Pensions vs Isas: what’s the best way to save for retirement?

British households are among the most indebted on the planet. We are also terrible at saving. Twenty years ago, we saved around 12% of our disposable income now it's more like 7.5%.

According to the Department of Work and Pensions (DWP), only 38% of working age people (equivalent to 11.6 million people) were saving into a private pension in 2010, compared with 46% a decade earlier. Younger people are saving even less as many struggle to make ends meet.

This is a real problem. The basic state pension will be £107.45 per week from April. That's not going to buy much. On top of that, the state pension is basically a Ponzi scheme, with today's pensioners being paid by today's taxpayers. There's no pot of money with your name on it.

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Ageing populations only make this arrangement worse. In fact, given the dire state of our government's finances, it may be prudent to assume that if you are under the age of 50 today, the government may not be able to afford to pay you a pension at all when you retire.

If you then consider that company pension schemes are becoming less generous and that a stockmarket or property boom cannot be counted on, our level of saving looks woefully inadequate. Unless we want to work for the rest of our lives, we're going to have to save more and spend less if we want to enjoy a decent retirement. So what's the best way to do this?

Are pensions worth it?

The first thing most people think about when it comes to saving for their retirement, is get a pension'. A pension like an individual savings account (Isa) is just a tax-efficient wrapper in which you can hold a wide range of investments. The main benefit a pension offers is that the government gives you tax relief on the contributions you make.

For example, a £1 contribution into a pension fund will cost a basic-rate taxpayer 80p and a 40% taxpayer 60p. If you're a taxpayer, you can contribute as much as 100% of your annual earnings into a pension, up to a maximum of £50,000 a year. Even if you're a non-taxpayer, you can put up to £2,880 a year into a pension fund, which the government will increase to £3,600 with 20% tax relief.

Companies also offer pension schemes to their employees. Not many of us are lucky enough to have a defined benefit or final salary scheme where a company pays a pension based on a proportion of our final salary.

However, some company schemes offer to match the pension contributions made by their employees. In some cases, the employer's contributions can be very generous. If your employer offers a decent matching deal then it's usually a good idea to join the scheme you're effectively turning down free money if you don't.

On top of the tax relief on contributions, all income received and capital gains within a pension fund are exempt from tax (although the 10% tax levied on dividend income cannot be reclaimed). When you retire, you have the option of taking up to 25% of the value of your fund as a tax-free lump sum. This is probably the biggest attraction of a pension.

With all these tax breaks, surely everyone should have one? Unfortunately, it's not quite that simple.

Do you trust the government?

While the government gives these generous tax breaks to encourage you to save, they come with conditions attached. That might not matter so much, but the trouble is that these conditions can easily change. In fact, the government has become very fond of changing the rules on pensions in recent years. So if you are using one to save for your retirement then you need to be aware that the rules could change again before you retire.

For example, you used to be able to take an income from your pension fund at age 50. You now have to be 55. What's to stop the government increasing the limit to 60 or 65 in the years ahead?

Then there's the issue of how much you can contribute. For the 2010/2011 financial year, you could put £255,000 into a pension fund. The limit is now £50,000. This is still a lot of money, but there is a strong possibility that these limits could be cut again in the future.

The amount of money you can build up in a pension fund has also fallen. This lifetime allowance has been reduced from £1.8m to £1.5m. If your fund has a value above this limit, the excess will be subject to a tax charge of 25% and a possible lump sum levy of 55%. Will this remain unchanged?

Tax relief on pension contributions for higher-rate taxpayers costs the government an estimated £7bn a year. While cutting this relief would act as a huge disincentive to save via pension schemes, the dire state of the government's finances means that a pension raid on higher-rate taxpayers could be an easy, though unpopular, option for politicians.

Another target could be the 25% tax-free lump sum available on retirement. Given that these tax benefits mainly go to the richer members of society, the temptation for politicians to seek out an easy cost saving remains a big risk to pensions.

The other major consideration with pensions is the tax status and flexibility of any income that you get from it. While the government gives you tax relief on pension contributions, income from your pension pot in retirement may be subject to income tax. The most recent budget dealt a blow to most pensioners by removing their extra personal income tax allowances. This will increase the amount of income tax that pensioners pay in future.

Pension funds also lack flexibility. After taking any lump sum payment, you have to use your remaining funds to provide an income stream for your old age. You have two main choices. You can either buy an annuity, where you give your fund to an insurance company in return for an income stream for the rest of your life; or you can draw a variable income directly from your pension whenever you wish, while the funds remain invested this is known as income drawdown.

Income drawdown used to be a good option. You could take 120% of the amount provided by an equivalent level single-life annuity. But the government has meddled again and now reduced the level to 100%. Annuity rates, meanwhile, have collapsed during the last 20 years and are under further pressure as quantitative easing keeps government bond yields artificially low.

This means that both annuities and income drawdown provide a 65 year-old man with about £5,600 of income per year for each £100,000 of pension fund assets. Put another way, it would take nearly 18 years to get your money back.

You can get a flexible income drawdown plan, which removes the cap on maximum income limits, but you need a secure income (probably from another pension) of at least £20,000 a year before you can use this option. The one advantage of income drawdown is that 45% (the government takes 55% of it) of your remaining pension fund can be left to a beneficiary when you die. With most annuities, this is not an option.

Isas a simpler alternative?

Pensions offer enticing tax breaks, but they're complicated and vulnerable to change. Would you be better off using the other tax-efficient wrapper an Isa instead? Isas have become increasingly attractive in recent years, as the government has raised the amounts that can be saved in these tax shelters.

For the 2012/2013 financial year, you can save £11,280, of which £5,640 can be in a cash Isa. These allowances will increase each year in line with the consumer price index (CPI) measure of inflation. Equivalent to saving £940 a month, Isas give most people scope to build a decent savings pot.

The beauty of Isas is simplicity. You don't get any tax breaks on contributions, but as with pensions all investment returns are tax free. Even better, any income or capital gain taken out of an Isa is also tax free. Also, unlike pensions, there are no restrictions on what you can do with the money.

However, this is a bit of a double-edged sword if you are going to use Isas as a way to save for retirement, you need to have the discipline not to touch your money before you need it. However, there is no reason why you cannot use an Isa pot to create a decent income stream to live on.

A diversified portfolio of high-yielding blue-chip shares with rising dividends, some preference shares and a low-cost corporate bond exchange-traded fund (ETF) could provide a better long-term income stream than an annuity. You would also be free to take capital whenever you wished although, again discipline is needed.

So which is the best? Take a look at thetable below. We have assumed that each fund receives £11,280 in year one (the 2012/2013 annual Isa allowance) and that these contributions grow by 2% each year (our assumption for CPI) for 30 years.

Investment returns are 6% per year, and personal tax allowances have been indexed to the CPI. At retirement, all funds earn an annual return of 5.6% (either as an annuity or drawdown). Annual management fees are based on current self-select Isa and Sipp charges. No further charges are assumed.

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As you can see, there is little difference in the amount of annual income each pot can buy. The benefits of tax relief on contributions are largely offset by the income tax paid on pension income. However, the value of the tax-free lump sum, especially to higher rate taxpayers, is clear. Netting off the extra tax relief and the 25% lump sum means that in effect buying a retirement income hasn't cost the higher-rate taxpayer anything.

This effect is even bigger with a company pension plan where the employer matches the contribution of employees. So the bottom line seems to be that pensions are good for higher-rate taxpayers and that company pension plans are probably worth joining.

But one thing to bear in mind is what a future government will do with tax allowances. If they are not allowed to rise in line with inflation then more pensioners will pay a lot more tax at higher rates. This will make Isas a more compelling investment. And this remains the key factor: do you trust the government? If not, then Isas, which are easier to understand, might be a better option. Of course, there's nothing to stop the government meddling with Isas too but it'll probably be easier to get your money out in a hurry if you need to.

Also, cut costs by managing your own fund if you can. It needs a bit of homework, but once set up, it should be simple to manage. A 1% annual fee lowers the return in our pension example by £225,000 and reduces income in retirement by 17%.

Why overpaying your mortgage can beat saving

Getting rid of debt is a good idea. Interest rates on loans are usually a lot more than the after-tax returns on most investments. So it doesn't make much sense to have money invested in low-yielding, tax-bearing assets if you have lots of debt. Very expensive credit card and personal loan debts should be cleared first, but paying off your mortgage early too makes sense for lots of reasons.

You could have a ridiculously low fixed mortgage rate. Or you might be a customer of the Nationwide Building Society, with a rate capped at base rate plus 2%. If so, you might be tempted to leave your mortgage alone.

However, other mortgage holders look like they will be paying more very soon. British mortgage lenders are paying more to borrow from the money markets. They are also competing fiercely for deposits by offering higher interest rates to savers.

These higher costs are being reflected in higher mortgage rates. Typical standard variable mortgage rates are approaching 4% and could go higher. The higher rates go, the more sense it makes to overpay your mortgage. For example, if you are a higher-rate taxpayer, you need to be getting returns of 6.7% before tax in order to be getting a better return than you'd get from paying off your mortgage at 4%.

Let's say you take out a £200,000 repayment mortgage at 4% for 25 years. Your monthly payment will be £1,056. At this interest rate, you will repay £316,702 over 25 years. If you decide to overpay by £100 per month (by paying £1,156 a year) and keep paying this amount, you would save nearly £18,000 of interest (tax free) and take just over three years off your mortgage term.

As you can see from the chart on the below, the numbers become more attractive with bigger overpayments. This looks like a reasonable savings plan something to consider as a complement to an Isa or a pension and also gives you the benefit of freeing up several years of spare cash.

If you have the ability to make bigger lump sum payments, the numbers are even more powerful. Overpayments could also allow you to increase the amount of equity (lowering your loan-to-value ratio) you have in your home, paving the way for better remortgaging deals.

For example, if you used your Isa allowance to make a capital repayment at the end of every year, a £200,000 mortgage at 4% interest could be paid off in 13 years, saving £64,211 in interest payments.