ISAs for Retirement Income
Investment Suitability
It has long been a principle of ours at Scottish Financial, that we should use anything suitable which is available, whether this is the standard solution or not.
Planning for retirement has usually been focussed on putting money into a pension plan of some sort, getting the tax relief going in, having some tax advantages within the investment, taking advantage of the tax saving on the 25% of the investment which can be taken as a lump sum, then buying an annuity, fixed for life, with the remainder of the fund.
It will be gathered from the fact that 25% of the fund is taken tax free, that everything else you take, for the rest of your life, is taxable at your highest rate.
Longevity
Now, that may have been all right when people typically only lived long enough to draw their pension for six or seven years of retirement. Is it not all right when our current pensioners are living to a healthy and extended old age, often into their eighties and beyond.
Advances in medical science, better living conditions, better nutrition, etc, could mean the current generation may live well into their nineties as a matter of course.
Investment Timescale
Now, living to a ripe old age is great, but consider the disastrous effect this has on our ability to save during our working lives, for these extended years of retirement, without a working income.
We usually think of the length of time money will remain invested, when we are considering the amount of risk of volatility, or investment risk, we can afford to expose the investment to.
So, a short term investment has to be absolutely safe, because we cannot afford to have to take the money out during an investment dip, so we go for cash, premium bonds, maybe gilts.
For medium term, we will perhaps choose UK income investments, cautious managed funds, distribution funds, maybe.
Then, for long term investments, we can afford to take the risk of weathering the ups and downs of the stock market. Stock markets are cyclical, that means they go up and down in cycles, the usual cycle for the UK being something like to five or six years, with the risk of it being less, or perhaps a little longer.
One thing we are absolutely sure of, stock markets will go down, they always do, we just don't know when it will happen, by how much, and how long they take to recover, or by how much.
We can use all sorts of prediction methods, nowadays very sophisticated software, to predict what the stock market will do, but the fact is, we can't.
Every predictable event which could make the stock market go down, has already been factored in to prices before we arrive at the event, so the risk when it actually happens is very small, or sometimes it means the market even goes up a little, when the risk has passed.
This could be a change of Government, interest rate rises, or anything which means money will flow in or out of stocks and shares.
So, if all the predictable events can be allowed for, we are only left with unexpected events, an earthquake, a political scandal, some sort of hostilities, we know these things can happen, but we have little idea when and where it will be.
Investing for the Long Term
So, how can we invest for the long term, if we have no way of knowing what is going to happen? Well, we do know some things with an acceptable degree of confidence, from history, research, etc. One of these is, in the long term, the stock market has always gone up, it just fluctuates a little, or a lot, on the way.
The second is, if you try to outguess the market by timing investments, there is more chance of getting it wrong than getting it right. One of the reasons for this is that the stock market usually drops faster than it rises, so if you miss any given day you are more likely to miss a day in which the market goes up, than a day on which it goes down.
Now, you could say that if you can be out of the market on those days when it goes down, you are likely to avoid more of a loss than you would make up in gains on a days when it rises. However, thinking back to predictability, that is just not going to happen is it, you will be more likely to get it wrong.
So, investing for the long term, and staying invested, is likely to produce better results, statistically at least.
Retirement ISAs
So, we want a long term investment, with some tax advantages, with a wide range of options for investment, a good range of funds available, the ability to switch between funds, while still remaining inside the tax advantaged wrapper, and flexibility both of the amounts you can invest, stopping and starting, monthly savings and lump sums, then finally, the facility to take regular withdrawals and lump sums at any time they are required.
The ISA is the obvious choice for long term retirement savings, however......
Pensions
However, indeed, have we even considered pensions? We have, and they are an option, and the best option in some circumstances, but not always, by any means.
Pensions are really good when employers pay into them, and must be considered as one of the safer options for retirement funds. However, ISAs can be invested in most of the funds you can choose for pensions, and usually a lot more besides, so, we are not choosing pensions for their investment choice or flexibility.
The main reason we have chosen pensions historically has been to take advantage of the tax reliefs available on the contributions to the pension plan. These can be strange, too, a person with no taxable income can get tax relief on contributions, take a quarter of the fund as tax free cash, then maybe draw a tax free income from the fund if they are still a non-taxpayer in retirement.
Is that a good idea? Well, yes, apart from the obvious flaw that a person without taxable income cannot often afford to contribute to a pension scheme, so, it is only those with capital who can do it, by putting their money into the pension scheme to get the tax relief.
There is a downside, though, the three-quarters of the capital you are giving up, which has to buy an annuity, the proceeds of which are potentially taxable, and there is the possibly of not living long enough to get it back in income.
Higher rate taxpayers can also benefit, if they may be basic rate taxpayers in retirement, although the reverse is also true, someone paying into a pension for a number of years may get tax relief at the basic rate, then in the later stages of their career, they do well, and are still a higher rate taxpayer in retirement, so they pay a higher rate of tax on the proceeds of the pension than they have enjoyed on the contributions, which is not so good.
The Answer
The answer was in fact provided by the Government when they carried out a major review of pensions, although perhaps they didn't quite intend it. The main disadvantage of pensions is that it is very difficult to tell when we start saving for retirement when we are in our twenties, how our career will go, what tax rates will be, how long we will live, what health we will enjoy, etc.
Now we can defer decisions about these factors for many years, decades even. But will we lose tax relief, or the ability to fund our pension? This is where the Government's review changed the whole of pension and retirement planning for the better.
It is now possible to save in ISAs for many years and defer any decision about making pension contributions until we have better information about our career progress, health, family circumstances, etc, without losing the ability to fund a pension later if we choose to, and importantly, without losing the tax relief.
The reason for this is the very much increased levels of contributions permitted by the new regulations. This means we can start in our twenties, save during our thirties, forties, then maybe fifteen years before retirement, consider whether we have an enough information to predict the next forty or fifty years, which is much easier than trying to predict our whole lives when we are just starting out.
So, what we can do is save over the years in ISAs, we can call them Retirement ISAs, to keep them separate from other savings, then later, we can decide whether we want to put the money into pensions.
By that time we may even be able to leave these savings intact and put other money into a pension, from an inheritance, perhaps,or a particularly good year of business.
Retirement ISAs
Individual Savings Accounts must be considered as part of one's overall retirement planning strategy.
Continued in ISAs in retirement
