Industry view PENSIONS VS ISAS Shifting dynamics
Tony Mudd suggests that the new pension reforms from April 2015 could herald a shift in the dynamics between ISAs and pensions
There is good evidence that UK investors have a strong affinity to ISAs, maybe even an emotional attachment. The same cannot be said about pensions, until, perhaps, the new pension freedoms become embedded in public consciousness. However, if you put these issues aside and ignore the greater complexities that exist in withdrawing funds from pensions, and instead look at the tax merits of both, the result is a significant shift in the dynamics between ISAs and pensions.
Taking these investment wrappers down to their base level, pensions are EET investments: contributions (E) are tax relievable, investment returns (E) are broadly tax exempt, and withdrawals (T) are taxable. ISAs on the other hand are TEE: contributions (T) are not tax relievable, returns (E) are tax exempt and withdrawals (E) are tax exempt.
While the profiles may be different, an EET investment, everything being equal, will produce the same net result as its mirror image, a TEE investment. This is easy to illustrate. A £10,000 pension contribution that doubles in value over a given period, less 20% tax, gives us £16,000. An £8,000 contribution into an ISA (after allowing for £2,000 tax), doubling in value will give us the same £16,000 figure. However, in practice, reality is a little more complex. The most notable issue is that the tax treatment on withdrawal is not purely T for pensions. It is actually 25% E and 75% T, which gives a very different result.
£20,000 less (75% of £20,000 x 20%) = £17,000. A 6.25% uplift.
Primarily, this is why when using a straightforward numeric comparison, pensions for investors over the age of 50 (assuming a five-year investment term) come out ahead of ISAs. This is magnified further for higher and additional rate tax payers (16.67% and 20.45% uplift respectively). To address the issue fully, it is appropriate to acknowledge a number of other factors that will influence the end net result and, ultimately, the decision of the investor. These include:
• Tax rates may differ between inception and withdrawal. In all likelihood, this will be a lower rate on the way out, which favours EET over TEE. However, the reverse will apply if tax rates are higher upon withdrawal; a position that may arise outside of the investor’s control, under changes in tax rates or bands, or pension rules.
• The calculations above entirely ignore the impact of National Insurance contributions. This could be a significant boost for pensions over ISAs, particularly if you factor in a salary sacrifice.
• Pensions are subject to timing constraints on withdrawals that do not apply to ISAs. At present, this is age 55, rising to age 57 in 2028. Contribution and value limits apply to pensions; a lifetime allowance of £1.25 million and annual contributions of £40,000 per annum. While there is no similar lifetime constraint on the value of an ISA, there are contribution limits of £15,000 per annum.
• Finally, when it comes to distribution on death, within limited constraints, withdrawals from pensions should be largely free from inheritance tax, while the same cannot be said for ISAs, unless the underlying investment is that of qualifying AIM shares and these have been held for a minimum of two years.
In an ideal world, clients would have both pensions and ISAs, but where a choice needs to be made, the case is no longer as clear cut.
Tony Mudd is Divisional Director, Development & Technical Consultancy, at St. James’s Place LIPPER LEADERS
An important classification
Jake Moeller uses the Lipper Leaders scoring system to analyse the best performing funds in the Investment Association UK Gilts sector
Of all the investment classifications, UK gilts are probably perceived by most investors as one of the least exciting and most vanilla of categories. However, while they may not form the basis of gripping dinner party conversation, they are a very important classification. This is especially true for investors who are approaching retirement and are looking at the possibility of taking an annuity from their pension pot.
The idea of investing in lower risk assets prior to retirement is a sound strategy, as it is important to reduce the risk that equities or corporate bonds can add to a portfolio. However, UK gilt funds are far from homogenous and there is considerable variability in this sector. In 2014, it was widely expected that a rising interest rate environment would eke into gilt fund returns. Many gilt managers reduced duration in their portfolios to protect against rising rates in what became known as the “pain trade”. This has not been the best strategy in a world where the rising interest rates did not come to pass, resulting in many active gilt funds having a difficult 12 months.
Top performing Investment Association UK Gilts Funds ranked over 3 years (with 5 year history)
3-year % 1-year % 3-month % Lipper Leader Lipper Leader Lipper Leader Lipper Leader growth to growth to growth to Consistent Expense Total Return Preservation end Jan 15 end Jan 15 end Jan 15 Return 5 Years 5 Years 5 Years
5 years
Newton Long Gilt Exempt 2 Gross GBP Acc
Schroder Inst Long Dated Sterling Bond I Acc
Henderson Institutional Long Dated Gilt A Net Inc
Vanguard UK Government Bond Index Acc
Invesco Gilt A Quart Dist GBP
Santander Sterling Government Bond
BCIF UK Gilts All Stocks Tracker L Acc
Scottish Widows UK Fixed Interest Tracker I Acc
Threadneedle UK Fixed Interest Retail Acc
25.48 24.92 AXA Sterling Long Gilt R Acc Net 20.14 18.90 14.15 12.56 12.05 11.53 11.15 11.04 21.65 22.31 20.74 19.65 12.43 12.23 11.44 11.28 11.15 10.87 3.95 3.73 3.60 3.52 2.05 2.15 1.93 1.75 2.18 2.04 4 3 3 3 2 2 4 2 4 4 2 4 4 3 3 3 2 2
This extreme can be seen in the best one-year performing fund in the sector (Vanguard Long Duration Gilt Index GBP), which returned 22.4% compared with the sector’s poorest performer over the same period - Royal London Short Duration Gilts Z Inc - which only returned 1.32%.
The key Lipper Leader (reflecting most investors’ rationale for investing in this sector) is the Preservation score, and a 4 or 5 rating over five years would be deemed the most preferable. After this, you would want to see a strong Consistent return - especially for active funds, as this would pick up potential wobbles over time by events such as the above-mentioned “pain trade”. While, for example, the Newton Long Gilt Exempt 2 Gross GBP Acc will have benefitted from its portfolio positioning over recent months, it has still proven itself over a longer time period.
Gilt funds should not be as expensive to run as equity funds, so a poor expense ratio should only be tolerated if the Total Return score is high.
Jake Moeller is Head of Lipper UK & Ireland Research 4 3 3 3
ilp
18
Investment Life & Pensions Moneyfacts
® March 2015
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