Playing a pension generation game

When Age Concern invented Grandparents' Day in 1990, its intention was to draw attention to the plight of the older members of families, who were often forgotten. But while it has meant a lot more cards landing on grandparents' mats over the years, today's Grand-parents' Day is being seen by many families as a chance to remind senior citizens that the Inland Revenue is encouraging them to set up a fund for their grandchildren.

Parents are often barred from giving their children tax-free money, but it is allowed if one leaps a generation. It has not taken long for the financial services industry to leap on the bandwagon and Legal & General has been especially prominent in heralding Grandparents' Day as the ideal time to kick-start grandchildren's pension provisions.

Since the introduction of stakeholder pensions in April 2001, it has been possible for grandparents to pay up to £3,600 a year into a pension for their grandchild. One of the main attractions is that grandparents automatically enjoy tax relief on their contributions. Contributing the maximum £3,600 involves parting with only £2,808, because the Inland Revenue adds a further £792 in tax relief. Another attraction is that the money is locked away for a period long enough to make it likely stock market-linked funds will produce substantial returns.

Tom McPhail, head of pensions research at the Bristol-based independent financial adviser (IFA) Hargreaves Lansdown, says: "If a grandparent put in £2,808 a year every year for the first 18 years of a child's life then stopped, the child would end up with a pension fund worth £1.4m at the age of 60, assuming the fund averaged 7 per cent growth.

"This illustrates the benefits of funding early and allowing contributions to compound. If no contribution was made for the first 18 years, but £2,808 was paid in for the next 42 years until the age of 60, you would actually end up with a fund less than half the size." The earliest age at which one can touch the proceeds of a stakeholder pension is 50, but this is likely to be increased to 55 from 2010. This means the grandchild should be able to take a responsible attitude to money. Rival forms of saving allow access to money at 18, when there is obviously a danger that it could get blown.

Some question the wisdom of giving someone a pension as a present when you are unlikely to be around to experience their full gratitude. But Nigel Gates, a 60-year-old university lecturer who has taken out a stakeholder plan for his 30-month-old grandson Harry, sees the near-certainty that he will predecease Harry's retirement as a positive.

He says: "I like the idea that he will have something to remember me by when I am dead and gone and he should get a healthy return, because over 50 years or more the stock market turmoil of today will seem like drop in the ocean. Fortunately, I get a final-salary pension, but the way the pensions market is heading means Harry may not be so lucky."

Mr Gates, who lives in Rickmansworth, Hertfordshire, with his 56-year-old wife Stephanie, invested the maximum permitted £2,808 in March 2002 and March 2003 for Harry in a stakeholder pension with Standard Life. Both investments, which are split between the managed and with-profits funds, won a 0.1 per cent reduction in Standard Life's annual management charge through being made via the Wolverhampton-based discount broker, Torquil Clark. This year, the couple intend to take out a further stakeholder plan for their other grandchild, Alfie, aged six months. This will also be for £2,808 a year but, because Inland Revenue regulations allow each individual to gift £3,000 a year free from inheritance tax, they will still not incur any liability on the contributions.

This £3,000 annual inheritance tax exemption still applies if gifts are made to other forms of savings vehicles and many IFAs feel gifting money via a unit trust or investment trust savings plan represents a far more attractive proposition.

They say that having your money locked away until you are 55 prevents it being used in a crisis or for the types of purposes that could really help a young person starting out in life, such as helping to pay their way through university or buying a car or home.

Patrick Connolly, director of Chartwell Investment Management, an IFA based in Bath, Somerset, says: "We find most grandparents prefer to invest in unit trust and investment trust savings plans for their grandchildren. The ability to get at the money at 18 is considered more important than the ability to get tax relief on contributions, which is available only in a pension. For the same reason, I suggested an investment trust savings plan when my mother wanted to start saving for my 18-month-old son."

Those who cannot decide between the pension or savings plan route could find they will enjoy the best of both worlds if they are prepared to wait a couple of years.

In this April's Budget, it was announced that child trust funds come into effect in 2005. These will entitle children born after September, 2002, to £250 at birth from the Government, with an additional £250 for children from low-income families. Friends and family can add £1,000 a year more to the fund, which will be accessible at 18.

But it is not clear what tax advantages these funds will enjoy, or whether they will offer access to stock market-linked investment. They are also still likely to involve one of the main disadvantages of stakeholder pensions and unit trust and investment trust savings schemes: if you fall out with your child or grandchild, you cannot get your money back.

WHAT ARE STAKEHOLDER PENSIONS?

* Contributions attract tax relief at the contributor's highest rate of income tax.

* The remainder is used to provide retirement income through an annuity, which is subject to income tax.

* With a few exceptions, you can contribute to a stakeholder pension if you are self-employed, employed, or not even working.

* To contribute more than £3,600 gross a year you must have earned income; the amount will depend on your age and income.

* You can make contributions for a child, grandchild or other non-taxpayer, but higher-rate taxpayers cannot reclaim the difference between the basic and the higher-rate tax.