Article by Yoram Lustig
In a second of three short articles in which we explore three ways to save and invest for retirement, we focus on personal pensions and specifically on self-invested personal pension (SIPP).
Regardless of whether you are a member of an occupational pension scheme arranged by your employer, you may be able to also save in personal pension. A SIPP is a type of a personal pension, offering a wide variety of investment powers. You can choose from a range of investments within a SIPP and switch among them.
SIPP is a defined contribution (money purchase) pension. You are responsible for how to invest your pot. When retiring from the age 55 onwards you can take it out as cash lump sum, flexible drawdown (meaning you withdraw as much income as you need, keeping the rest in the pension) and/or buy an annuity, which pays guaranteed income for the rest of your life.
The UK pension system allows most individuals to contribute up to £40,000 a year (it could be lower for high earners) without paying income tax on the contributions. Over your lifetime your pension value can grow by up to maximum of £1 million before paying a tax charge. You pay no taxes on earnings while the money is in the pension, but you pay income tax when taking funds out. Spreading withdrawing cash over tax years can minimise the tax bill.
Consider diversifying the ways you withdraw your money. Take up to 25% as a tax-free lump sum. Use it to pay off debt, buy a property or spend it however you like. An annuity can give you some stable income that alongside your State Pension can satisfy your minimum financial needs for the rest of your life. Keep the remainder invested to continue growing and providing some additional income.
SIPPS allow you to choose the types of investments
One of SIPP’s strengths is that you can choose the types of investments. Stocks are risky, with high potential returns and a stream of income in the form of dividends. Bonds are not as risky as stocks and can balance some of the portfolio’s risk, while providing income in the form of coupons. Other types of assets, such as commercial property, can diversify your portfolio, reducing some of its risk and expanding the spectrum of return sources.
In a SIPP you decide how to allocate your capital across different investments, depending on your appetite for risk and your circumstances. When you are in the accumulation phase, years before retirement, you may wish to take investment risk by holding stocks. In the consolidation phase, 5-10 years before retirement, you should start reducing risk by shifting more to bonds and cash deposits. Finally, in the de-cumulating (spending) phase post retirement, you should have a less risky portfolio, emphasising income and capital preservation considering inflation. A SIPP allows you to dynamically manage your investment strategy.
SIPP should sit alongside your other pensions, ISAs and other ways to save and invest for your retirement, such as residential property which is the topic of our next article.
Part 1: ISAs
Part 3: Residential Property
Yoram Lustig is the author of the new Financial Times Guide: Saving and Investing for Retirement. It is out now, priced £26.99 from FT Publishing, and available from Amazon