My partner and I are tenants of a public house. Over the last 18 months, we have put a lot of effort into turning the place around. We have relatively little income left over each month. Our bank, with which we have an overdraft, has recommended that we both save £100 a month in a stakeholder pension. Should we do this?
It certainly makes sense to save for the future. It also makes sense to pay today's bills and to have some money to enjoy yourself as well. It is all about striking the right balance.
I assume you can both afford to save £100 a month. Stakeholder pensions have a number of attractive attributes but also some limitations and there are alternatives that you should consider.
If you save £100 a month in a stakeholder pension, you will effectively be investing £128.21. This is because basic-rate tax relief will be added to your £100 contribution. Alternatively, if you save £78 a month, a total of £100 will be invested.
Your contributions will be invested in a pension fund that is also tax-privileged as it pays no capital gains tax and no income tax either on many investments.
Part of the proceeds will eventually be available as a tax-free cash lump sum. In fact, you can take 25 per cent of the value of your pension fund as cash. Any pension income payable to you for as long as you live is then taxable. Finally, the value of the stakeholder plan will also constitute a lump-sum death benefit, usually payable free of inheritance tax.
However, you should not allow the tax tail to wag the investment dog. There are limitations to stakeholder pensions. For example, you may not receive any of the benefits from the plan until you reach age 50. In this respect, stakeholder pensions are inflexible. If you needed the money in the plan in an emergency, you might not be able to get hold of it.
While the tax privileges are attractive, three-quarters of the value of the fund you accumulate must be used to provide an income. This is usually done by the purchase of a financial instrument called an annuity. Annuities are inflexible arrangements although, on the positive side, they do provide good guarantees.
What matters most about stakeholder pensions is that the underlying investment funds are inexpensive. The maximum charge any provider may levy is 1 per cent a year. You should certainly find out about your bank's offering. What investment choices will you have and what sort of performance record do they have? While past performance is not a guarantee of future performance, most of us feel more comfortable investing with a fund manager who has got it right in the past.
You should consider the alternatives. Has the adviser from the bank spoken to you about Isas, for example? While there is no tax relief on the money you save in an Isa, the proceeds, either in the form of a lump sum or income, are tax-free. More important, any fund you accumulate in an Isa is accessible at any time. You do not have to wait until age 50.
Isas also provide a wide range of investment choice running from low-risk cash deposits to more volatile equity funds. One tactic you might consider is to split your savings between Isas and stakeholder pensions. This might provide you with the best of both worlds.
You can then rest assured that you will be able to access some of your capital in an emergency at a date earlier than age 50. That said, you do need to be careful. There is a very good reason for the warnings on financial products that the value of investments can go down as well as up. If you disinvest at an inappropriate time, it may well be the case that you get back less than you have invested.
A better solution might be that you put some of the money you propose to save into a mini cash Isa. The capital value of this will be secure and it may then allow you to invest in your pension fund and the mini equity Isa that I recommend you consider in a more, dare I say it, adventurous fashion.
Your combined Isa and stakeholder pension savings should be spread through the main asset classes, by which I mean cash, property, UK and international equities and some fixed-interest investments. Get your financial adviser from the bank to talk you through a balanced selection of these.
Finally, do consider using some of your income to reduce your overdraft. This is likely to be costing you more in interest than you will earn in the mini cash Isa.