Personal finance: Skip the rent and boost the pension

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The Independent Online
THE MAKEOVER

Name: Gordon Rae

Occupation: Marketing and business consultant

The problem: How to buy a home, save money and boost a pension - all at the same time.

The advice: Gordon is advised to move from renting to a special kind of mortgage with fixed payments. By utilising his savings, he can keep over pounds 400 a month, which will help the pension.

Gordon, who is divorced with no dependants, has two big problems to solve: his home and his pension. He is paying pounds 750 a month to live in rented accommodation - which concerns him.

Second, he earns over pounds 35,000 a year and has saved pounds 122,000 through an old-style personal pension. But, at 57, he knows he needs to boost this fund to have anything like a decent retirement income. Can he kill two financial birds with one stone?

The Adviser: David A Holland, managing director of RK Harrison Financial Planning, a long-established firm of independent financial advisers with offices in London, Bedford, Salisbury, Exeter, Banbury and Scotland. Telephone: 01234 305555.

The Advice:

A special kind of mortgage

Gordon is renting a property in central London which is costing about pounds 750 per calendar month. At 57, repaying a mortgage before he retires will put a severe strain on his finances.

Being self-employed with only 18 months' accounts would normally bar him from many lending opportunities, but the Shared Appreciation Mortgage (SAM) from Bank of Scotland answers many of Gordon's problems.

He can fix the interest rate for the life of the mortgage, which can be repaid on death by the sale of the property. In return for a very preferential interest rate, the borrower shares a percentage of the future increase in the value of the home. In effect, this subsidises the low interest rate.

For example, if the maximum loan of 75 per cent is taken on a flat costing pounds 85,000, the loan would be pounds 63,750 - requiring a deposit of pounds 21,250.

The value of the loan determines the lender's cut. In this case, any future appreciation in the value of the property would be shared 75 per cent to the lender, 25 per cent to the borrower.

The current interest rate under the Bank of Scotland's SAM is 5.99 per cent (APR 9 per cent).

The saving

The gross monthly repayments (interest-only) for a loan of pounds 63,750 would be pounds 318.22 per month. Allowing for tax relief at 10 per cent on pounds 30,000 of the loan (appropriate after 6 April) it would be pounds 303.25. This would save Gordon some pounds 446.75 a month.

The mortgage would take up a large portion of Gordon's savings. However, he does have a Legal & General endowment policy, held jointly with his ex-wife, due to pay out pounds 28,000 on maturity in 2006. The intention is to split the proceeds 50/50 between him and his wife either on death or maturity.

A better pension

Gordon is well aware that his personal pension will not provide an adequate income in retirement. With potential income released from property purchase, he can afford to put pounds l,000 a month into his pension.

Based on realistic assumptions (fund growth of 8 per cent and salary growth of 5 per cent with contributions linked to rising salary) and assuming he retires at 70, we have projected he would have a cash sum available of pounds 678,470. He can take around pounds 170,000 as tax-free cash, leaving about pounds 508,000 to purchase a pension. This will provide pounds 53,444 per annum, increasing in line with the retail price index.

This represents approximately 75.5 per cent of his projected earnings just prior to retirement. This should give him a comfortable retirement or even allow him to retire before 70 and maintain a reasonable standard of living.

His NPI contract is a traditional with-profit policy and investment performance with these policies has been very good in the past. However, based on a recent survey, NPI ranks 17th out of 21 companies for policies maturing after 20 years, the yield excluding terminal bonus being 10.62 per cent pa, with terminal bonus 14.27 per cent pa.

These returns may seem extremely good, but they reflect historic returns where inflation has been much higher. Most with-profit bonus rates have fallen dramatically in the past few years and future returns are unlikely to be as good as in the past. Also, with-profit contracts, with modern day technology, represent a very crude way of managing risk; it should be noted that of NPI's total payout over 20 years, 52 per cent is represented by the terminal bonus, which does not attach until retirement. Some would say you couldn't get a riskier investment than this!

I would recommend Gordon finds a good IFA and explores switching to another pension. His attitude to risk is commensurate with a managed pension fund; I would advocate a Lifestyle Fund, where the equity exposure gradually diminishes as he nears retirement.

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