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Planning Retirement Online


ISAs v Pension Schemes


Growth over 20 and 40 years

When looking at future pension pots it’s worth getting an idea of just how growth affects things because when we talk about pension pots we are going to be talking big numbers and you need to put them in context.

Look at the table below :


Salary growth
over 20 and 40 years
Growth p.a. Salary 20 years 40 years
Annual inflation of 3% 3% £20,000 £35,070 £63,341
1% real increases on top 3% + 1% £20,000 £42,137 £92,327

If someone started on a salary of £20,000 at age 20, and inflation was 3% each year, then if they only ever had inflation pay increases their salary at age 40 would be £35,070 and at age 60 would be £63,341.

However if they also managed to get 1% real increases in salary on top of the 3% inflation, then their salary at age 40 would be £42,137 and £92,327 at age 60!

It’s important to bear the scale of change in mind when we look at the figures below as the fund sizes at the end of 20 or 40 years are relative to the growth in salary.


Impact of saving within a Pension Scheme v ISA

ISAs are an attractive means of saving within a tax free wrapper. So within the allowable annual ISA limit you can build up significant savings, and assuming they are Share ISAs, then you can also profit from any growth of the funds you choose, again tax free.

However any money you put into an ISA will already have been taxed at your highest rate of tax.

(Note the details below are based on the situation in tax year 2016-2017 however from April 2017 the government is introducing a new Lifetime ISA for any adult under 40 allowing up to £4000 to be saved each year for purposes of buying a first home or saving for retirement. Crucially savers will receive a 25% bonus from the Government, so this will change the comparative calculations below).

On the other hand any money you invest in a Pension scheme is tax free. So for every £1000 of salary you invest in a pension scheme, you would only be able to invest £800 in an ISA if you are a basic rate tax payer, or £600 if you are a higher rate tax payer. In fact it’s not quite this simple because if you invest in a pension through salary sacrifice you also don’t pay National Insurance on it. Whereas you will also have paid National Insurance contributions on any amounts you are investing in ISAs, so the amount you have available to invest out of every £1000 could be up to a further 12% less at current NI rates.

Take a look at the 3 tables below which show an example of the fund that can be built up over 20 and 40 year periods, (assuming the same growth rate of the ISA funds chosen and the pension funds chosen) in (a) a pension scheme (b) an ISA if you are a basic rate tax payer (c) an ISA if you are a higher rate tax payer.

 All the examples assume a starting salary of £20,000, a contribution of 15% of salary, an inflation rate of 3% and salary growth of inflation plus 1%. They assume an underlying growth of the funds invested of 5% per annum. Be aware that small changes in investment growth make a significant difference to the actual fund accumulated (alternatives of 3% growth and 8% growth are include in the first table to get a feel for the impact).

Pension fund example   Accumulated pot after:
Salary £20,000 20 years  40 years
Contribution  15%    
Contribution p.a. £3,000 £89,334 £285,077
Fund Growth 5.0% £138,652 £671,690
  3.0% £115,504 £461,695
  8.0% £185,238 £1,269,263
Salary growth above inflation 1.0%    
Inflation 3.0%    
ISA Basic rate example   Accumulated pot after:
Salary £20,000 20 Years 40 years
Contribution  15%    
Contribution p.a. £2,400 £71,467 £228,061
Fund Growth 5.0% £110,922 £537,352
Salary growth above inflation 1.0%    
Inflation 3.0%    
ISA Higher rate example   Accumulated pot after:
Salary 20,000 20 years  40 years
Contribution  15%    
Contribution p.a. £1,800 £53,601 £171,046
Fund Growth 5% £83,191 £403,014
Salary growth above inflation 1%    
Inflation 3.0%    

However with the ISAs the comparison would be even worse as mentioned above if National Insurance is taken into account as the fund accumulated would be up to £80,000 lower (depending on exact rates of NI paid on salary). So the ISA fund built up could be as low as £456,749 for 20% rate tax payer and £322,411 for higher rate tax payer compared to £671,690 within a pension wrapper.

If an employer is paying into a pension fund as well, then their contribution is effectively free money, so again the disparity between a pension wrapper approach and an ISA approach becomes even greater. So if your employer pays into your pension scheme and also matches your contributions to some extent, there is a simple rule of thumb that if you can afford it make sure you do at least enough to maximise your employer’s contribution.

So clearly a Pension wrapper is more effective at building up the size of pension fund than an ISA. However this is not the whole story. The fund built up in an ISA is totally tax free. When you put a pension into service you can take 25% of it as a tax free lump sum, but the remainder is typically turned into an annuity giving you an income for life which is taxable. However it may be wholly or partially taxable at a lower rate in retirement than when you were earning, depending on your overall sources of income in retirement including basic and 2nd state pensions and the personal allowances at that time.

Taking a simple approach if we take the £671,690 pot then 25% is tax free leaving approximately £503,000 to be paid out and taxed. If we take the worst tax case for a moment i.e. you already have sufficient income from State pension/s and other income to use up your tax allowance before this pension, then all of this will be taxed as it is paid out. At 20% this amounts to £100,600. So this effectively reduces the tax free fund to £571,090.

Clearly the pension approach still provides a substantially better performance in building up a fund even where there is no employer contribution.



Return to Retirement Income

However if you feel that you need some help from a financial advisor, then visit our section on obtaining financial advice, or our page on Laterlife selected services and associated advice.



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