How should you save for the long run?

James Ferguson made it clear why the Lifetime Allowance (LTA) is something that most of us will have to consider in our financial planning, but the big question is: what can you do about it?

If you’re on the verge of retiring and have a big pot, the answer is fairly straightforward. You have a few options for maximising your LTA, so chat to an adviser quickly about the best option for you.

If you aren’t quite so close to retirement, but already have a large pot, or you’re a high earner in a final salary scheme (see below), it’s also worth investigating your options.

But if you’re further away from retirement, or near the start of your investing career, it’s not so simple. All of these rules and assumptions can change, after all.

The LTA may not stay at £1.25m. In the short term, depending on who wins the general election in May 2015, it might even be cut from where it is now. However, over the very long run it seems unlikely that the LTA will be frozen permanently – as James’s calculations show, it could render pensions near-worthless as a tax vehicle for anyone in their 20s and 30s.

Equally, perhaps future nominal stock-market returns won’t be as high as the average 11.4% seen over the past 50-odd years. Maybe this low interest rate ‘new normal’ world is here to stay for longer than any of us expects.

Our best guess assumption – as my colleague Merryn Somerset Webb has noted on her blog – is that the LTA will drop to around £400,000-£500,000 in ‘real’ terms. So a good bit lower than it is today, but not so low that it becomes pointless to save in a pension.

Why this level? Because that should give the average person enough income to keep them from being a burden on the state in retirement, while minimising the amount of tax the government needs to sacrifice. Again, however, this is all conjecture.

What this really demonstrates once again is why we prefer individual savings accounts (Isas) over pensions – they are more transparent, more flexible, and are trickier for governments to target.

Yes, the government could make whatever changes it likes to the Isa regime, and perhaps one day it will. But as 17th-century French finance minister Jean-Baptiste Colbert once put it: “The art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the least possible amount of hissing.”

And pensions are ripe for plucking – history shows they are far easier to tinker with in the most outrageous ways without people fully realising that they’ve been fleeced. The LTA, for example, is effectively a cap on the amount of tax relief you can get on a pension.

But it’s a much sneakier way to do it – and one that’s therefore likely to result in a bigger penalty tax take for the government – than simply imposing a much smaller maximum annual contribution, or directly cutting the amount of relief available.

And given that the public finances are not going to fix themselves any time in the foreseeable future, pensions will remain high on the agenda as a potential source of tax revenue.

There’s still a place for pensions, of course. The chancellor’s latest changes have made them more flexible and more attractive than before the budget. And it would be a mistake to stop contributing to a pension if your employer is paying into one for you and refuses to offer alternative compensation.

However, beyond that, we’d suggest you prioritise taking advantage of the increased Isa allowance as a home for your savings. From July, you’ll be able to put up to £15,000 a year in your Isa. That’s £30,000 a year between a couple, which should be plenty for most people’s needs. And you’ll be able to split it between cash and investments as you see fit.

It’s true that one day some future government is likely to cast a covetous eye over all those Isa pots too. But it’ll be taking a much bigger political risk in targeting them – and at least you have the flexibility to pull your money out as and when you want to if it looks as though an unhelpful regime change is on the way.

What if I have a defined benefit pension?

The good news for anyone on a final salary/defined benefit pension is that the LTA is a lot less punitive for you than it is for your average worker on a defined contribution plan.

That’s because the value of your pension for the purposes of the LTA is valued at 20 times your annual payout. So that means you can be on target for an inflation-protected retirement income of £62,500 a year (excluding any lump sum payout) before you have to worry about the impact of the LTA.

But if you were to buy an index-linked single life annuity at age 65 with a pension pot of £1.25m, then you’d get around £44,000 a year – two-thirds as much. It hardly seems fair – but then, MPs are on a final salary scheme, so perhaps it’s not a surprise.

If you are in danger of breaching the LTA as a defined benefit pensioner, the Investors Chronicle notes that you may be able to reduce the value of your pot by increasing the pension that will be paid to your spouse if you die, depending on the terms of your scheme. It’s certainly an option worth investigating.

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