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Bubbly loses its fizz

I will retire later this year when I reach 65 and have heard that through the use of stakeholder pensions I could get a guaranteed return of nearly 10 per cent on my money with apparently no strings attached. Such a level of interest sounds very attractive as at present I am getting less than half of that from my building society deposit account but what is the catch?

This arrangement is becoming a heavily marketed scheme. But while it is suitable for some people, you are right to be suspicious. It involves an immediately-vesting stakeholder pension to which you pay a net premium of £2,808. The Government adds a further £792 by way of basic-rate tax uplift, making a total credit of £3,600. By vesting immediately, you can take 25 per cent of the total value – £900 – in the form of tax-free cash. The remaining fund of £2,700 is used to buy a guaranteed annuity which would give you an annual gross income of £175.26, with the first payment being received immediately. The annuity is taxed as income, giving you £136.70 net as a basic-rate taxpayer. Once the first payment is received, your net out-of-pocket cost is £1,771.30, being your original £2,808 less the tax-free cash of £900 and the annuity income of £136.70. One year later and on each subsequent anniversary, you will receive a further £175.26 gross, which is 9.9 per cent of your effective out-of-pocket cost. What is more, you can make a similar investment every year until you are 75 (although you can bet your last dollar that legislation will change before then).

Even though the net income will be more than double that which you receive from your building society, you are right to be suspicious and, as ever, it certainly pays to get professional advice.

No doubt, you have read in the paper about problems associated with what have become known as precipice bonds, where people invested their capital for a guaranteed annual income of 10 per cent or so for a number of years, only to discover that at the end of the term they received only a small portion of their capital back. Well, there are some similarities with this arrangement in that the income is guaranteed but this arrangement goes one better in that you are guaranteed not to receive any of your capital back whatsoever. The pension or, specifically, the annuity is an investment for life. Once you have committed to it, you cannot change your mind a few years down the line. When you die, your spouse or estate will receive nothing because the annuity used to produce the high rate of return in the marketing is a single-life annuity that will cease when you die. Obviously, you could buy a joint-life annuity but the return will look no where near as attractive. So while you may feel that you have a good few years in you yet, the value of the stakeholder arrangement to you or your estate depends on just how many.

Let us assume that rather than take the stakeholder option, you simply invest the net out-of-pocket cost of £1,771.30 in a building society deposit account which earns interest at a rate of 4.5 per cent gross or 3.6 per cent net, from which you withdraw an amount equal to the same after-tax income you would have received from the stakeholder annuity, that is, £136.70. Assuming that the interest remains constant, it will be 17 years before your capital runs out, which is your effective break-even point for the stakeholder arrangement. Put simply and crudely, if you do not live beyond your 82nd birthday, the stakeholder arrangement will have been a bad investment.

I have been negative thus far so let us look on the optimistic side and assume you live to the ripe old age of 90. Having recovered your breath after having blown out all those candles, you can open the post, which will include your 25th annuity payment, and relax comfortable in the knowledge that the decision you made 25 years earlier to enter into the stakeholder arrangement has secured you a clear profit of around £1,000 compared with the more flexible building society deposit account. After taking into account the effects of inflation, this might be enough to cover the cost of the Champagne.

So, given that you – or, more accurately, your estate – will lose all your capital, the apparent yield from an immediately-vesting stakeholder should not be confused with the yield from a building society account, in which your capital is secure.

That said, it is apparent that the immediately-vesting stakeholder option could prove to be a beneficial investment should you live long enough but financial incentives are not usually sufficient to keep a person out of their deathbed. DOCE:

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