How Effective are the substitutes for Pensions?

When it comes to saving for retirement, pensions are no longer the only option to consider. The effectiveness of popular alternatives as potential substitutes is now being questioned. The reliability of traditional pensions has diminished in the eyes of the public due to factors such as the decline in pension values caused by investments in bonds that decrease in value when interest rates rise. Additionally, economic uncertainty has led savers to seek diversified options rather than relying solely on pensions.

ISAs instead of pensions?

Helen Morrissey, Head of Retirement Analysis at Hargreaves Lansdown, suggests that individual savings accounts (ISAs), lifetime ISAs (LISAs), and property have become attractive alternatives for savers.

ISAs provide flexibility, allowing individuals to withdraw income as needed, which can be beneficial for self-employed individuals who cannot access their pensions until they reach age 55. While ISAs do not offer upfront tax relief or employer contributions like pensions, the income earned from ISAs is tax-free, and individuals have the option to choose between cash or stocks and shares ISAs.

Or LISAs?

On the other hand, LISAs were specifically designed for young people saving for retirement or their first home. By saving up to £4,000 per year in a LISA, customers receive a 25% government bonus, similar to basic-rate tax relief on pensions.

This bonus can significantly impact the final savings amount. While there is no employer contribution for LISAs, they can serve as a useful supplement or alternative to traditional pensions, particularly for groups like the self-employed who do not receive employer contributions to their pensions.

It’s important to note that accessing funds from a LISA for any reason other than buying a first home or retirement results in a 25% penalty, which reduces both the bonus and personal savings. Additionally, LISAs can only be opened between the ages of 18 and 40, and the bonus on contributions is only available until age 50.

Property

Many individuals view property as an alternative to pensions, considering it as their retirement fund. However, Morrissey cautions that relying solely on property comes with important considerations.

Costs associated with buying and selling property, such as stamp duty, solicitors’ fees, and capital gains tax, can significantly impact the overall returns. Additionally, property prices can fluctuate, and a sluggish market can make it challenging to sell the property when needed, potentially disrupting retirement plans.

Other options

Another lesser-known option, the Venture Capital Trust (VCT), has gained significant interest recently, particularly among high earners seeking alternatives to traditional pensions. VCTs are listed investment companies that support small and medium-sized enterprises (SMEs).

They offer a 30% income tax relief on investments made and tax-exempt dividends, resembling certain aspects of pensions. However, VCTs are high-risk and often illiquid investments, so relying solely on them could potentially diminish retirement funds.

Tim Stovold, Head of Tax at Moore Kingston Smith, emphasises the importance of being aware of certain aspects of pension alternatives compared to traditional routes. Undrawn pensions can be passed on to beneficiaries without incurring inheritance tax (IHT) charges, which does not apply to ISAs or VCTs unless the ISA investments qualify for Business Property Relief.

Additionally, the tax regime for buy-to-let properties has made them less appealing as pension alternatives. Pensions remain highly tax-efficient due to upfront income tax relief, tax exemptions on income and gains within the pension scheme, the ability to withdraw a tax-free lump sum, and the potential to transfer undrawn pensions to the next generation free of IHT.

Morrissey agrees that pensions are a highly tax-efficient way to prepare for retirement, thanks to pension tax relief and employer contributions in workplace schemes. Pensions benefit from long-term investment growth, especially since the money cannot be accessed until the age of 55 (rising to 57 in 2028). While ISAs and property have their roles in retirement planning strategies, pensions typically form the core component.

Accountants play a crucial role in guiding individual clients in managing their retirement strategies. While they cannot provide investment advice due to regulations, they can help clients navigate alternatives by explaining upfront tax relief, taxation of investments leading up to retirement, taxation of pension income, and the application of IHT rules.

It’s important to consider political factors as well. If there is a change of government in 2024, the Labour Party has indicated potential reversals of recent pension rule changes.

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