The near-abolition of tax on savings income was one of George Osborne’s less-noticed legacies. A shareholder can now receive £5,000 of dividends and £11,100 of capital gains tax free, together with £500 or £1,000 of other investment income. These exemptions take an investment portfolio of up to £200,000 or so out of tax completely. And with the annual limit on Isa contributions rising next year to £20,000, a couple able to make the maximum investment can expect to build up over 20 years a tax-exempt retirement fund of well over £1 million.
Given the flexibility of Isas — you can access your money at any time — that vehicle should be the first home for most people’s savings. And that outcome is what Osborne (who every year imposed further restrictions on pension tax relief) plainly intended. But some reluctant savers may find the easy access available through an Isa an undesirable temptation rather than an advantage, while the tax breaks available on a Self-Invested Personal Pension (Sipp) mean that such vehicles still deserve consideration.
Isas are straightforwardly free of tax on income, capital gains and withdrawals, whereas a Sipp gives tax relief on what you pay in but taxes you on what you take out. A higher-rate taxpayer might therefore get relief at 40 per cent on contributions but be taxed only at the basic rate of 20 per cent on his or her pension, since income is likely to be lower in retirement. A further concession allows you to take 25 per cent of your accumulated Sipp fund tax-free. You need not actually retire to begin withdrawals, which are now freely permitted after the age of 55.
So although a Sipp is no longer as essential an element in retirement provision as before, it retains many attractions. And although the £1 million you might accumulate in an Isa may seem a lot, at current interest rates even £1 million may not be enough for a comfortable retirement.
Any retirement plan today has to come to terms with the reality of unprecedentedly low interest rates. If you stored nuts during 25 years of saving to consume during 25 years of retirement, you would need to put half your nuts aside every year to maintain your standard of living. Suppose, instead of storing nuts, you were able to earn 1 per cent in long–dated government bonds: that is what’s on offer today. Although the proportion of your income you would need to save falls slightly, it is still more than 40 per cent. This hopeless situation has been created by the monetary policies adopted since the global financial crisis. The collateral damage to long-term pension planning is incalculable.
The derisory returns on bonds mean that you can only hope to save for a comfortable retirement if you invest in what are generally regarded as risky assets: shares and property. The security of bonds, always exaggerated, is today illusory. To characterise bonds as ‘safe’ in present conditions rests on two confusions. Security is not the same as certainty: the man who knows he will be hanged tomorrow has certainty but not security, just as someone who today entrusts long-term savings to bonds achieves only the assurance of a low future standard of living. And risk is not the same as short-term volatility; while shares often rise and fall, on past experience the premium you earn for accepting that risk has averaged 3 per cent or more. If that historic premium is maintained, the probability that over 20 years you will earn more in bonds than in real assets is vanishingly small.
Even at the point of retirement, current bonds are unattractive. You don’t know how long you will live; but if you do not live to a ripe old age, volatility in the value of your portfolio does not matter much. And if you do live for more than the 20-25 years most people hope to enjoy after retirement, the only way you can provide for future care needs is to earn the best return on your assets in the meantime. So almost any Sipp portfolio should focus on shares and property.
The ‘S’ in Sipp stands for self-invested and you should take that very seriously. Paying someone to manage investments within your Sipp may well cost you 2 per cent per year, when platform fees, fund charges, and trading costs are taken into account. Over time, such a loss compounds to dramatic effect. If you earn 5 per cent per annum on your investments, £1,000 becomes £3,400 in 25 years. If charges reduce this return to 3 per cent, you accumulate only £2,100. The lowest-risk way to improve your returns on investment is to pay less in fees and charges. Several providers will operate your Sipp for a single low annual charge. If you then use exchange traded funds (ETFs) or low-cost index trackers, the total costs should be less than 0.5 per cent per year.
Which funds to buy? The policies that have made bonds untenable for retirement savings have also driven up other asset prices, so there are few bargains. But regular saving for retirement benefits from ‘pound cost averaging’. If you save £100 per month, market volatility is your friend; you buy more shares when prices are low and fewer when prices are high, so the average price you pay is lower than the average around which the market fluctuates. Of course you would do better still to buy only when prices are low, but you don’t know when that is — and nor does anyone else.
Regular saving allows you to avoid making judgments on market timing, but you cannot avoid making decisions on how much to invest in different asset types. One simple way to determine asset allocation is to mimic the decisions of leading global investors with long time horizons — funds such as NBIM, which manages Norway’s oil wealth, or Calpers, which provides pensions for California’s public employees. Closer to home, the Wellcome Trust, which funds scientific research, is by some distance Britain’s largest endowment. All such organisations and occupational pension schemes provide breakdowns of their holdings, and following them offers you a free ride on the results of the best and most costly advice available.
If you took the average of the practice of these institutions, you might find yourself aiming for a portfolio of 60 per cent global equities, 30 per cent global bonds and 10 per cent property. Three trackers or ETFs would enable you to replicate that asset allocation — and enjoy, at low cost, an outcome which is unlikely to be much worse than that experienced by the biggest investment funds in the world.
But perhaps you can do better still. You don’t need to make that allocation to bonds, which will yield almost no return. Indeed another reason for taking matters into your own hands is to avoid the commitment to bonds which an investment manager would almost certainly make on your behalf. Regulation may even require the plan manager to implement such an allocation. Relative to bonds, property offers a higher yield and prospects of long-term capital appreciation. And within that category there is considerable diversity; America’s largest real-estate investment trusts (REITs) include companies that own not only shops, factories and offices but also care homes, storage lockers and mobile phone masts.
Diversification — holding assets whose returns are independent of each other, not holding a large number of stocks which are likely to perform similarly — is the best way to reduce risk without compromising return. Try to be contrarian: the conventional wisdom, the product of the herd behaviour prevalent in financial markets, is ‘in the price’. The momentum of the crowd often drives prices in the short term. But mean reversion — the tendency of prices to return to fundamental values — will always reassert itself over the lengthy time horizon relevant to a Sipp investor. And discipline yourself to think probabilities; there are no certainties in the investment world and the search for them is expensive and fruitless.
Top Sipp Providers
AJ Bell YouInvest
Top Sources of Sipp
(0300 123 1047)
*Named ‘Best Sipp Provider’ by What Investment magazine for the past 10 years