You can no longer rely on the State to fund your senior years but in an unstable financial market what is the best way to save for retirement?
While you are working your aim should be to put aside sufficient funds so you can enjoy a comfortable retirement.
But it can be hard to know the best way to do this.
Pensions are without a doubt the most popular option, but they're not necessarily the right choice for everyone, especially when used in isolation.
ISAs present a solid alternative but, again, do have their drawbacks.
Here's a breakdown of their respective features so you can work out whether either ISAs or pensions present a workable strategy for you to save for later life.
What are the contribution limits?
ISAs
Each tax year (6th April - 5th April) you are given a new ISA allowance. This represents the amount of money you can pay into both Cash ISAs and Investment ISAs in total over the coming tax year.
For the 2012/2013 tax year you can save up to £11,280 in ISAs. You have the option to use all of this allowance to build up investments via an Investment ISA, or you can choose to save up to £5,640 as cash in a Cash ISA and the remainder of your allowance via an Investment ISA.
Pensions
Fewer restrictions are placed upon the amount you can save in pensions.
There isn't any limit on the amount you can pay into a pension scheme over the course of a year. However, for the 2012/2013 tax year you are only able to get tax relief on pension contributions of up to £50,000.
Any amount you pay into your pension over this £50,000 annual limit will be taxed at your current income tax rate.
What are the tax benefits?
Pensions and ISAs both offer tax breaks to investors so they are both well suited to long term retirement savings, but there are significant differences between the benefits the two offer.
ISAs
When you put cash into an ISA it’s likely that you’ve already paid tax on the money.
Assuming you're a tax payer, any money you take from your wages to pay into an ISA is likely to be from your net pay. As such you will already have paid income tax on any amount you go on to save.
However, once your money is deposited in an ISA, any income you earn through interest or profit is tax free. You'll also be able to withdraw your savings and spend them without incurring any further taxation.
Pensions
Unlike an ISA, if you pay into a pension directly then your contributions are usually taken from your gross wages before you pay tax or NI. This tax relief can help to boost your pension savings considerably.
For example, if you were a basic rate tax payer every £80 you paid into your savings would actually equate to £100 in your retirement fund as you haven't paid tax at the 20% rate. The benefit is even greater for higher rate tax payers.
However, while paying into a pension is tax-free, the income you receive from your pension when you retire is subject to tax, as if it were income from a job.
While this may sound unappealing it could still prove tax efficient, especially if you are a higher rate tax payer before you retire. This is because the rate of income tax you'll pay on your pension income will be dependent on your total retirement income, and not your pre-retirement income.
For example, if you were a higher rate tax payer while you were working but your pension income puts you into the basic rate tax bracket, then you will be taxed at the 20% rate rather than the higher rate of 40% if you'd have taken the money as cash while working.
What's more, when you come to retire, the majority of pension schemes also allow you to take up to 25% out of your investment pot as a lump sum tax free. If you decide to do this then you will not have paid tax on the money whilst you were saving it and also don’t have to pay tax on the lump sum element when you retire.
How risky are ISAs and Pensions?
Whether you use ISAs or pensions to save for retirement it's likely your investment will carry a certain amount of risk, however both the level and type of risk will vary depending on where you choose to build your pension pot.
ISAs
If you are using ISAs to save for retirement you are able to hold up to 50% of your annual tax free ISA allowance as cash in a Cash ISA. Saving this way is a relatively low risk option; the money is held in a cash account and growth is not dependant on the performance of stock markets or individual fund managers but instead the rate of interest paid on your savings.
However, over a longer term the returns from Cash ISAs tend to be lower than the potential returns from stocks & shares.
There's no doubt that Investment ISAs are more risky than Cash ISAs as the return you'll see depends entirely on the performance of the investments they hold. However, by carefully choosing the investments you make, and the investment vehicles you choose to invest through it is possible to mitigate this risk to a certain extent.
It is also worth bearing in mind that once you retire your ISA savings are a finite resource. Essentially once they're gone that’s it. As a result, saving in an ISA with the intention of using it to provide an income for retirement can be viewed as betting against outliving the amount of money you’ve been able to save.
Pensions
Like Investment ISAs, the performance of your pension will depend on where your money is invested and how these investments perform over time.
While some pension proviers only offer access to a single fund in which you'll be able to invest, others enable you to choose from hundreds of funds, each with a different investment strategy and different level of risk.
If you hold a company pension then it's possible that where your money is invested is beyond your control.
In larger companies it's often the case that your pension fund is pooled with your fellow employees' pension contributions and managed by a company fund manager. This person would then decide how your money is invested and the amount of risk that is taken with the company pension fund.
However, if you have a personal pension then you will be able to directly manage the level of risk you are willing to take with your fund.
When it comes to the risk of outliving your pension pot you have some reassurance that if you choose to trade your pension for an annuity you will often have a guarantee source of income for the rest of your life; with an ISA there are no such guarantees.
Can you access your money?
Although you should treat the money you save for retirement as a long term investment, being able to get at it in an emergency is something worth considering.
ISAs
If you decide to save using Cash ISAs you can chose to either lock the money away for a fixed period - usually up to 5 years - to get a better interest rate, or choose an ISA that offers instant access to your money.
This means the funds you are saving for retirement are accessible at any point. But remember, while it may be handy to have access to your cash in case of an emergency you could also tempted to spend it.
If you choose Investment ISAs then accessing your savings will be more costly. Investment ISAs are designed to be used as a mid to long term savings vehicle and due to to the management fees if you were to withdraw your money within the first 5 years then chances are you would lose out.
Pensions
A pension locks your money away until you retire and the savings it holds usually can’t be released until you reach the age of 55.
This means that if you need the money in an emergency, you would be unable to draw on the funds you've built up in your pension. However this may not be a bad thing as it ensures that you don't spend your retirement money before you decide to stop working.
What happens after you die?
ISAs
Any savings left in an ISA when you pass away will be treated as part of your estate and can be left to anyone you choose.
Pensions
What happens to your pensions after you die will depend on whether you are still working or have retired and used your pension fund to take out an annuity.
If you are still at work most funds are treated as a tangible asset and included in your estate which is in turn passed on to next of kin. However, the exact terms will vary depending on the type of pension you hold and whether you are an active member (still making contributions) or a deferred member (you have stopped making payments or have left the company) at the time of death.
If you die after you begin taking your pension through an annuity then any dependant will receive a lot less from your pension provider or in some cases nothing at all. Some annuities include the option of providing an income to a partner or dependant beyond your death; however, this will come at a cost and means that your standard income will be lower.
If you have already used your pension fund to purchase an annuity and have made no provisions for a partner or dependant then you are unlikely to have anything to pass on to your next of kin when you pass away.
The exact terms regarding what will be paid to a dependent if you pass away should be one of the things you check before starting a pension scheme or using your pension fund to purchase an annuity.
What are the other benefits?
If your company offers a pension scheme it's possible that your company will offer to match any contributions you make up to a certain limit.
This means that you are essentially doubling your pension contributions and boosting your earnings so it's well worth taking advantage of this opportunity if it's available.
However, depending on the type of company pension scheme you have it is possible that how your funds are managed after you invest may then be beyond your control.
Best of both worlds?
Although there are clearly pros and cons to both ISAs and pensions, there is nothing stopping you using both to save for your retirement.
In fact spreading your retirement provisions in this way could prove an astute move as when it comes to your finances it is often advisable not to have all your eggs in one basket.
You can compare the best ISAs currently on the market using our ISA Savings comparison table and personal pension providers using our Pensions comparison table.
