In this short feature we discuss some of the most common pension pitfalls that investors face. Pensions often represent the highest proportion of an investor’s overall wealth, yet in most cases they are the most overlooked and neglected. We will touch on how Hurst Hill can help you avoid some obvious planning mistakes and add to your bottom line without making any changes to your underlying investment strategy.
- Lifetime allowance trap: While many investors believe they are well below their lifetime limit (currently just over £1 million in the UK) they often underestimate the compounding effect that 20 years of returns may have on their pension. If you are 35 and sitting on a £300,000 pension pot, then you are fairly likely to run out of allowance purely by making modest contributions and earning returns of more than 5% per year. After modelling one of our new client’s pensions (making reasonable assumptions for inflation and potential returns) we established that even without further contributions he would exceed his lifetime limit 10 years before retirement thus making him vulnerable to the dreaded stealth tax. Your pension needs to be constantly monitored and modelled, as it makes little sense to increase your portfolio risk for returns that can open you up to penalty tax.
- ISA versus SIPP advantages: Many investors own a range of equities and funds across both their ISA’s (Individual Savings Accounts) and SIPP’s (Self-Invested Pension Plans) without considering the differing suitability of these vehicles to different risk profiles. Your higher yielding growth investments should generally be sitting in your ISA account (higher gains allow you to enjoy higher uncapped tax advantages in an ISA) and your more conservative investments should generally be sitting in your SIPP as they are less likely to increase your stealth tax risk (remember you can potentially be penalised for excessive returns in your pension, but are not refunded for potential losses). Your ISA also has a distinct liquidity advantage in that you can liquidate all gains at any time without paying tax (you will however lose your built-up allowances). The decision to channel excess savings towards either your SIPP or ISA also heavily depends on your current rate of tax and the overall size of your pension. In short – 2 investors with identical investment portfolios will quite often have completely differing optimal investment vehicle mixes.
- Gross-ups: We recently grossed up a pension for a client utilising prior year allowances which instantly added 55,000 pounds to his investment portfolio, simply by switching holdings he had in an investment account into his SIPP account. Currently the annual pension allowance in the UK is £40,000. This can often be used to offset income tax paid and thus increase the size of your pension (exact requirements need to be checked on an individual basis).
- Leverage: Many investors are unaware that they can borrow within their pensions in some cases. This means that you could potentially release 50% of the value of your assets at a borrowing rate lower than your investment return, and then reinvest the proceeds into additional pension assets.
- Under-managing your pension: A large majority of investors are often not even aware of exactly what their pension is invested in, despite usually having full flexibility on investment selection. Provider selection and fees are also often overlooked. Make no mistake – your pension is an investment portfolio which requires a tailored risk profile just like any other portfolio. One size does not fit all. Your overall net worth, age, and various other life circumstances have a huge influence on the type of return profile you should have.
The majority of portfolios we have looked at have contained most of the planning errors listed above, as well as a few others. Most clients don’t know what their pension is invested in for a start. Many that have underutilised allowance don’t realise that they could be boosting their pension pot. And almost all seem agnostic about which investments to hold within their ISA versus their SIPP, oblivious to the fact that over 20-30 years this could be costing them a fortune. If you would like to figure out the optimal pension strategy for your exact individual circumstances, please feel free to contact us via the website.