Savers wanting to put money aside for their retirement, and wondering whether they can get a better deal by saving within a pension scheme or by putting their money in a more flexible individual savings account (ISA), now have the answer, after some number-crunching by independent financial advisers Hargreaves Lansdown.

If somebody receives an employer’s contribution towards their pension plan, the advantages of a using a pension plan for retirement funds are clear, because of the uplift the extra cash gives.

However, those who don’t receive an employer’s contribution have in the past often been prepared to sacrifice tax relief on contributions, which a pension plan offers, in exchange for an ISA’s tax-free returns, freedom to spend the money how they please and a greater possibility of leaving any unspent cash to their heirs. Pension savers in schemes other than a company final salary plan are eventually forced to buy an annuity, which gives an income for life but dies when they do.

The good news is that, with the advent of reforms to personal tax allowances announced earlier this year, the advantages of saving in a pension plan have become more pronounced. Under new rules due to be introduced in 2011, which give those at retirement age a huge boost to the amount of income they can receive before paying tax, most savers would be better off saving within a pension scheme than outside one.

Even in cases where there is not much difference between the annual income provided by a pension after tax and that generated by a tax-free ISA, the pension still has the edge, because of the additional longevity hedge that it gives. The annuity guarantees an income for life, but ISA savings could run out.

The Hargreaves Lansdown research runs a series of scenarios using data that includes the basic state pension and the state second pension, on the basis of assumptions extrapolated from announcements already made by the Department of Pensions, and projected forward.

It takes examples of investors at different ages and projects them forward to their actuarial death date. For instance, a man who is aged 65 now is expected to live for another 19.7 years, according to the Government Actuary’s Department. The research uses these figures to calculate likely returns from a pension scheme, and then uses exactly the same time span to compare returns from ISA savings.

ISA money runs out 

According to the scenarios, the annuitant is “expected” to die at the end of the timeframe, but if he survives, the annuity continues to be paid until he does die. The ISA saver’s money has run out completely.

The longevity assumptions in the research are current figures used by actuaries. However, the Office for National Statistics expects longevity to increase, and projects that the number of centenarians will continue to grow by about 6 per cent a year, and that there will be 40,000 of them by mid-2031. There are already 1.2 million people over the age of 85 in the UK, and centenarians are the fastest-growing sector of the population.

Tom McPhail, head of pensions research at Hargreaves Lansdown, who produced the figures, says: “In only one scenario  - where the investor receives 22 per cent tax relief on a £1,000 contribution and pays 20% tax on all the emerging benefits from the pension - is the financial return from the ISA up to the point of life expectancy significantly better than the pension, and then by less than 6 per cent. Even one extra year of life would negate this advantage.”

Those who do best are working husbands with non-working wives, who will find the most advantageous option is to top up their wife’s pension fund to the maximum allowed for non-earners. The scenario shows that, in order to generate nearly £20,000 of tax-free income for the couple, the pension saver needs to make a considerably smaller outlay than somebody saving in an ISA.

By the 2011/2012 tax year a pensioner over the age of 65 will have a personal allowance of £9,770, while an over-75 will have an allowance of £10,000.

A non-earning or low-earning spouse would, therefore, be unlikely to use up all of her tax allowance. This means that a 40-year-old basic-rate taxpayer saving £250 a month could be £1,000 a year better off in retirement by investing the money in their non-earning spouse’s name, to make the most of the joint tax allowance.

Opportunity for couples 

McPhail says:  “The rapid increase in the personal allowance has created a significant financial opportunity for couples. The combined value of their personal allowances from 2011 will be enough to lift many pensioner couples out of the income tax system altogether. The important step is to anticipate the future distribution of retirement savings within a couple, and to ensure that they are as evenly shared as possible.

“For many investors, a little forward planning now can make income tax in retirement a voluntary system, from which it should be possible to opt out. Almost irrespective of personal circumstances, pensions are the most effective way to save for retirement income.”

The argument against pension savings has been “inheritability” – that once a pension saver has purchased an annuity his funds are locked up and die with him. McPhail says, however, that pensions provide the best form of inheritabilty up to the point of annuity purchase. The pension fund is outside the saver’s estate, so it is free of inheritance tax, and once the age of 55 is reached, 25 per cent can be extracted as tax-free cash.

ISAs are most suitable for people who already have a bedrock of pension saving, such as through a company scheme, or a fund from previous employment. Their flexibility is also their drawback: money can be extracted, thereby leaving inadequate savings for retirement.

McPhail adds: “ISAs work best for investors who can tolerate fluctuating income and capital values, and who are already building a secure pension income for retirement.”

Case study

John Wraight, 55, from Whitstable in Kent, is a general manager in the UK for Sanrio, the company that markets Hello Kitty products, where he has worked for 16 years. His company does not make employer contributions, so he has organised his own self-invested personal pension (SIPP) [with Hargreaves Lansdown] and chooses his funds himself.

He says: “I organised my own pension because of the tax benefits pension savings offer, and because I can have control, which I believe his important.”

He also has a small final-salary pension entitlement from his previous employment at Pedigree, where he was responsible for the Sindy doll brand.

Mr Wraight’s wife, Jackie, aged 53, a former teacher, has a small teacher’s pension entitlement, and also has a Standard Life stakeholder pension.

The couple, who have three grown-up children, plan to take annuities as late as possible. “I don’t want to retire,” says Mr Wraight. “If I need my pension money, I will use drawdown as long as possible, until I am forced to take an annuity.”

In the light of the current figures, the couple will now be looking at how they can maximise their income in retirement by topping up Mrs Wraight’s pension fund.

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