I understand that it is possible to pay a contribution into a stakeholder pension plan and then immediately take the benefits.
I am aged 66. As a woman, I thought that the low annuity rates available to females would not make this particularly attractive but what do you think?
You are correct that it is possible to invest in a stakeholder pension plan and take the benefits immediately. To do this, you have to be aged over 50, the minimum age at which benefits may be paid from such an arrangement.
It is a very tax-effective way of producing income for those who have capital to invest and are looking for guarantees. However, there are some important issues to consider.
First, let us look at income tax relief. You pay your pension contribution net of basic-rate income tax relief. Even if you have no earnings, you can still make a contribution of £3,600 gross (you actually pay £2,808 net) and qualify for this tax relief.
If you have had earnings in the last five years, you may be able to select one of those years as the basis year on which to base your pension contributions, in which case you may be able to contribute more than £3,600 gross. For the purpose of this exercise, I will assume that you may only pay a £3,600 contribution.
You pay £2,808 net and the product provider claims £792 of tax relief from the Inland Revenue. You immediately take the benefits, one of which is a tax-free cash lump sum of 25 per cent of £3,600 – £900. The net cost to you of making an investment of £3,600 is therefore only £1,908. In other words, you have an immediate investment return of 88 per cent. Actually, that is a little exaggerated because £900 is simply a return of some of your capital.
The remainder of £2,700 in your stakeholder pension is used to purchase an annuity which produces an income payable for life. For a woman of your age, that will produce an annual gross income of £166.38. The annuity is on your life only, payable yearly in advance, guaranteed for five years in the event of your early death and without any escal-ation in course of payment.
As £2,700 has been used to buy this annuity, once you take into account tax relief of £792, the real cost to you has been £1,908. In other words, you have achieved a gross yield of 8.72 per cent. If you pay tax of 22 per cent on the income, the net yield you have achieved is 6.8 per cent.
This is pretty good. Most other investments that might be capable of producing such a yield tend to carry a greater degree of investment risk than a stakeholder pension plan which, to use the industry jardon, immediately vests.
The downside is that you have given up capital control. Once you have handed over the money to the product provider, you will not get it back, apart from the tax-free cash lump sum. Some people like the attraction of tax-free cash and tax relief but rather resent the loss of capital control. However, that is the price you have to pay.
If you are a taxpayer, it might be possible to achieve 40 per cent tax relief against your contribution but the net yield will be reduced because the annuity income you receive will be taxed at 40 per cent.
All annuity purchase is a gamble. The longer you live, the more income you will receive from your investment. The trick is to live a long time so that the annuity provider pays you an income for many years hence.
You could look at the above figures and conclude that, if you have a net cost of £1,908 and yearly income of £166.38, you effectively need to live another 11.46 years to see a complete return of your investment. If you look at the after-tax return at a 22 per cent tax rate, then you need to live another 14.7 years to see a complete return of your capital cost.
You can choose the shape and content of your annuity, including or excluding as you see fit such things as guarantees, provision for a surviving spouse or increases to the income in course of payment.
Remember, the greater the level of add-ons, the lower the starting level of the annuity