FOOL SCHOOL
Pensions vs. ISAs

December 10, 2004

Just because you've got to save for your retirement, it doesn't mean that you should automatically get a pension. There's more than one way to skin a cat and ISAs provide a useful alternative.

The big difference between the two methods is when you get your tax benefit. With a pension, you make contributions out of your pre-tax earnings, but get taxed on the income when you draw your pension. With an ISA, you contribute out of your post-tax earnings, but get tax benefits on any income that you take from it.

All things being equal, this amounts to the same thing. For example, look at the position for a higher rate taxpayer who earns £100 gross (that is, £60 after tax), saves it and gets 9% growth for three years before drawing income at a rate of 5%. Each year's income will be the same, for the ISA and the pension:

As ever though, this position is confused by a number of factors. First of all, you're able to take part of your pension pot (usually up to 25%) as a tax-free lump sum.

Secondly, the above example assumes that you will pay the same rate of tax in retirement as you do during your working life. In most cases, your income (and therefore tax rate) in retirement is likely to be lower. So, if you are a higher rate taxpayer now but expect to be a basic rate taxpayer in retirement, the pension route has a slight tax advantage.

Other benefits of saving via the pensions route are that, if you lost your job, you'd have to use up most of your non-pension savings before you qualified for any welfare benefits. Similarly any pension that you have will be protected if you are made bankrupt. The last main benefit of pensions is that the contribution limits are much higher than for ISAs. If you are already making full ISA contributions, the tax benefits of pensions become much more obvious.

Traditionally, the biggest problem with pensions has probably been their high charging structure. Generally, financial service companies don't miss an opportunity to muddy the waters on charges and this means that, traditionally at least, the charges on pensions have been a good deal higher than those on a cheap, transparent ISA. The good news is that the appearance of stakeholder pensions has done a great deal to solve this problem, and pension charges are now lower than they used to be.

So, arguably the main problem with the pension route now is its inflexibility. Once money has gone in, it can't come out until you reach 50 years of age (and the new pension legislation, which takes effect from 2006, will see this age limit gradually increased to 55). Most of the fund then has to be used to buy an annuity, which provides you with annual income for life, but is taxable (although the new pension legislation will change this a bit, giving you slightly more options).

Once you have taken out an annuity, you can't pass your pension fund onto your heirs. However, had you saved in ISAs, whatever remained upon your death could be passed on. Of course, this has its drawbacks too. If you spend your money too quickly, your ISA retirement fund could expire before you do!

All in all, there are as many different arguments about the pros and cons of pensions over ISAs as there are different types of pensions and ISAs. The important thing to take on board is that the decision, either way, is generally not clear-cut. If someone tries to tell you that a pension is unambiguously a good idea, then there is a fair chance that they have an expensive pension to sell you.

Whichever way you choose to go, don't forget the normal principles of Foolishness. Remember to avoid high charges as, over the long term, these will have a very significant and negative impact on your investment performance. Remember also that when you are saving for the long term, the returns from shares are almost invariably superior to the returns from other types of investment.

> Find out more about pensions here.