It may seem a strange idea to gift your child or grandchild money that they won’t be able to use for many decades, but pensions set up by family members for children are nonetheless an interesting idea. The bottom line is that the sheer length of time your money is invested means a relatively small contribution can be transformed into a very substantial pension pot.
The basic premise is a simple one. It’s quite possible for parents or guardians to set up a junior self-invested personal pension (Junior SIPP) for their child under 18, and for grandparents or indeed anyone else to make contributions into it.
Up to £3,600, including 20% tax relief, can be paid in in total each tax year, so that means contributors pay up to £2,880 and the taxman will top up the rest.
The parent is responsible for deciding how the pot is invested for as long as the child is under 18, but it will transfer automatically into the child’s name when she comes of age. Just as with any other pension, she is not allowed to withdraw money from the SIPP until she reaches age 55 (57 from April 2028).
That’s a very long time off when you’re a youngster, and many investors may well feel their child is going to need financial help much earlier in life. Nonetheless, if you want to do something that could materially change your child or grandchild’s later life, a Junior SIPP is well worth considering, especially if you initiate it shortly after they’re born.
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A quick look at the growth potential puts the idea into perspective. Let’s say you’re a comfortably-off grandparent and want to give your newly born granddaughter Rosie some help down the line.
If you pay the maximum £2,880 into a Junior SIPP, set up for baby Rosie by her parents, £720 of tax relief will bring it up to £3,600.
Assuming that one-off sum is invested and grows at an average 5% a year net of fees until she accesses it 60 years later, it will be worth almost £72,000 (although of course the money will buy considerably less than it does today because of inflation).
If you invest the lump sum a little more adventurously so that it generates an average net total return of 7% a year, however, your contribution will be worth a meaty £237,100 after 60 years.
That’s because of the extraordinary power of compounding, which means that the reinvested returns earned by the pension themselves earn returns the next year, and so on.
The differences are pretty small in the early years, but as the fund grows, so does the value of the returns ploughed back in and working for you each year.
To give that some context: 7% growth from £3,600 in year one produces £252 to reinvest, while in year two, 7% growth from £3,852 rises marginally to £270; by year 60, 7% growth from £237,100 is worth £16,600. The difference between 5% and 7% is similarly compounded and magnified over time.
Perhaps you feel sufficiently flush to commit to the full £3,600 SIPP contribution for each of the first five years of Rosie’s life; or maybe several members of the family decide they will club together to fund it (lucky Rosie!).
Astonishingly, and even assuming no more is added after those first five years, after 60 years invested at an average 7% that pot will be worth almost £1.3 million. Rosie really could be a SIPP millionaire!
Of course, most families don’t have that sort of money to tuck away for future generations, particularly if there are several grandchildren to cater for on an equal basis.
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But even a single SIPP contribution of £1,000, made up of £800 from you and £200 of tax relief and invested at an average 7% a year, would be worth around £66,000 in 60 years’ time.
Lesley Mackintosh, a financial planner and founder of the women’s wealth management business Independent Women, says that she sees clients using Junior SIPPs both to make one-off gifts and for regular giving. “Others use a combination, paying into both a pension and another savings vehicle such as a Junior ISA,” she adds.
Although it may not be the most obvious choice for families with limited resources, Mackintosh believes that building a pension for a young child is a really valuable exercise.
“It’s the ultimate goal to start saving into a pension as early as possible,” she comments. As well as the lengthy timescale, “it is much more tax-efficient than other savings vehicles, as the contributions made through the child’s life will attract tax relief on top.”
She suggests that ideally, building a child’s pension works well alongside something that can be drawn on earlier in the child’s life – to help with university fees or for a first home deposit, for example.
But there are also potential advantages to the inaccessible nature of pensions and the fact that they cannot be dipped into until retirement is approaching.
“Parents and grandparents will have the peace of mind that the money won’t be spent in a way they might not wish,” Mackintosh points out. In contrast, “children with a Junior ISA may be tempted to spend it when they reach age 18 and it matures – and it is legally their fund at that stage so the family cannot contest their decision”.
If you do decide that a child’s pension is the way to go for the youngster in your life, how should you invest the money once it’s in the tax wrapper? Clearly, as the worked examples above show, taking a slightly more adventurous tack can make an enormous difference over the decades.
It makes sense to invest in equities, which have historically outperformed fixed interest investments and cash over the very long term.
If you’re keen to be able to leave the investment to look after itself as much as possible, you could consider using a global generalist investment trust such as F&C Investment Trust (LSE:FCIT) or Alliance Trust (LSE:ATST) for most of the money, or alternatively a cheap global equity tracker such as that from Vanguard.
However, with this sort of time perspective you could also put a chunk of the money into more volatile but long-term rewarding parts of the market such as smaller companies, or into a future-facing thematic fund focusing on, say, technology, healthcare or water management.
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Mackintosh reports that many families choose ESG or sustainable funds, largely because they are thinking about their child’s future and what the world will be like for them.
“We see this with a lot of women as they look to pass on their wealth to the next generation but also want to shape the future with their financial choices,” she adds.
She makes the additional point that it’s perfectly feasible to modify your pension fund choices over the years. “As the years go by, funds can be reviewed and changed as needed.”
Of course, when the child takes charge of the investment, their attitude to risk and interests may well be different from those of the parent, in which case they can tweak the portfolio as they wish.
Importantly, too, this could be a good way to introduce a youngster to the stock market: taking responsibility for their SIPP as they move into adulthood could help to whet their interest in investing more generally.
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Important information – SIPPs are aimed at people happy to make their own investment decisions. Investment value can go up or down and you could get back less than you invest. You can normally only access the money from age 55 (57 from 2028). We recommend seeking advice from a suitably qualified financial adviser before making any decisions. Pension and tax rules depend on your circumstances and may change in future.