May 032014

The proposed changes to UK pension rules announced in the March 2014 Budget will make Self-Invested Personal Pensions (SIPPs) far more flexible. From April 2015, investors should be able to withdraw as much of their SIPP fund as they want immediately on retirement.

Since the choice between a SIPP and an Individual Savings Account (ISA) is a trade off between flexibility and tax relief, many investors will feel that this tips the balance in favour of SIPPs. But while the changes are welcome, I think it makes less difference than you’d expect.

Unlike some finance writers that I generally agree with (this piece on Monevator, for example), I think that the practical advantages of SIPPs over ISAs are easy to overstate. To see why, let’s look at how much the added tax relief from a SIPP is really worth for the average investor.

How much do you gain from a SIPP?

I’m going to assume that you already know how ISAs and SIPPs work. If not, there’s a summary at the foot of this post.

The table below shows the net gain from investing in a SIPP depending on your tax rate when saving (down the side) and drawing an income (across the top). It assumes that the full 25% tax free lump sum is taken on retirement and all income is taxed at your marginal tax rate.

Tax in retirement (top)
Tax while saving (down)0%20%40%45%

As you can see, the added value of the SIPP varies greatly. If you contribute while paying tax at 40%, but switch to being a basic-rate taxpayer in retirement, the gain on your original contribution is more than 40%.

But if you pay basic-rate tax while contributing and after retirement, you get a smaller uplift of 6.25%. Some uncommon situations would even show a net loss.

The 6.25% gain for a basic-rate taxpayer is the key figure, because the average person pays basic-rate tax when earning. And once you take into account the state pension and any saving into a company pension scheme – which is automatic under the new National Employment Savings Trust (NEST) – it’s probably reasonable to assume that most of their income from a SIPP will be taxed at the basic rate when they retire.

Do basic-rate taxpayers get enough of a break?

An extra 6.25% can’t be dismissed, but in my view it’s not large enough to ensure that everybody should opt for a SIPP rather than an ISA. There are two main reasons for this:

  • Pension and tax legislation changes a great deal. The rules governing tax rates and access to pensions could be very different by the time you come to retire. One obvious target would be a cap on the maximum size of the tax free lump sum. So you are taking political risk by locking your money away until retirement age. You need to ask whether a 6.25% bonus is enough to compensate for that risk.
  • These figures are gross of costs. However, SIPPs are generally more expensive to run than ISAs. Based on cost estimates from the Lang Cat, the median SIPP would be 0.35 percentage points more expensive than an ISA for a £20,000 fund and 0.17 percentage points for a £50,000 fund1. So the gains from the 6.25% tax break will be eroded over time; if we assume that the SIPP costs 0.25 percentage points more per year on average, it would take 25 years to erase all the benefits versus an ISA.

This means that the value of the SIPP tax break depends more on your individual circumstances than many people believe.

If you’re a higher-rate taxpayer in your mid forties, but will be a basic-rate taxpayer in retirement, saving into a SIPP probably makes sense. You get a significant tax boost, your political risk is probably reasonable and costs will not be too great a drag.

If you’re in your twenties, paying basic-rate tax and with retirement a long way off, the deal looks less attractive. You face 30 or more years of political risk for a small tax boost that could be largely eroded by costs. An ISA might be more cost-effective at this stage.

It’s important to remember that this is not a one-time decision. If the pension system remains the same when the younger saver reaches middle age, switching to a SIPP at that point may be the right move.

What more do pensions offer?

As with anything related to pensions, there is a long list of caveats to this. One vital point is that I’m only considering the merits of contributing to a SIPP or other personal pension arrangement by yourself, versus using an ISA.

Where you have the option of a workplace scheme to which your employer makes an additional contribution – and most people now do – the calculation changes dramatically. The gain from the employer contributions will probably outweigh the disadvantages at any age.

However, any further personal contribution above what’s required to get the full employer contribution might still be better deployed into an ISA.

It’s true that you can exploit the tax relief of a SIPP far more efficiently if you can retire as early as possible, withdraw from your SIPP as your sole taxable income for several years, then draw on other sources afterwards. That could let you get much of your pension fund out at 0% tax, after paying in with relief at 20% or more.

This is a great trick if you can bring it off. But I doubt that the average investor will be able to retire at 55, while anybody starting to save early with the goal of doing so is taking a big gamble on whether the rules will be so favourable when they retire.

Lastly, there are situations in which other features of a SIPP  make it superior to an ISA. Examples include:

  • access to a greater range of investments (usually only available in more expensive SIPPs),
  • the ability to hold foreign currency (avoiding the hit from FX costs when investing abroad)
  • small wrinkles like avoiding all withholding tax on dividends from US companies (in an all-US portfolio yielding 2%, that could be worth 0.3 percentage points per year, offsetting the higher costs).

However, these will not tip the balance for the average investor.

When should you pick a pension?

I’m certainly not opposed to SIPPs. I have one myself, albeit mostly because it was used to transfer old employer pensions. But it’s possible to oversell the benefits of SIPPs, while the strengths of an ISA as a long-term investment vehicle are sometimes undervalued.

Always bear in mind that the financial services industry likes to sell pensions, because they cost more and lock you in for longer. The choice between a ISA or SIPP depends on your circumstances  and the SIPP won’t always come out on top.

All else being equal, there is quite a strong argument for using a SIPP at any point when you’re paying tax at a higher rate. However, basic-rate taxpayers may be better off using ISAs to complement workplace pensions in their younger years and only considering SIPPs or personal pensions later in life.

ISAs and SIPPs – a comparison of key features

ContributionsNo tax relief on contributions. Pay in up to £15,000 in 2014/15 tax year (rises from £11,880 on 1 July 2014). Contribution limits not affected by income or tax status. Unused allowances cannot be rolled forward.Receive tax relief on contributions at your marginal tax rate. Pay in up to £40,000 in 2014/15 across all pension schemes (the "annual allowance"), so long as you have at least that much in relevant taxable income. Anybody can pay in up to £3,600 gross of tax regardless of earnings or tax status (you pay in £2,880, to which £720 is added by HMRC). The last three years' worth of unused allowances can be rolled forward in some circumstances.
Tax on investmentsNo UK capital gains or income tax due on investments inside account. No special treatment by foreign tax authorities.No UK capital gains or income tax due on investments inside account. A SIPP is a UK pension scheme, so sometimes subject to special treatment under tax treaties. Additional benefit most widely implemented is full reclaim of withholding tax on US dividends.
Tax on withdrawalsNone.A lump sum of up to 25% of the pension fund can be taken tax-free on retirement. Further income taxed at your marginal tax rate.
Investment limitsNone, although there has been some talk of introducing a cap.Combined value of all your pension funds restricted to a maximum of £1.2 million at retirement (the "lifetime allowance"). Any excess taxed at 55%. This limit has been reduced over time, but at current levels is still unlikely to affect most savers.
Investment choicesRestricted to eligible investments (as deemed by legislation and HMRC), although a reasonable range available. Inability to hold foreign currency is frustrating for international investments.Almost unrestricted in theory, although most low-cost platform SIPPs will offer a similar choice to ISAs.
Restrictions on withdrawalsNone.No access to money before minimum retirement age (currently 55). New rules due in April 2015 will remove most other restrictions. Currently, must either buy an annuity or draw down an income directly from the SIPP. When using drawdown, maximum yearly drawdown capped at 150% of equivalant annuity unless have more than £12,000 in other pension or annuity income.
Treatment on deathNo special treatment. Subject to inheritance tax.If death occurs prior to taking benefits and before age 75, whole value of SIPP can be paid tax free, as long as the £1.2 million lifetime allowance is not breached. If SIPP is in drawdown or deceased is over 75, lump sum will be taxed at 55%. Alternatively, can be used to provide a dependant's pension, taxed at dependant's marginal tax rate.


1You can question whether this is the right portfolio size to compare. The average low-cost (“platform”) SIPP is about £90,000, but the average for a basic-rate taxpayer will be smaller. So I think £20,000-50,000 is a fair basis. If you want to assume £100,000 instead, the cost differential according to the Lang Cat’s figures falls to about 0.1 percentage points.

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