EVERY year that passes brings each of us another year closer to retirement and the provision of sufficient income in retirement becomes of greater and greater importance.
Whilst the basis for the majority of an individual’s retirement savings is made up from pension schemes, it must be noted that Her Majesty’s Revenue and Customs’ (HMRC) registered pension schemes are, clearly, not the only way to provide income in retirement. Other investments need to be considered in the planning process both before and after an individual stops earning.
In this article we will attempt to discover some viable alternatives to pensions. Many of these are becoming increasingly significant to our clients due to the continuing pressure on pension funds to live up to expectations.
Investing in the business
The introduction of capital gains tax taper relief, particularly in its current (and final form) for business assets, has increased the relative tax efficiency of alternative investments, while all forms of taper relief will disappear from the end of 2007-08, the replacement capital gains tax regime, due to come in force on 6th April 2008, remains relatively attractive.
Business owners may prefer to invest capital in their businesses rather than pensions because, from 2008-09, their maximum rate of capital gains tax will only be 18%.
However, owners who choose to invest solely in their own business to provide for their retirement are generally taking a high-risk approach. This is because pensions and other investments are normally more diversified and more liquid than unquoted businesses.
Another potential problem for business owners is that it can be problematic to find suitable cash buyers, especially at a time to coincide with their planned retirement.
Individual savings accounts (ISAs)
The ISA can be considered as a viable, if limited, alternative to a pension. In tax terms the ISA is a mirror image of a pension but, whereas pensions benefit from tax relief on contributions, ISAs have the advantage of tax freedom on proceeds.
Also, during the investment period, both pensions and ISAs are broadly free of UK tax. An added benefit of ISAs is that they are much less restrictive in terms of how and when benefits may be drawn.
It has been suggested by experts that a wise approach is to invest in ISAs initially to gain maximum flexibility during the early and middle part of working life. Then, as retirement nears, the ISA funds could gradually be moved across into pensions, picking up tax relief en route.
The good performance of the equity and residential property markets since 1999 has led to the suggestion that building a portfolio of buy-to-let properties may be a better option than the traditional pension.
This is based on the assumption that assumes that the rental income can fund the purchase of the property or properties during the working lifetime, leaving the owner to enjoy the income in retirement.
An added bonus is that the interest on loans to buy and improve rented property is normally allowable for tax purposes against the rental income received.
The main residence is also a retirement plan for many people. The value of an individual’s home can be accessed in a number of ways, including various types of equity release, downsizing to a relatively cheaper property, or sub-letting. For example, a recent report by Standard Life illustrating the value of downsizing can be seen in Table 1.
Tax advantages of pensions
It is reasonable to say that changes in recent years have reduced the appeal of the pension route as a means of retirement planning. However, pensions still have several factors in their favour which makes them a favoured means of retirement provision.
For example, tax relief on pension contributions may be higher than tax paid on benefits. Higher rate taxpayers could receive 40% tax relief on their contributions, but only pay 20% tax on their pension from 2008-09, if taking retirement income within the basic rate tax band.
Also pension plans generally provide an element of tax-free cash, which improves their tax efficiency. Under the new simplified tax regime, all pension plans are now able to offer a tax-free cash lump sum of 25% of the fund.
Decisions at retirement
In conclusion, it can be seen that the choices a person makes at the point of retirement, when his or her earnings stop and he or she has to live on the income from pensions and investments, are generally crucial.
In many cases, especially in the pensions area, the decisions are highly complex, cannot be reversed and will have life-long consequences.
It can be seen from the above that pensions are not the only way to build up income for retirement. Although pensions are still probably the most tax efficient way of retirement provision for the majority of people, other investments are still worth consideration, many of which can provide a significant boost to providing income in retirement. This may enable individuals to maintain their preferred lifestyle, even after they have finished working.
Perhaps the best way to consider pension plans now is as just another investment wrapper to use in retirement planning, rather than the only way to build up retirement funds. Of course, the pros and cons of each option will depend on the investor’s attitudes and needs but all are worth thoughtful consideration.
Andrew Neale can be contacted at Allchurch Bailey Investment Consultants Ltd, Almswood House, 93 High Street, Evesham, WR11 4DU; telephone 01386 442597, e-mail email@example.com, website www.allchurchbailey.co.uk.