so £117.62 goes into the pot. At retirement 25% of this can be withdrawn tax-free (£29.4), leaving £88.22 to be taxed at 20%. This leaves £70.6 post-tax, plus the £29.4 = £100 post-tax.

[4] A post-tax £85.7 contributed to a pension pot would receive £57.1 in tax relief, so £142.8 goes into the pot. At retirement 25% of this can be withdrawn tax-free (£35.7), leaving £107.1 to be taxed at 40%. This leaves £64.3 post-tax, plus the £35.7 = £100 post-tax.

[5] Penalty-free access at any age is also permitted in event of terminal illness (with less than 12 months to live), or when transferring to a different Lifetime ISA provider.

[6] £100 saved attracts a £25 bonus to equal £125. On withdrawal, £125 x 25% = £31.25p, i.e. £6.25p more than the bonus received on the £100 originally saved. This penalty only adds complexity and serves no consumer purpose: it should be scrapped by simply reducing the withdrawal repayment to 20%.