Hand in hand with a pension

PEPs and pensions
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The Independent Online
PERSONAL Equity Plans have a useful role to play in retirement planning, but only as an addition to a pension, not an alternative.

Both forms of saving enjoy significant tax benefits, one on the money going in, the other on the money coming out.

Payments into a pension are tax free, allowing the higher rate taxpayer 40 per cent relief on premiums. On retirement, holders of personal pension plans can take up to 25 per cent tax free, but must use the rest to buy a compulsory purchase annuity. The income from the annuity is taxable.

Payments into a PEP come out of taxed income, but the proceeds are tax free. Peter Hargreaves, director of Hargreaves Lansdown, a firm of financial advisers, says PEPs will not necessarily carry on in their present form. He pointed out that a past Labour Government taxed unearned income more highly than earned income. People saving for retirement should therefore try to use their PEP allowances to the full, in order to maximise their tax-free income in retirement.

New types of PEP are particularly appropriate to those approaching or in retirement. PEP holders will soon be able to follow the established investment practice of pension funds, which switch into lower risk and fixed-interest securities as the pension holder nears pension age. The addition from 5 April of corporate bonds and convertible and preference shares as "PEP qualifying" will offer a class of PEP with a high yield and greater security of capital.

Guaranteed PEPs are also likely to receive more attention in the future, according to indep-endent advisers Chase de Vere.

Investing over five years with the guarantee of at least the original money back is likely to appeal to those averse to risk and to elderly people who need their retirement income to live off.

Although generous tax relief on pensions makes it hard for a PEP to accumulate as large a capital sum - a higher rate taxpayer can invest £10,000 in a pension for every £6,000 put in a PEP - there are occasions when the two can be used together to best advantage.

Hargreaves Lansdown gives the example of a higher rate taxpayer of 65 years, retiring tomorrow. If he puts £10,000 as a single premium in a personal pension plan, he would gain £4,000 back. Assuming a 5 per cent front-end charge on the pension, he would invest £9,500.

He retires the next day, takes a £2,000 tax-free lump sum (he is allowed up to £2,375), which he adds to his £4,000 tax relief, and buys a £6,000 PEP.

The £7,500 left in the pension is used to buy an annuity that would pay about 12 per cent gross, or £75 a month. A PEP paying out 5 per cent income would generate another £300 a year, tax free.

The PEP would go into the man's estate on death (although interest and dividends would become subject to tax), but the pension would die with him.

Mr Hargreaves says: "The deal is pretty irresistible and demonstrates the tax relief advantage of both the pension plan and the PEP."

There are occasions when PEPs are more suitable than pensions. They have a role to play if an employee has reached his or her pension cap and can pay no more additional voluntary contributions (AVCs) into the employer's company scheme or free-standing contributions (FSAVCs) into an insurance company policy. Self-employed high earners are also limited in the amount they can contribute to a personal pension.

They also provide retirement savings for a non-earning spouse who cannot benefit from pension tax relief. Women leaving the workforce to bring up children, and not contributing to a company or personal pension plan, can build up a PEP to which they or their partner could contribute.

PEPs have the advantage of flexibility. Whereas most company pensions have a rigid retirement date, employees who want to retire early could use PEPs to keep them going before becoming eligible for pensions. PEP holders can always get their money back, but money paid into pensions is earmarked. PEPs provide a hedge against inflation, but fixed annuities will diminish in value. Life companies have moved to increase flexibility of pensions by providing escalating and equity-based payouts. Personal Equity Plans also provide a hedge against the dangers of rising tax rates.