Stop using a pension to save for retirement!

Many of you hate pensions, but are savings accounts or cash ISAs a sensible alternative for financing your retirement?

I can understand why you might not trust a pension company to look after your money.

After all, the pensions industry has let ordinary people down numerous times. 

Some of you may prefer the relative safety and transparency of savings accounts or cash ISAs.

But are they really a suitable way to prepare for your retirement?

Let’s get right into some calculations which compare the different strategies. The figures below have been based on these assumptions:

• You’re 30 now and you intend to retire at 68. You’ll survive for 17 years in retirement until you reach 85. You’re a basic rate taxpayer before and after retirement. 
• You pay £120 a month into your pension, which will rise to £150 with 20% tax relief. Your pension grows at 7% pa with 1% deducted in annual charges.
• Alternatively, you pay £120 a month into your savings pot or cash ISA (with no extra contribution from the taxman). Your savings pot grows at 5% pa gross or 4% net, while your cash ISA grows at 5%.
• Your pension, savings and ISA contributions increase by 2.5% pa to keep pace with inflation. Final values are shown in ‘today’s money’, which takes inflation into account at 2.5% pa.

Recent question on this topic

• hammer asks:

  I am contributing £110 per month in order to receive a monthly pension of £123. Am I stupid? Should I save in an ISA instead?

  • 
    SoftwareBear answered "How old are you now ? What age does this plan say you will retire ?..."
  • 
    hammer answered "I am 58 and retire in 8 years...."
  • Read more answers

Pension strategy

After 38 years of investing, your pension pot could be worth £131,989 at retirement. Assuming an annuity rate of 7%, you could receive a fixed income from an annuity of £9,239 a year or £770 a month. Remember, an annuity converts your pension lump sum into a guaranteed income for life.

Don’t forget this amount is taxable at a rate of 20%, giving you a net income of £7,391 pa or £616 a month.

Note for simplicity no tax-free cash is taken from the fund. The entire amount is used to generate an income. In practice, however, it would most likely be beneficial to take the maximum tax-free lump sum permitted of 25%.

Savings strategy

Alternatively, using a savings pot instead of a pension, could generate £69,938 by the time you reach 68.

If you had gone down the pension route, your pot would cease to grow as soon as you bought an annuity. But with this strategy, your savings remain in place, and keep earning interest as you draw an income during your retirement.

For the next 17 years, you could take an income of £5,676 a year after tax or £473 a month. But, by the time you reach 85, your savings will have totally depleted to £0.

The results

All this means you could take a total payout from your annuity of £125,647 (£7,391 pa x 17) after tax over 17 years. Of course, you would get even more if you lived beyond 85. But the total income you could draw from your savings pot would be far less at £96,492 (£5,676 x 17).

In this example, you would be £29,155 better off by choosing a pension over a savings account.

• Take a look at our Prepare for your twilight years video.

Would a cash ISA beat a pension?

These results are fairly obvious given that the pension is growing faster than a typical savings account and you have the benefit of tax-relief on a pension, which you don't get with a savings account. 

This begs the question: would saving into a tax-free cash ISA beat saving into pension?

According to my calculations, if you pay in £120 per month without tax relief for the next 38 years, your cash ISA could be worth the equivalent of £86,555 in today’s money in 2048.

Remember your ISA continues to grow at a rate of 5% tax-free throughout. That means, for the next 17 years, you could draw an income of £7,572 a year tax-free or £631 a month so that your pot runs out by 85. This equates to a total income of £128,724 (£7,572 x 17).

This time, you would actually be £3,077 better off using a cash ISA over a pension.

Bear in mind the cash ISA is growing at a slower rate than the pension and there’s no tax relief on contributions resulting in a lower final value at retirement. But, despite these drawbacks, the continued growth earned throughout your retirement, plus the tax-free income once you start drawing from the fund, has given your ISA the edge.

However, there is one important exception to this rule if you're a higher rate taxpayer. Remember that higher-rate taxpayers get twice as much tax relief on their pension contributions as basic-rate taxpayers, and so their pension pots will grow much faster. This means that, if you're a higher-rate taxpayer, you will be better off saving into a pension than a cash ISA (assuming that you become a basic-rate taxpayer in retirement).

Pensions versus savings: factors to consider

Of course, it's not all about hypothetical calculations. In these examples, we have seen that cash ISAs can beat pensions and savings accounts as a more effective strategy for financing your retirement. But you should also think about these factors:

Growth rates

I have used standard growth rates which may, or may, not be realistic going forward. In the worst case, your pension growth could be negative. Or, if it’s invested particularly well, it could grow at a much faster pace than 7% pa.

On the other hand, the return from cash will never be less than 0% minus the inflation rate, but it’s unlikely to produce returns above 5% pa over the long-term. This means a pension which produces strong growth could easily outstrip cash savings.

Investment risk

To achieve a return of 7% pa or more, your pension will have to be invested in equities which involve a degree investment risk. This isn’t an issue with savings accounts or cash ISAs.

Income guarantees

The income paid from your annuity is guaranteed for as long as you need it, and can be fixed at the same level each year if required. Even if you live to 100, it will still pay out. But, if you use cash savings to fund your retirement, you’ll have to create your own income schedule. If interest rates drop - or you survive way beyond average life expectancy - there's a risk you may be left with a shortfall where your savings or ISA pot depletes to zero too early.

Annuity rates

If annuity rates deteriorate by the time you come to retire, you could be left with far less income from your pension than the example illustrates. Annuity income is inflexible, but you have the right to vary the income taken from your savings as required.

Early death

Finally, y?our annuity will stop on death. If you don’t survive for long after retiring, you could lose a substantial part of your pension’s value to the annuity company. However, any cash left in savings can be passed onto your family ?f?a?r? more easily.?

The figures: a summary

Compare savings accounts and ISAs at lovemoney.com

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