A “SIPP”…see what we did there!! Anyway…we’ve had a question from Tony, a regular Moneystepper reader, concerning his pension. He effectively wanted to know how to open a self-invested personal pension (SIPP). However, after some quick discussion, we realized that the real question he was asking was: is it worth opening a SIPP? Today, we answer this question.
Should I invest in a pension or ISA? – Summary
There are many variables involved in determining if it is worth opening a SIPP. The main crux of the answer comes down to what we have already answered in the following article:
To determine whether it’s worth opening a SIPP, we need to first analyse the above article to conclude whether a pension or an ISA is the most appropriate “tax-free” savings vehicle. It all boils down to three main factors:
- Employer match – if your employer matches a certain proportion of your pension contribution through an employer match scheme, it is usually preferable to invest in a pension compared to an ISA
- Flexibility – if you put money into a pension, you will not be able to touch it until you are 55 (with ongoing rumours that this is set to increase to 58). Therefore, you need to be 100% sure that you’ll have no need for this money in the short to medium term.
- Income tax rates – arguably, the most important factor. The decision between an ISA and pension will be highly dependent on your current and future income tax rates. Remember, a pension effectively defers when you pay your tax from today until when you withdraw the cash at retirement. Therefore, you generally have the following decision:
* It is mathematically superior to invest in a pension for the segments where employment income tax rate is the same as retirement income tax rate. This is because a 25% lump sum of your pension can be withdrawn tax upon retirement.
Is It Worth Opening A SIPP? – An Introduction
So, if from the above, you’ve decided that an “ISA” is preferable to a “Pension” then you can stop here.
However, if like our reader Tony, you’ve done your sums and you’ve determined that you still think a pension is worthwhile, you may need to consider a SIPP.
A SIPP is a “self-invested personal pension” and does exactly what it says on the tin – it’s a pension pot which is effectively managed by YOU.
Who would need a SIPP? Well, maybe people like Tony.
Tony has considered the following:
- Employer match – Tony receives no employer match on his pension contributions so this has no impact. Additionally, his employer currently doesn’t offer a pension scheme.
- Flexibility – The 24 year old Tony is happy with his emergency fund and, although he is currently saving for a house, the “pension vs ISA” money will be separate and will specifically assigned for retirement and won’t be touched for the next 30-40 years.
- Income tax rates – Tony has done his sums and is fairly sure that he will be paying an equal tax rate in retirement. Therefore, based on the 25% tax free lump sum, a pension seems a good idea.
Note: we have no idea whether in 40 years’ time you’ll be able to take a 25% lump sum amount tax free as politicians change pension policy every year. However, we can only make our decision on the knowledge that we currently have – this isn’t “Back to the Future”!
Is It Worth Opening A SIPP? – Costs
Tony thinks that he should be opening a pension, but his employer doesn’t offer a pension scheme. Therefore, he’s the perfect candidate for opening a SIPP. Or is he?
Tony currently estimates that he’ll be putting £100 a month into his SIPP. So, let’s have a look at his options.
Moneyweek publish some excellent information on the comparison of costs for certain providers. You can find the full comparison here:
The cheapest option as time of writing this article is with AJ Bell Youinvest:
Whilst the ISA is free, the charges for the SIPP are £5 per quarter under £10,000.
Therefore, we need to build these costs into our calculations:
Assumptions for the SIPP return:
- £1,200 (post tax) invested in the year when Tony is 24
- 25% tax credit applied to investment (to reflect that pensions contributions are pre-tax)
- 8% annual return
- Fees remain static as per the table above (25 years under £10k, 9 years above)
- 25% tax free taken at age of 58
- Final retirement pot:
- ((£1,200 x 1.25) x (1 + 0.08)^34) – (£20 x 25) – (£60 x 9) = £19,495
- Taxes on retirement: (£18,674 x 0.75 x -0.2) = -£2,924
- Final Amount = £18,674 – £2,801 = £16,571
Assumptions for the ISA return:
- £1,200 (post tax) invested in the year when Tony is 24
- 8% annual return
- No fees
- Final retirement pot: (£1,200 x (1 + 0.08)^34)) = £16,428
Therefore, for Tony, the fees and charges associated with the SIPP actually show very little difference in the outcome (£143 or 0.9% of the final pot). Therefore, at this stage, the flexibility and the liquidity of the ISA makes that a more appealing option in my opinion.
Is It Worth Opening A SIPP? – Ongoing Investments
You may have noted that in this analysis we have only looked at one year of contributions. However, these fees are fixed and so will become smaller (relatively) over time. What about if Tony added £1,200 into the account every year until he retired?
- Final retirement pot: (£1,200 x 1.25 x (((1.08^34)-1)/0.08)) – (£20 x 4) – (£60 x 4) – (£100 x 26) = £235,020
- Taxes on retirement: (£225,502 x 0.75 x -0.2) = -£35,253
- Final Amount = £18,674 – £2,801 = £199,767
- Final retirement pot: (£1,200 x (((1.08^34)-1)/0.08)) = £190,352
So, even when we look at continual investment like this, the results are still pretty close although the SIPP now starts to exceeds the ISA somewhat (by about £9,415 or 4.7%).
Again, you need to weigh up the difference between these additional returns and the uncertainty of future pension policy and the additional flexibility and liquidity that an ISA provides. Personally, in this situation, I would still be tempted to opt for an ISA rather than a pension in Tony’s position as it’s unlikely this process will continue as it is for the next 34 years.
Also, we should consider the fact that in this example, we are paying fees outside of the investment. However, with most SIPPs, the fees will be charged annually and removed from the SIPP balance and hence the fees are effectively higher once we remove the compounding effect that we have in the calculation. This again narrows the difference between SIPP and ISA and means that the “no-fee” ISA option may be better.
Is It Worth Opening A SIPP? – Other Considerations
However, there are yet more variables and questions to consider. For Tony, at the age of 24, they include:
- Do you intend to increase your contributions in the future?
You would imagine that Tony would be gradually increasing the contributions from the current level of £100 per month, and in that case the final retirement pot becomes larger. As the final retirement pot becomes larger, there is more chance that his retirement income hits the 40% tax rate and, in that case, the ISA becomes more appealing.
- When will your employer start offering matched contributions?
Remember that with auto enrollment rules being phased in over the coming few years, the vast majority of employers will need to match some part of your pension contribution. This means that almost all employers will offer managed pension schemes and hence Tony may only be contributing to his SIPP for a short period before moving his new contributions into an employer managed pension. Again, as per the above calculations, this makes an ISA a better home for his money in the short term before investing in the matched employer pension scheme in a couple of years’ time.
- Do you have control over your employer pension?
Another question raised from the previous point is the range of investments you can make in a SIPP compared to an employer pension. Occasionally, there can be very restricted options when investing in an employer pension scheme, where these can be much wider in a SIPP. Therefore, this gives the thumbs up for a SIPP.
However, in the argument of SIPP vs ISA (which is more relevant for Tony right now), there is usually little to no difference in the range of investments available.
- How much are you contributing?
As a basic rate income tax payer, this probably isn’t a huge issue for Tony right at this second, but it’s worth remembering that the current annual allowance (the most you can put in) for an ISA is £15,240.
However, you can contribute up to 100% of your annual salary into a SIPP up to a limit of £40,000 per year.
Is It Worth Opening A SIPP? – Conclusion
Like most things with money, there isn’t one right answer for everyone. You need to do the calculations for your own situation and have a think about what will be happening in the future.
For Tony, my recommendation would be to take advantage of his stocks & shares ISA allowance in the current year and not worry about a SIPP at this time. Then, a couple of years down the line following the auto enrollment implementation with his employer, he can reconsider that decision.
If you want any help with your calculations or decision on opening a SIPP, or you have any other comments, I’d love to hear from you. Either leave a comment below, or get in touch with us via email. I look forward to hearing from you.