There is nothing magical about pensions versus ISAs, the UK’s two tax-free savings wrappers, that somehow enables pensions to break the laws of mathematics.

Both pensions and ISAs deliver one-shot tax relief, as well as allowing your savings to grow tax-free.

• Pensions give you the relief upfront, by rebating the tax you’d otherwise pay on your contributions.

• ISAs give you the tax break later, since you pay no tax when you cash in your ISA investments.

You’ll often hear people claim that pensions are better than ISAs because upfront relief is more valuable. “You have more money to compound over the years with a pension,” they say, which they claim gives pensions the edge.

But this is wrong – all things being equal.

Now, all things are rarely equal, and I’ll get to that in a minute.

But first the science bit.

Pension versus ISAs: A quick recap

Pensions

• With a pension, you get tax relief on your contributions.
• If you pay 40% tax, say, then a £1,000 contribution costs just £600 of taxed income.
• You pay tax on the money you take out when you retire.

ISAs

• With an ISA, you get no initial tax relief.
• Instead, you put some of your taxed salary into the ISA.
• However, you do not have to pay tax on the money you withdraw later.

Mathematically speaking, there is no difference between these two situations, provided the tax rate is the same.

Proof that ISAs and pensions are the same, maths wise

Here’s some algebra to prove pensions and ISAs are equivalent – all things being equal.

Consider the variables:

• A lump sum investment of £x
• Tax rate of t%
• Annual growth of i%
• Investment period n years

With an ISA you get no initial tax relief, and you pay no tax on withdrawal.

The formula for how your money compounds over ‘n’ years is therefore simply:

• ISA = x * (1+i)^n

With a pension you get tax relief of t%, but you also pay t% tax when you withdraw the money later.

The formula for how your money compounds over ‘n’ years is:

• Pension = x/(1-t) * (1+i)^n * (1-t)

Now, (l-t)/(l-t) cancels out. This leaves us with:

= x * (1+i)^n

Which is exactly the same as the ISA!

This is why some prefer to use the phrase ‘tax deferment’ rather than ‘tax relief’ when talking about pensions. The relief you get upfront is cancelled by the tax you pay later – all things being equal.

A worked example of tax equivalence

Here’s an example of pensions versus ISAs with real numbers.

Consider a higher-rate taxpayer who:

• Sets aside £1,000 of his gross salary to invest every year
• Pays 40% tax
• Gets 10% a year growth on his investment
• Leaves it to compound for five years
• Draws an income of 5% a year in retirement

With the ISA, he is funding his contributions out of his taxed income.

Higher-rate tax is 40%, so our man’s £1,000 contribution is multiplied by (1-0.4=0.6) to reduce it by 40%, then compounded over five years, and then finally, he takes out 5% (so we multiply by 0.05).

• £1,000×0.6×1.1×1.1×1.1×1.1×1.1x.05 = £48.32

With the pension, our chap can put in the £1,000 from his salary tax-free. However, he must pay 40% tax at the back-end.

This time, we get:

• £1,000×1.1×1.1×1.1×1.1×1.1×0.6×0.05=£48.32

The same!

Important caveat: Things are NOT equal

I’ve shown there’s no difference between an ISA and a pension from a pure maths standpoint.

But I said that was with ‘all things being equal’. And things aren’t equal!

Caveat 1: Lower-rate taxpayer in retirement

Most people pay a lower-rate of tax in retirement (0-20%). This can make a pension a better option than an ISA for higher-rate taxpayers who will be lower-rate taxpayers in retirement, because the rate they pay on withdrawing the money (20%) will be lower than the tax relief they got on when they put the money in (40%, or 45% for additional rate payers ((But beware of reduced annual allowances if you’re a high-earner.)) ).

In my worked example, instead of multiplying by 0.6 to represent the tax on withdrawal, as a lower-rate payer you’d multiply by 0.8, which gives a much higher income of £64.42.

But there’s more! You still have an annual income tax personal allowance as a pensioner. So a good chunk of your pension income may not be taxed at all. (The first £11,000 at the time of writing, presuming no other taxable income streams are complicating matters.)

On the other hand, some of your personal allowance should be used up by (hopefully) a State Pension at some point in your retirement. The State Pension counts as taxable income.

As you can see the marginal tax rate you’ll pay can be very uncertain 15-20 years in advance.

Caveat 2: Tax-free lump sum with a pension

A second important factor is that you can take out a one-off 25% lump sum ((Technically it’s called a Pension Commencement Lump Sum, or PCLS.)) entirely tax-free with a pension.

On this portion of your money you get tax relief going in, and yet can pay no tax on that 25% coming out later – the best of both worlds!

Again, this gives pensions an edge over ISAs.

Caveat 3: Employers pay into pensions, but not ISAs

Employers contribute to pensions, which can be a substantial advantage, and there are National Insurance savings too.

Pensions are also better protected if you lose your job and need to claim benefits.

Pensions versus ISAs: Same but different

In the old days – that is, three or four years ago – we’d now shift gears to talk about the huge and hidden downsides of pensions.

Gloomy organ music would rise up out of nowhere, an unseen wind would shutter the windows and plunge us into darkness, and we’d somberly recount the onerous restrictions on what you could actually do with your money that you’d saved into your pension when you were old enough to need it.

All that changed though with the 2014 Budget’s pension freedoms.

There are still some rules on what you can do with your pension pot – most particularly when you can get access to it. Currently you need to be 55, but that age climbs if you’re younger and many fear it will keep rising.

You do also need to be aware of the tax implications of different withdrawal strategies.

In contrast, with an ISA you can spend your accumulated money how and when you like. It’s always tax-free.

But still, when it comes to how you invest your pension pot once you’ve retired and how you withdraw it, most of the old strictures are gone.

Most dramatically, you’re no longer compelled to buy an annuity. You can instead invest your pension in other assets to create an income that suits you.

Famously, you can even withdraw the money to buy a Lamborghini if that floats your boat.

Our contributor The Greybeard has been covering this brave new world of pensions and deaccumulation. Please do check his articles out.

The changes mean that most people on a fairly normal retirement path will conclude that a low-cost pension based around tracker funds or an ETF portfolio is the best vehicle for retirement savings.

My co-blogger The Accumulator certainly thinks pensions have the edge.

ISAs are still massively valuable for all-purpose savings. They can also back up your pension contributions, and diversify the risk of future governments fiddling with the rules.

And if you want to retire very early, ISAs will probably have to feature heavily in your strategy, given the age restrictions on accessing pensions. ((If you’re trying to retire in just ten years say, then the annual ISA contribution limits are going to be a snag. Make sure you’re fully up-to-speed on capital gains tax strategies and the like.))

In an ideal world you’d have both a pension and ISAs. But whatever you do make sure you’re using some sort of shelter to stop tax reducing your investment returns.

Note: Older comments below may pre-date the pension freedoms. Check the dates! Also I’ve not gone into Lifetime ISAs, as there are signs that the government is already having second thoughts about the inherent inconsistencies in this halfway house. If they are implemented we’ll come back to them, so please do subscribe for updates.

Good reads from around the Web.

This week saw the Financial Conduct Authority (FCA) publish the interim findings of its deep dive into the asset management industry and how it treats its customers.

With the report weighing in at 200-pages, I’ve only been able to superficially skim it so far for myself.

But pundits and campaigners seem pleased.

Andy Agathangelou, founding chair of the Transparency Task Force group, says:

“There’s not been a chance for a detailed analysis yet but their opening comments are extremely significant […]

They are even talking about the idea of introducing an all-in fee to make it easy for investors to see what is being taken from the fund. Wow, this would be a seriously progressive approach to costs disclosure and is exactly the kind of costs regime that is needed.

Let’s hope this helps avoid the ‘patchwork quilt of protocols’ that trade bodies seem to prefer over market-wide regulation.”

You can read Mr Agathangelou’s comments in full at The Evidence-Based Investor.

The mainstream press has also begun digging into the report.

Citywire flags up the finding that so-called ‘Best Buy’ and ‘Rated’ funds touted by distribution platforms typically fail to beat the market:

“…although funds on ‘buy’ lists did better than non-recommended funds, in common with the vast majority of funds they did not perform better than stock market indices, such as the FTSE All Share, once charges were taken into account.”

And in a separate article it homes in on talk of that all-in-one fee:

UK fund managers don’t compete with each other on price, which means investors end up overpaying on fund charges, the City watchdog has concluded

Following a damning review [the FCA] found that actively managed funds do not beat the stock market after charges.

It also concluded that the stated investment objectives and fee breakdowns for funds are unclear to investors.

The regulator is proposing asset managers introduce an all-in fee to improve the disclosure of costs that investors incur.

ThisIsMoney has published the most comprehensive recap of the report’s findings. Handy for those of us who won’t get paid to wade through the 200 pages!

Shrink in the wash

Here at Monevator Towers, we can only welcome the FCA looking into the egregious profits earned in aggregate by the financial services sector.

Remember, active management is in practical terms worse than a zero-sum game. The only group that benefits from its dominance are the managers themselves.

That’s not to say there is no role for financial professionals in the money matters of the person in the street. Some active investing will always be necessary to keep the market efficient (though most private investors can dispense with it) and financial planning has a place.

A right-sized industry would undoubtedly be far smaller than today’s, though. Which means we can probably expect it to fight the FCA on any radical changes.

Revolutionary Summit

Indeed, that’s the wet blanket I’d throw on this report. (I always have a supply of wet blankets to hand…)

You may remember how RDR was supposed to revolutionize retail investing. It definitely made positive changes (getting rid of trail commission, for instance) but one can argue that many of the insidious costs of investing just migrated elsewhere.

Post-RDR, savvy Monevator readers who’d read up on index investing have perhaps found it harder to keep their costs at rock-bottom lows. I suspect the ill-informed masses were previously subsidizing cost-conscious passive investors to a greater extent.

A selfish quibble? Maybe, but the bigger point is that the sharks will always keep swimming when there’s this much money at stake. Self-education is the best defense, not regulation that tries to keep pace with them.

And that is the really big revolution of the past decade.

I mean, consider the Evidence-based Investing Conference that took place in New York last week. It seems that every writer and fund manager that we feature in Weekend Reading was there. (Sometimes it’s a drag being anonymous…)

Here’s a wrap:

• Josh Brown at The Reformed Broker recounts his highlights.

• The bps and pieces blog has summarized the day via a stream of Tweets.

• For those in a hurry – hey, that FCA report won’t read itself – the Blog of Newfound Research offers four key takeaways.

Investors have wised-up to the most egregious nonsense peddled by the asset management industry, and the Internet makes that knowledge available to all.

It’s great that the FCA is wising up too. But most of us will keep doing it for ourselves.

[continue reading…]

See my earlier article on investment trust NAVs, discounts, and premiums if you don’t know what those terms mean.

The stock market isn’t totally efficient, in my view. But it seldom hands out free lunches.

You might then wonder why an investment trust would ever trade at a price below what its assets are worth (that is, at a discount) – let alone why some people would be dumb enough to pay more for it (a premium).

Actually, there can be good reasons for both situations. Discounts are especially common.

In late summer 2008, for instance, I posted about numerous income investment trusts trading on 10% discounts in that deep bear market.

Discount aisle

Reasons for a trust trading on a discount may include:

• Investors are scared, and so having been dumping their shares in investment trusts. Most trusts are less liquid than their underlying holdings. This can mean the trust’s share price falls faster than its NAV, increasing the discount.

• Investors may be skeptical that the trust’s NAV is really as much as is claimed. Private equity trusts – where valuations are infrequent and often off-market – are typically discounted for this reason. Commercial property trusts (REITs) may trade at a discount if investors suspect real world prices are falling faster than management is updating the trust’s NAV.

• A lack of faith. Investors may believe bad management is going to reduce the investment trust’s NAV instead of growing it. This is often seen with trusts with a poor track record.

• Disinterest. Simply the whims of fashion. Discounts often close and widen from month to month with little apparent rhyme or reason.

Theoretically a very large discount should be arbitraged away by the market before long. In reality sometimes discounts can persist for years before action is taken.

For example, when I first published a version of this article in August 2010 I wrote:

Alliance Trust is one huge old trust that has traded on a discount of nearly 20% for an age.

Arbitragers have looked at releasing the value (by buying the entire trust and then selling all its holdings for a 20% gain, minus costs) but so far nobody has pounced.

Interestingly, the discount finally began to narrow a few weeks later! It’s now around 10%.

What happened? Well, from memory Alliance Trust’s performance improved a tad – or at least investors took a more generous view of it.

But more importantly, an activist investor called Laxey Partners targeted the trust in late 2010, demanding the board take action to limit the size of Alliance’s discount. This interest was enough to close the discount to 15% even before Alliance’s board implemented any explicit measures in response (such a formal share buyback plan).

The Alliance story went through many twists and turns, including the involvement of another activist and much boardroom drama. A Telegraph article from last October provides a recap.

The takeaway for our purposes – apart from wondering whether activist investors read Monevator – is to note that big discounts do not necessarily mean a trust is permanently impaired. They can be and often are reversed.

But sometimes big discounts do portend doom. I’ve seen the value of several specialist property trusts implode over the years. Usually they were overwhelmed with debt. In every case a huge discount preceded their demise.

Finally, discounts may persist when for some reason it’s not possible for an outsider to stir up much of a threat to the status quo.

Typically there’s a large controlling shareholder – perhaps the family that initially set-up the trust. Hansa Trust is a good example.

Premium aisle

As you’d expect, reasons for the rarer situation of a trust trading on a premium are the inverse:

• Investors are bullish, and have bid up the price of relatively illiquid trusts in their mania.

• Suspected undervaluation in reported NAVs. As with the equivalent situation with discounts, this will typically involve unquoted investments, such as property or private equity. Investors may guess the NAV of a trust has risen beyond its officially reported value. The Lindsell Train investment trust is a great example, currently trading at a 58% premium! Investors seem to believe the trust’s holding in its own management company is dramatically undervalued, despite said management urging otherwise. A clue that this is the cause of the premium (besides the sheer enormity) is that the Finsbury Growth Trust has the same manager and very similar holdings – except it has no stake in Lindsell Train. Finsbury currently trades around NAV.

• Strong faith in management. For example, Anthony Bolton’s China trust initially traded on a premium. Investors believed Bolton’s superb record with his UK fund implied he would grow the China trust’s NAV fast enough to make up for the premium and more. But it turned out he couldn’t – at least not in the short-term – and the premium evaporated. The fund now boasts new management and a 15% discount.

• Fashionable. If an investment trust has been in the news or is one of the only trusts operating in a hot sector, it’s often bid up in price.

As a rule of thumb, it’s best to avoid buying investment trusts trading on a sizeable premium, as you may lose money if it narrows.

However I wouldn’t quibble over just a 1-2% permium if you’re a hardcore investment trust owner. Refusing to pay anything but a discount can keep you out of excellent trusts with strong multi-year records for years.

Equally, a trust trading on a discount may not be the bargain it first appears – or at least the discount may not be set to narrow anytime soon. As always, it’s vital to do your own research.

Want more? Please do peruse our other articles on investment trusts.