I think that following the budget’s non-event over pensions it’s time that I returned to one of my biggest gripes about the financial services industry. The question of using an ISA over a pension.
I’ve got form on this subject indeed in financial services terms it’s probably as close as I ever get to religion, but in this analogy I’m certainly viewed as the outlandish nut job preaching against orthodox thinking.
So what’s my great heresy, well simple Pensions are totally unsuitable for the vast majority of the UK population as their main means of long term savings. Pension as a first port of call for investors should be confined to the rich and wealthy, the rest of us should use an ISA first strategy.
It’s not a case of this being an unfortunate technical failure I’m convinced this is part of a grand conspiracy by the vested interests of the industry to make life and earnings easier for themselves at the expense of their clients. Furthermore it lies at the root of many of the evils abroad in the UK financial services arena such as the appalling savings gap. Thankfully I suspect these vested interests are finally beginning to break down.
The failure of the industry (and I include the FSA and the financial media in that definition) in not adopting an ISA first strategy is something that should bring great shame on us all.
I did warn you it was a religion for me!
The ISA first strategy
Ask any focus group what’s the main problem with pensions and it all boils down to locking your money away. Now clearly when it comes to long term savings locking your money away can be a good thing, but when trust in the financial sector is at an all time low (according to the CEO of the FSA), it’s a recipe for ensuring that the last thing a client will want to do is legally lock their money away for 30 years.
And yet there is a simple solution to all this – let the client invest in an ISA. At least then they know that their money isn’t locked away for 30 years, it’s portable, accessible and just as tax-free.
So what is an ISA first strategy? Simple, when it comes to saving for your retirement customers should be encouraged to use their ISA allowance first. Whilst about half of the population use their cash ISA allowance, very few people (hat tip to Scottish Widows) use their stocks and shares ISA allowance, so every year this tax allowance goes down the plughole for about 9 out of 10 of the UK population.
Before anyone from the nanny state brigade comes along to argue that the problem with this is that clients can’t be trusted not to raid their savings, well if you truly believe that then you can still set up an ISA and make access hard, complicate and financially painful for the client that you so distrust.
More importantly the nanny state school have to look at the practical consequences of their decision to legally lock up client’s money, investors are voting with their purses and wallets and just not bothering to save. I’d rather a client tried to save and dipped into those savings when times get tough, rather than not bother at all. Those who know better than the muggles would clearly prefer the latter state of affairs!
ISA first then pension (if you want to)
Let me be clear here. I’m not against pensions far from it, I just feel that the vast majority of the population are better off investing in an ISA first and then – at the time of their choosing – they can tip their ISA bucket into a pension when they are closer to retirement.
This has several beneficial effects – firstly and rather obviously by moving the money into a pension later in life it’s locked up for a much shorter period of time.
Secondly, when you move your money into pension much closer to retirement you will have a much better idea of the tax landscape at the time. For example you may be able to identify that switching to a pension will provide you with an income in retirement that will be means tested away, in those circumstances you may well be better continuing to shelter your assets in an ISA which may well not have the same issues, it’s certainly a strategy that some investors prefer.
Thirdly, and more importantly, using the ISA first strategy you can hold off investing your money into a pension until such time as you are a higher rate taxpayer. That way you will capture higher rather than basic rate tax relief.
Meaning you can be significantly better off! Indeed on current difference between basic and higher rate relief you could be up to 33% better off using a ISA first strategy. In practice it’s unlikely to be that high and tax treatment of any plan, pension or ISA depends on your individual circumstances and can change in the future, however even capturing half that amount can make all the difference between a mediocre and a comfortable retirement.
FSA rules on projections make it decidedly impractical for me to from demonstrate this with detailed numbers but it’s covered in more detail in the Telegraph article.
A x B = B x A
So why don’t clients use their ISA allowance? Some say it is because clients are terrified of the stock market (and hence a stocks and shares ISA) where they are not guaranteed to get back all of their original investment? I can understand that, especially given the market over the last decade, but the argument doesn’t hold water as these very same clients are normally investing in funds that would qualify for a stocks and shares ISA through their pension. So it can’t be risk that’s the problem.
The argument generally proceeds along the lines of “ahh but with pensions you get tax relief on your payments and the sooner you get it the more you earn”. At this point I usually lose it (the argument and my temper) and respond like Hugh Laurie playing House.
Let me be clear it’s a mathematical truism (if tax rates stay the same) that it makes no difference if you get the tax relief now or on the day before retirement. As long as you are getting tax free growth (which, other than taxes on dividends, you are in a pension and an ISA,) then you will it makes no difference when you get tax relief.
So if you use your ISA first you can have access, flexibility in retirement and you can be significantly better off. This isn’t a debate about pension versus ISA it’s game set and match to ISAs.
So why doesn’t the ISA first strategy prevail in the industry?
It all boils down to the same reason that I’m typing this blog on a QWERTY keyboard – Ken Arrow’s first mover advanatge. The current layout of a standard western keyboard is not the most efficient. The most commonly used letters (the vowels for instance) are not exactly placed in the ideal spots for speedy typing. However we tolerate this inefficiency as we are locked-in to the QWERTY method of typing and no one can be bothered to learn how to type all over again, even though in the long run it will make us faster and better at putting words on screen.
So too it is with the financial services industry. Pensions have been locked-in to life company and pension provider’s systems. After A-day in 2006 when the ISA first strategy effectively became unanswerable, the cost and effort involved in switching from pension to ISA first became a difficult business case for an organisation to justify.
Surely with such intransigence from the industry we could rely on the independent advice sector to pull the providers into an ISA first strategy. It was after all clearly in their client’s best interests? But no: There was silence.
The commission conspiracy
I’ve heard the answer that advisers were not interested in the ISA first strategy because it was too complicated. Please, are you telling me that pensions are simple! More importantly guiding a client through complication towards their best interest is what an adviser is paid for!
No, there is something else going on here. Pension first survived because it locks the client into their plan, and with a lock-in comes upfront commission to the adviser. You can’t go paying out large amounts of upfront commission if the client might just up a leave the next day. The latter is quite possible with an ISA, but a pension, that’s a different story it’s much stickier and less likely to move.
So the industry has locked itself in to a pension first strategy, at the financial expense of investors themselves, for entirely self-serving reasons.
The media were sold a pass by their own admirable need to offer balance to any story, especially one that bucked conventional thinking. So when looking at the ISA first strategy they would get a range of opinions from advisers and providers who, remarkably, would all give the same answer and pour cold water on the idea, it wasn’t balance they were getting but a common vested interest.
How the regulators tolerated this I really don’t know. The Financial Service Authority brought in RU65 to rightly force advisers to justify if they were not recommending a stakeholder pension, but where was the equivalent requirement to justify an ISA as opposed to a pension?
But let’s be thankful for the abolition of commission for financial advice, that at least will break the unholy alignment of interests between the providers and advisers. And as if by magic the industry is suddenly warming to the idea of an ISA first strategy – now called a corporate wrap. There’s no legislative change in favour of ISA first but the end of commission is breaking the unholy alliance that kept clients locked in to pensions unnecessarily.
ISA first, at last
With these commission changes in place I’m quite confident (short of another fundamental change in tax legislation) that in 10 years time the ISA first strategy will be the most common way of saving and investing for retirement. Pensions will still be used but they will be used strategically and generally only in later life.
I always thought my tombstone would have “ISAs are better than pensions” carved into it, I’m hoping that soon I’ll be able to upgrade to “I told you so.”