There are lots of good reasons to save in a pension, but your ISA can play a significant role in ensuring a comfortable retirement. Faith Glasgow explains how to do it.
When it comes to making financial preparations for retirement, the core of your planning is always going to be a pension.
There are several reasons why it makes so much sense. The most important ones are that the government automatically tops up your contributions by 20% and higher-rate taxpayers can reclaim the extra tax they’ve paid through their tax return; your employer is also obliged in most cases to contribute each month; and you can’t access the money until you reach 55, so it can’t be raided to fund more immediate expenses.
In effect, an enhanced sum is being invested into your pension wrapper each month, where it is then left to grow tax-free over the very long term. That means your contributions will be worth more when you come to access your pension than if they had been put into any other long-term investment, all else being equal.
However, saving into an ISA is an excellent complementary strategy. ISA subscriptions don’t receive up front tax relief, and nor do employers have to contribute to them, so they aren’t ‘turbocharged’ in the same way.
But they do provide flexible access, which could be useful, for instance, if you’re phasing your retirement and need an income supplement but want to keep on contributing as much as you can to your pension.
Moreover - particularly attractive for retirees – there’s no income tax or capital gains tax to pay on withdrawals, so you can boost your pension income without boosting your tax bill or slipping over the income threshold into a higher tax band.
So, if you’re thinking about building up your ISA with an eye to retirement, what should you bear in mind?
1) Start early!
There’s nothing new in this message, but it’s a great idea to embrace the discipline of building an ISA in your 20s and 30s. By starting when you’re young and keeping it up, it’s possible to build a substantial pot of tax-free cash over the decades.
Not only could this prove useful in your middle years when it comes to childcare or university fees, replacing the roof or extending your home, but if you’re disciplined about withdrawals and continue to make use of your £20,000 annual allowance each year, you’ll have a valuable source of supplementary income in later decades too.
2) The power of compounding
The reason for starting an ISA early is not simply that you develop good savings habits and have some resources to fall back on if need be as you go through working life.
It’s also that as your investment grows and the profits and dividends or income are reinvested, those reinvested returns themselves produce profits that can be reinvested, and so on – a process known as compounding. This becomes exponentially more powerful as the years roll by and more and more returns are reinvested for further compound growth.
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For example, say you invested £1,000 as a single lump sum growing at an average 6% per year with monthly reinvestments. After 10 years it would be worth £1,820 (so compound growth of £820); after 20 years it would have grown to £3,310 (compound growth of £2,310), and after 50 years to almost £20,000 (compound growth of £19,000).
3) Lump sum…
Many ISA investors do little about using their ‘use it or lose it’ annual allowance until the end of the tax year looms, and then scramble to make a lump sum contribution at the last moment. That may suit you if you want to see how much you have spare to put into your ISA, or are waiting to pay in an annual bonus.
It’s worth noting that you don’t have to actually invest the whole lot at that point. You can make your subscription as cash, and then take your time to decide how to invest it over the coming months, once you’ve had time to do some research and ideally when there’s a dip in the market.
4) …or regular saving?
However, there is a strong argument for regular monthly saving direct from your earnings. In part it’s about discipline again - you can set up a regular investing arrangement, which means it’s all taken care of each month and you don’t have to get organised or make a decision about whether to take action.
Regular investing also means you don’t have to worry about what the market is doing, because your money goes in through thick and thin. And you benefit from pound-cost averaging, whereby your fixed sum buys more units when the market’s down, and fewer when it has risen.
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In an uncertain environment that tends to mean you end up with more units for your money and a lower price per unit than if you had put in a lump sum at the start of the period.
To give an idea of how regular investment could enhance our £1,000 investment, let’s say you decide to pay £50 per month into your ISA (ie £600 per year in total) on top of the £1,000 lump sum. After 10 years of annual returns at 6%, your investment will be worth £10,050, after 20 years, £26,500, and after 50 years more than £210,000.
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5) Pension versus ISA contributions?
This is very much a matter of personal circumstances. As Ben Yearsley, investment director at Shore Financial Planning, points out: “It really depends on your medium and long-term goals and your current pots of both pension and ISA, as well as frequency of bonuses/windfalls, other savings, mortgage commitments and so on.”
For instance, if you have a generous public sector final salary pension, you may be quite happy to focus on building your ISA. If you didn’t start funding a pension until midway through your career, but now receive generous matched contributions from your employer, it makes sense to maximise the amount you pay into your pension.
Yearsley adds: “I always used to treat my pension as the savings I did from my regular monthly income, and then the ISA was done on the receipt of any bonus or other windfall. I took the view that I needed my pension, whereas it was nice to have an ISA.”
Against that, as we’ve seen above, regular ISA savings are also a good discipline if you can afford to make them. Even small monthly amounts build up and compound over the years; you may be able to bolster the amount you put away in later years, when you’ve cleared your mortgage.
6) Keeping it simple
What should you be investing your ISA allowance in, if you’re taking the very long view?
It makes sense to focus primarily on equities over that kind of time frame, as they tend to outperform other asset classes over the long term. And particularly if you’re investing small amounts regularly, a one-stop shop fund helps keep things simple.
For diversified long-term equity exposure, an actively managed global investment trust such as Alliance Trust (LSE:ATST) (which takes a multi-manager approach) or F&C Investment Trust (LSE:FCIT) is a good bet.
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If you’re saving regularly and you’re in your 20s or 30s, you could consider splitting your monthly contribution between a core global trust and a more specialist fund investing, for example, in smaller companies, emerging markets or future-facing sectors - perhaps investing in renewable energy, healthcare or technology.
Such funds will always be relatively volatile over the short to medium term, but the best ones provide exposure to global success stories for coming years. Interactive investor’s and investment ideas comprise a range of high-quality funds, including smaller companies and regional funds as well as clean energy, infrastructure and environmental ideas.
These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.
Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.
Please remember, investment value can go up or down and you could get back less than you invest. If you’re in any doubt about the suitability of a stocks & shares ISA, you should seek independent financial advice. The tax treatment of this product depends on your individual circumstances and may change in future. If you are uncertain about the tax treatment of the product you should contact HMRC or seek independent tax advice.