You & Your Money: Get the balance right

THE most obvious advantages to having a personal pension are that contributions are tax deductible at your marginal rate of tax and funds grow free of all taxes. On retirement you can take up to a quarter of the fund as tax-free cash and there is a variety of options as to how you take your income.

Unfortunately, there are major disadvantages. Currently, pension funds are not accessible until age 50. After retirement you must purchase an annuity (a guaranteed income) before the age of 75, using the fund - less the tax-free cash. Returns from annuities have fallen dramatically. Also, the money used to buy the annuity, unless it is insured, will always die with you. You cannot pass it on to the kids.

Pensions are not tax-free - the money you get is taxed as income and thus pensions are tax-deferred. The returns from your fund may be taxed at a lower rate than the relief you received on the contribution. Lots of plans have high charges many are poor value and benefits are frequently eroded by costs.

Should you invest in a pension?

A pension is a long-term investment and you may face heavy penalties if you stop and start your payments. They could become more flexible when stakeholders are introduced from April. If your earnings are sporadic, or you are on a short-term contract, you may be better off selecting a more flexible investment.

The ISA option

All the growth within the fund is tax-free. You can take the fund or make tax-free withdrawals at any time. The compulsory purchase of an annuity is not even an issue and you can leave the fund to the kids. Charges may also be lower than pension funds and there is considerable flexibility on contributions.

But, as with pensions, there are some disadvantages. Your investment capital will probably come out of taxed income.

There may be some extra ISA charges in addition to the normal costs of the underlying investment.

Should you invest in an ISA?

THE cost of investing in some pension plans may mean ISAs are a better option for higher-rate taxpayers, who will nearly always gain more in tax savings than they will pay in extra charges. However, it is the investments within the ISA that count, and for far more than the tax efficiency.

The first requirement for a good ISA is charges that do not eat up all the tax advantages.

Also, the manager must offer good core investment.

Additionally, savers must be able to withdraw income and capital gains from their ISA portfolios at little or no expense.

Which product has the edge?

Tax-free growth within the fund is the main benefit of both pensions and ISAs. However, UK dividend income within a pension is not longer tax free but the ISA still receives a reduced dividend tax credit - at least until 2004.

However, with a pension, the tax free fund growth advantage may be more than offset by charges - especially for basic rate taxpayers, and on the contributions made in early years - or for those who stop contributing.

Indeed, for those on basic rate, the value of the additional tax relief is not substantial in itself. If there were no difference in charges, basic-rate taxpayers would only have to pay an extra 7% for the substantial flexibility of a CAT-standard ISA, in order to make that the more worthwhile choice.

It is very much a case of horses for courses and many will conclude that a variable combination of the two is the best solution.

The average premium for new personal pensions taken out in Britain last year was 79 per month. This represents less than 5% of the British average salary of 20,000 a year. It is nowhere near enough to generate a decent income in retirement, or to overcome the effect of charges.

Saving through an ISA may be the more attractive option. In particular, unlike pensions, ISAs do not lock your money away for the long term, contributions are more flexible and you can leave the money to the family.

For an average level of contribution, the difference between the charges on the average personal pension and those on a CAT-standard ISA broadly cancel out the tax advantages of the former, even when contributions are paid until retirement.

The best option for most people is to set up a low-cost regular savings pension plan and use ISAs to mop up any spare cash. Ian Howe of Towry Law says: "Saving for pensions is never perfect. Retain some flexibility and control, but have a regular savings discipline.

A combination of investments is almost certainly required."

Copyright 2001
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