Trying to solve PEP or pension quandary: Caroline Merrell looks at ways of providing income for old age

CHOOSING between a personal equity plan or a pension to provide an income in retirement is like deciding whether to pay tax on the money you put on a horse or to pay it on the winnings.

Keith Diggle, a director of the music magazine publisher Rhinegold Publishing, was faced with this dilemma when trying to decide whether to invest a lump sum of pounds 9,000 into a PEP or a pension.

Mr Diggle is a higher-rate tax payer and anticipates remaining one when he retires. He already has a number of pensions policies including ones with Equitable Life, Scottish Widows, Legal & General and Black Horse Life.

He said: 'Much of what I have read in the newspapers recently about the pensions industry has disturbed me and I am wondering what to do to supplement the provisions I have already made.'

Pensions investment is free from tax on the way in, while PEP investment is not. The gains within both types of fund roll up free of tax, but the returns at the end of the investment period are taxed differently. Only 25 per cent of the pension fund is tax-free cash, while all the PEP investment is tax-free.

The bulk of a pension when it matures has to be used to buy a pension annuity, whereas the cash from a PEP can be invested to provide an income in any type of product. At the moment low interest rates mean that annuity rates are low. However, by the time Mr Diggle retires this situation may have changed.

Ronald Henderson, managing director of the independent financial adviser, Premier Investment Group, said: 'Charges on pensions are higher, but the funds in a PEP would have to grow by a further 7 per cent a year to have a fund value as good as a pension.'

He said a pounds 9,000 PEP investment with an initial charge of 5.25 per cent, and an annual charge of 1 per cent, would be worth pounds 21,814 after nine years assuming a standard growth rate of 12 per cent - this could provide a tax-free income of about pounds 1,090 - 5 per cent - if it was left in the PEP after retirement.

Mr Henderson pointed out that the client could purchase an annuity to provide an income, but this would be taxed.

Investment of pounds 9,000 into a pension would immediately give Mr Diggle gross investment of pounds 15,000. Growth of 12 per cent would produce a fund worth pounds 37,800 after nine years - only 25 per cent - pounds 9,470 would be tax-free. A pensions annuity would pay pounds 3,310 per annum income, all of which would be taxable at the higher rate.

Mr Henderson said that he had included standard pension charges in his calculation, but added that a PEP was more flexible.

'It can be encashed at any time. All the cash is available at the end of the period, and there is no need to purchase an annuity.'

Other specialists agreed that a PEP would need to outperform by a considerable amount to make it better than the pension.

Stephen Ingledew, of the independent financial adviser Frizzells, said: 'Over 10 years, if the personal pension grew by 5 per cent per annum the PEP would have to grow by 10.5 per cent to get the same result.'

There is a wide variation in fund performance. Pensions have much greater investment freedom in the markets they can invest in. PEPs are constrained by having at least 50 per cent of their portfolio invested in an EU country.

The average pension fund grew by 84 per cent over five years, while the average PEP grew by 94 per cent. However, the top performing pension fund rose by 482 per cent over five years, while the top performing PEP rose by 190 per cent.

Mr Diggle has been pursuaded by the pensions argument and believes a self-invested personal pension will give him some control over investment decisions.

(Photograph omitted)