Personal Finance - Building a suitable nest egg.
Anyone who has spent more than a few minutes looking at the issue of retirement planning will recognise the sense of shock that follows the realisation of how little we are likely to receive when we finally stop work.
The government’s ‘big idea’ or at least a significant element of its strategy when it comes to retirement planning, is the stakeholder pension.
New Labour has proved reluctantly to increase the basic state pension and has a top-up ‘minimum income guarantee’, together with a proposed second state pension to replace the current state earnings-related scheme.
Stakeholder pensions, meanwhile, are aimed at those of us who want to save for our retirement.
The advantages of stakeholder schemes as a potential savings vehicle have been much chronicled, particularly the facility allowing parents to set up pensions for children as soon as they are born. The fact that non-working spouses can contribute up to #3,600 into a stakeholder scheme has also been well publicised.
But there is an additional advantage to stakeholder pensions, which, until now, has received remarkably little publicity: their capacity to generate high levels of retirement income almost instantly.
Tom McPhail, pensions director at Torquil Clark, a firm of independent financial advisers in Wolverhampton, explains: ‘You are not allowed to contribute to a stakeholder scheme if you have earnings over #30,000 and are already a member of a final-salary pension scheme.
‘On the other hand, there is a loophole allowing employees who earn more than #30,000 to set up a stakeholder scheme if they have an additional source of income. Even a paper round, or a single payment for a sperm donation, qualifies you to pay an extra #3,600 into a stakeholder scheme, with the attendant tax benefits.’
Depending on your taxable income, the amount you contribute attracts generous tax relief. For higher-rate taxpayers, the total cost of a #3,600 contribution is #2,160 (22% relief is automatically granted and you have to claim back the rest from the Inland Revenue).
For a lower-rate taxpayer, the effective contribution is #2,808.
Because government rules stipulate that stakeholders must be totally flexible, it is possible to cash the contribution in immediately to buy an annuity – without penalty. Although not many companies offer annuities for such small lump sums, a few of them do, including Standard Life.
Annuities have come under sustained criticism in the past few years.
Annuity rates are falling, while the fact that the lump sum used to buy them can no longer be passed on to dependents after death is considered unfair, especially if a person taking one out only lives for a few years afterwards.
What are the advantages, therefore, of investing #3,600 and buying an annuity straight away?
According to the FTyourmoney.com annuity calculator, a male aged 60 could buy an annuity worth about #310 a year (without inflation-proofing, spouse’s pension or guaranteed payments for five years after the annuitant’s death) with that #3,600 lump sum. A female of the same age would receive #280 (women’s pensions are lower because they generally live longer).
Alternatively, you are allowed to take back 25% of the pension pot as a tax-free lump sum. In this instance, it would equate to that proportion of the original lump sum investment, or #900.
Based on the original #3,600 investment, you keep #900 and invest the remaining #2,700. Again, according to our calculator, this would buy an income of about #230 – based on no inflation-proofing, as above. A woman would receive around #210.
For a higher-rate taxpayer, it means that the contribution needed to generate #230 a year is just #1,260 (#2,160 after tax relief, minus #900 lump sum), an equivalent gross rate of return of more than 20%.
For a lower-rate taxpayer, that #230/#210 annual pension comes at a cost of #1,908 (tax relief is not as generous), a gross rate of return of about 12 to 14%. Repeating a similar tactic once a year for several years in a row could ensure a mounting level of income for a relatively small outlay.
The idea is not new, of course: it was always possible to use personal pensions in a similar way. The difficulty with old-style personal pensions lies both in the greater restrictions over contribution levels and their inflexibility relative to penalty-free stakeholder equivalents.
Are there any catches to this strategy? McPhail says: ‘Of course, you have to take into account that any income paid to you may be taxed. But after the age of 65 you will benefit from slightly higher age-related tax relief, which means you can earn #5,990 before paying any tax and then you pay 10% on the next #1,880 of taxable income.
‘You also have to accept that once you have bought the annuity you are handing over that money permanently and there is nothing to pass on to your estate. However, you can still include inflation-proofing to the annuity, plus a spouse’s pension and a guaranteed payout to a dependant for five years after your death, if required – although the annual income paid out would be lower. So the money is not completely lost after death even when an annuity is bought.’
Theoretically, it is possible to opt for an income drawdown option, which allows you to take a small lump sum each year while leaving the rest of your money invested. You would have to cash in the rest of the lump sum at age 75 (under current pension rules).
McPhail adds: ‘The snag is that there are no pension providers currently offering a drawdown option for lump sums as small as #2,700, even if they were to be repeated annually. But it wouldn’t surprise me if, assuming there is enough demand for it, someone doesn’t enter the market.’
By the way, if you do believe annuities are an effective way to ensure retirement income, it makes sense to take the #900 tax-free lump sum and use it to buy an annuity afterwards, because rates are slightly higher than compulsory annuities.
Nic Cicutti is editor at www.FTyourmoney.com, the Financial Times’ personal finance website.