Alternative Pensions: Regularly top up the tank to fuel a healthy retirement

MORE people are considering alternatives to pensions as tinkering with tax relief, the demise of final salary schemes and cuts to public sector schemes drives demand for other ways of saving for retirement.

While many of those who piled into bricks and mortar during the housing market boom as a substitute for a pension have since realised the error of their ways, more and more savers are questioning whether a pension remains the best vehicle for retirement savings.

So, how do pensions stack up against other vehicles through which to save for retirement, such as stocks and shares, individual savings accounts (Isas) and buy-to-let property? Here we compare and contrast the various options.

RETIREMENT VEHICLES

Pensions have endured a string of legislative changes in recent years, stoking a growing negative public perception of their benefits.

On the downside, they tie your money up until at least age 55, but they remain the most “fuel efficient” of retirement savings vehicles: in other words, the more efficient the vehicle, the less fuel it needs to reach the same destination.

A basic-rate taxpayer will find that a pension is slightly more fuel efficient than an Isa, and both are more efficient than a general savings account, due to the higher levels of tax relief available.

A higher-rate taxpayer will find a pension markedly more efficient than an Isa, because they receive tax relief of up to 50 per cent on pension contributions (for people earning £150,000 or more), while Isa savers simply shelter capital gains.

There’s also the ability to put more fuel into a pension. From the start of the current tax year, every taxpayer has been able to stash up to £50,000 a year, with tax relief at their highest marginal rate, into a pension, compared with £255,000 previously. Any unused £50,000-a-year allowance over the past three years can be carried forward.

The Isa allowance, meanwhile, was raised at the start of the current tax year on 6 April, but only from £10,200 to £10,680 a year. It is set to go up to £11,280 a year next April, provided the government rubber-stamps the increase, which is in line with the September rate of inflation.

TYPES OF FUEL

Having selected one or, more likely, a combination of retirement savings vehicles, how do you then identify those investments that will gather their own momentum, so that as you approach retirement, you are almost coasting, requiring comparatively low fuel input?

Let us turn to independently-researched data to establish long-term compound return characteristics of various asset classes.

The Barclays Capital Equity Gilt Study 2011 shows that over the past 11 decades – covering the period from 1900 to 2010 – real returns (adjusted for inflation) on equities were, on average, 5.1 per cent – 3.9 per cent higher than those on gilts.

Interestingly, in the decade that ended in 2010, returns from bonds were 2.4 per cent, 1.8 per cent higher than those on equities. However, that has happened in just three out of the past 11 decades.

Over the longer term, shares have given the strongest performance, followed by bonds, then cash. In the past 50 years, these asset classes have returned an annualised 5.4 per cent, 2.5 per cent and 1.7 per cent respectively.

What about property? Again, equities win. The Halifax Scottish residential house price index shows an annualised 5.4 per cent gain in the years 1982-2010. This figure excludes rental income and is not adjusted for inflation. Comparable equity returns in the same period were 9.29 per cent a year.

Of course, some retirement savers choose to own buy-to-let property – a sound strategy provided this is just part of your overall plan. Rent should be used to pay down a significant part of the mortgage before you consider saving up a deposit to buy another property.

FREE RIDE

Retirement savers often agonise over which assets to purchase. In reality, simply converting fuel each month into assets – be that fixed interest, a property investment fund or equities – will inevitably be a superior strategy to holding cash and trying to time markets.

You could buy into these three classes in equal weightings for the rest of your working life and, in doing so, get a free ride from three phenomena: pound cost averaging, compounding and rebalancing.

Regularly drip-feeding money into markets – what is known as pound-cost averaging – means you buy in at different times and, thereby, mitigate risk.

Compounding refers to making returns on returns. The re-investment of income is one of the most important determinants of returns over time.

If you invested £100 in the UK stock market in 1899, it would have grown to £180 in real terms without the reinvestment of dividends, but a mammoth £24,133 with reinvestment, according to the Barclays Capital study.

Meanwhile, rebalancing your portfolio, say, once per year, to ensure your mix of assets remains in line with your risk profile and investment timescale will mean you will automatically achieve what most investors do not – to sell high and buy low.

FUELLING DISCIPLINE

Even primary school children know that a vehicle without fuel will not go very far. A pension or an Isa vehicle which is low on fuel and not being topped up on a regular basis will never build the momentum to get to its destination – a future point in time called “financial independence”.

When you reach this, you’ll have converted a lifetime’s fuel into a collection of investments so that you can give up work and live the rest of your life without being in danger of running out of money.

Many in my generation – the baby boomers – talked of having a good pension. What they meant was that their pension administrators had a good discipline, taking sufficient contributions from employee and employer each month, in good markets and bad, so that someone working their entire life for the same company would be able to retire on, say, two-thirds of final salary.

Few people these days are lucky enough to be in a final salary pension scheme, but this remains a disciplined, fail-safe approach from which we can all learn. These schemes did not have superior investment strategies, but they had superior fuelling strategies.

So, how much fuel will your retirement vehicle consume before you can give up work?

As a rule of thumb, someone in their 20s setting aside 10 per cent of net income every month for the rest of their working lives would be able to accumulate sufficient funds to retire on two-thirds of their final salary.

Irrespective of which retirement savings vehicle or type of fuel you plump for, it is this fuelling or savings discipline that will get you to your destination safely.

• Sandy Robertson is a certified financial planner and managing director of Acumen Financial Planning