To submit your own question or scenario for consideration as a future case study, please e-mail editorial@hemscott.co.uk. Previous case studies have addressed coping with suspended pension payments, retirement planning under changing circumstances, fixed rate investments for Self-Invested Personal Pensions, and more. This month's independent financial adviser responds to a reader who's considering using Individual Savings Accounts to supplement her retirement plan.
Case Study
"Everyone’s talking about ISAs again and I’ve promised myself I’m going to sort my finances out this year, so I think I want to invest in one (or some?) but I’m a bit clueless about how to go about it. I’m self-employed, don’t have any debt (excluding mortgage) and don’t yet have a personal pension plan but I want to start at least putting some money aside for my retirement, which I estimate will come about in around 35 years.
"I’ve got just under £4,000 sitting in an old company pension from my previous employment and on top of this I calculate I can comfortably afford to save £400 per month, which equates to approximately 20% of my salary. If there’s any left over at the end of the year I’ll happily put this into ISAs or other savings/investments.
"So, what I need to know is, with interest rates so low but expected to go up this year (?), should I go for both a cash ISA and a stocks and shares ISA, or just a stocks and shares ISA? What should I look for when choosing an ISA (is interest rate the only thing I need to base my decision on)? And what should I look for when choosing stocks or funds to go into my ISA? I’ve read many of Morningstar’s articles on asset allocation and diversification, so I understand the principles, but with so many funds on the market I’m not really sure where to start. ETFs, for example, should I be looking at these?? I would really appreciate some help with this. Regards, Nayantara."
Independent Response
Andrew Reeves, Certified and Chartered Financial Planner, Director of The Investment Coach Ltd.
"Hi Nayantara, you raise lots of interesting points so I will deal with them one by one. Firstly, it’s good you want to "sort your finances out." I know of no better way than creating a financial plan. A fairly sophisticated version that we use at The Investment Coach is available to the consumer at Voyant, which you can access here.
"You should always have an emergency fund before you start investing--as a very rough guideline between three and six months’ earnings after allowing for tax. This is commonly kept in cash ISAs, which answers one of your questions. Interest rates, accessibility and the institution's financial strength are key areas to consider.
"ISAs come in two basic types: cash ISA and shares ISA. The risk profiles are very different with the latter being suitable for more "adventurous" investors as there will be ups and downs.
"You are right to be considering your retirement plans for many reasons, including the fact that as a self-employed person you do not benefit from the State Second Pension. You say you would like to save for retirement, you have a long time horizon, and you list two possible investment products to invest for your retirement: a pension or an ISA. You should research the differences as this will make an impact on your size of funds at retirement. You may choose to consult with an Independent Financial Adviser on this subject.
"In essence, a pension gives you tax relief on your contributions, thereby improving the invested amount. However, pensions work best for higher rate taxpayers (provided their income levels, under new rules, do not cap the relief available). Your income appears to make you a basic rate taxpayer at the moment and therefore pension may only be part of the solution. However, keep this point in mind for any years where you do become a higher rate taxpayer. Pensions are inaccessible in your case until age 55 and at that time you can only take 25% out as a tax-free lump sum, the rest is as a taxable income.
"An ISA, by contrast, has no tax relief on contributions but the whole amount is available as a lump sum (there is no Capital Gains Tax within an ISA or pension for that matter). You should consider a share-based investment for a minimum of five years to help smooth out fluctuations in the underlying market.
"You may like to do a blend of pensions and ISAs. This seems sensible as the long-term nature of pensions stops you dipping into the capital early, while ISAs give you some flexibility. A lot depends on your character--are you a disciplined investor?!
"You should particularly review charges and your asset allocation if you choose an asset-backed investment (i.e. not a pure cash investment like a cash ISA). The financial plan will be able to project forwards using assumptions you or your adviser have inputted and this will show you possible differences between the pension and ISA route.
"Pensions and ISAs are just "tax wrappers"--your performance will live and die by the investments you have chosen. These should be reviewed at least annually and a strategy put in place for reducing the portfolio risk approaching retirement. Expanding on my point above, many studies show the importance of asset allocation to your returns. Regarding the level of charges, a key determinant here is whether you choose active investment managers or passive investment vehicles (or a blend!)
"Passive investments would include the ETFs you mention. I am quite a fan of these but without knowing your risk profile it is not possible to be specific. Compare the charges with an index-linked tracker unit trust which, for say, a FTSE-100 tracking investment, is a similar beast. ETFs are traded real time like a share whereas index-tracking unit trusts are usually priced once a day.
"Returning to pensions: stakeholder pensions, personal pensions and Self-Invested Personal Pensions (SIPPs) will be the main types of pension vehicle available to you. You could consider an online stockbroker for the ISA, which will allow ETFs, and a low-cost pension for actively-managed funds. An Independent Financial Adviser would likely discuss with you a "wrap account" where you could hold both the ISA and pension under one login.
"Finally, you say you would like to save a regular amount. This can work really well as you make use of a concept called "pound cost averaging". Morningstar.co.uk has written plenty on this ‘characteristic’ as well as on some of the other topics I’ve touched on such as asset allocation. Have fun in your research and I hope it leads to great things!"
Disclaimer: All views expressed in this article are those of the financial adviser and not necessarily those of Morningstar, Inc. Morningstar is not responsible for the financial adviser's comments nor will it be liable in any way for any advice or information provided by the financial adviser.
