Flexible friends?

Relaxed rules on pensions offer investors greater freedom in how to spend their retirement funds, but what is best: a pension, an ISA or a combination of the two?

How you are going to spend your pension fund has replaced house prices as the hot topic at dinner parties across the UK.

Chancellor George Osborne's plan to relax pension rules, allowing investors much more freedom in how they draw their defined contribution pension funds, initially triggered speculation that pensioners would blow all their money on a Lamborghini or a world cruise. More recent research by Saga and financial intermediary Hargreaves Lansdown, however, suggests investors are more likely to use their pension funds to support their children or invest in property.

Regardless of how people intend to use their pension funds, Osborne's proposals have been met mainly with enthusiasm. Pension investors have not only been released from buying expensive annuities, but provided they have reached the age of 55, they will also have the freedom to use their money how and when they want.
"For most investors, it will not be a case of choosing one or the other, but using both"Until now, ISAs have played an important role in providing the flexibility and easy access to money not available from pensions. While money paid into a pension scheme is tied up until the investor turns 55, money can be withdrawn from an ISA at any time. This makes an ISA ideal for those with limited resources who may need to draw on those funds before reaching retirement, maybe to pay university fees or provide a deposit for a child's first home.

Pensions at a glance:

Tax benefits: relief at marginal rate on contributions; gains roll up tax free; 25% of fund can be taken tax free; remainder is subject to tax

Annual allowance: 100% of annual earnings; £40,000 a year

Lifetime allowance: £1.25m

Eligible age: from birth

Access to money: at age 55
Michael Johnson, a research fellow at the Centre for Policy Studies, has even suggested increasing the role of ISAs in retirement planning by turning them into 'lifetime' savings schemes that benefit from government contributions. 

But is such a move necessary now, and will the existing role of ISAs in retirement planning be diminished thanks to the impending pension freedom?

Greater choice From April 2015, pension investors aged 55 or over will be able to take as much of their pension fund as they require, and have greater choice in how they take it.

Some investors may still prefer the security of buying an annuity, an income guaranteed to last for the rest of your life. As before, you will be able to take 25% of the pension fund as a tax-free lump sum, using the remainder to buy the annuity.

ISAs at a glance:

Tax benefits: no tax on income or capital gains

Annual allowance: £15,000 for adult, £4,000 for under 16s

Lifetime allowance: N/A

Eligible age: from birth for junior ISA, age 16 for cash adult ISA and age 18 for stocks and shares adult ISA

Access to money: at any time, subject to individual ISA's T&C
Investors who feel that annuities offer poor value for money can already opt for a system called pension drawdown instead. By putting the entire pension fund into drawdown, you can again take one quarter of the fund as a tax-free lump sum at the outset, and generate an income from the remainder. You retain control over the remaining fund, can vary the amount of income you withdraw, and pass remaining money on to beneficiaries when you die, subject to tax.

The third method is new - and is the one that is getting investors excited. The money can be left in its existing pension scheme as an 'uncrystallised fund', with the investor withdrawing as much as they like, when they like. One quarter of each withdrawal will be treated as tax-free cash, and the remainder taxed at the investor's marginal rate.

The new freedom in how pension investors can take out their money added to the existing generous tax reliefs seems hard to beat.

Winning combination? It is not just pensions that are improving. ISAs have already benefited from a large increase in the annual allowance, rising to £15,000 from the beginning of July this year. The new ISA, or NISA as it has become known, has also become more flexible, enabling investors to invest any or all of the full annual allowance in cash or stocks and shares.

Patrick Connolly, a certified financial planner with independent financial advisers Chase de Vere, says that for most investors, it will not be a case of choosing one or the other, but using both.

"For most people, the best approach for long-term savings is a combination of pensions and ISAs," he says. "Pensions provide initial tax relief which give your savings an immediate uplift, whereas ISAs can still be tax efficient and you are able to access your money whenever you like."

The right approach for investors will depend on the level of flexibility and access to their money that they need, adds Connolly. "If you are prepared to invest over the long term then it could prove beneficial for you to hold more in pensions, especially if you are a higher or additional rate taxpayer," he explains. "However, if you think you might need to access your money, perhaps for a shorter-term goal such as paying a mortgage deposit, for school fees or a wedding, then you should put more focus on ISAs."

Design for life So is there any need for a lifetime ISA now? Independent pensions expert Ros Altmann, recently appointed as the UK Government's Older Workers Business Champion, does not think so.

"Investment in pensions has plummeted to record lows in the past few years, and the flexibility of ISAs has proved more popular than inflexible pensions," she says. "But auto-enrolment, where every worker joins an employer pension scheme, and the new flexibility for pensions announced in the recent Budget are likely to increase pension coverage significantly in future."

Laith Khalaf, Senior Analyst at Hargreaves Lansdown, notes that the UK has a hugely popular ISA market - total ISA subscriptions totalled £57.3bn in 2013-14, according to HM Revenue & Customs - and an improving pensions market.

"Chopping and changing is one of the barriers to people saving, so we should be mindful of that and build on the structures we have, rather than sweeping them away and starting anew," warns Khalaf. "I would say that savers now have a really great framework within which to save for their future while sheltering their money from tax, though many still need help and information so they can make the most of this environment."
Published: 11 Nov 2014
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