Special Report on Pep's and Tax Planning: Your useful flexible spend: Alison Eadie reports on the use of PEPs for long-term planning and examines the advantages and drawbacks

PEPS are a useful vehicle for long-term financial planning particularly against the present background of falling interest rates and low inflation.

Chase de Vere, the investment advisers, say it is possible to achieve an average gross yield of 6 per cent a year on income oriented PEPs compared with building society rates of around 5 per cent net a year. In addition there is scope in a PEP for capital growth.

As a result PEPs are increasingly being used for school fees planning, providing a tax-free income in retirement and paying off mortgages. The flexibility of a PEP is one of its chief advantages. Although often viewed as a capital investment requiring an annual lump sum payment, it is possible to pay into a PEP on a monthly basis out of income.

The regular saver is less dependent on performance than the lump sum investor and may benefit from a volatile market through Pound Cost Averaging, says Chase de Vere. This means that from a fixed periodic investment more units are purchased when the price is low than when the price is high, so the average purchase price may work out at less than the quoted price over that period enabling more units to be accumulated.

Withdrawals from a PEP can also be made whenever the requirement arises. Those saving for school fees can therefore withdraw lump sums when the fees need to be paid and those using PEPs as a top up to a pension can make withdrawals whenever they have a large expense. The fruits from a PEP are tax free but the original investment is paid out of taxed income; the reverse is true of a pension.

Richard Twydell of stockbrokers Henderson Crosthwaite says that for this reason it is hard for a PEP ever to outperform a pension. A pounds 16,000 lump sum paid into a PEP each year over 20 years would generate a lump sum of pounds 243,000, assuming a conservative growth rate of 8.5 per cent and deducting standard PEP charges.

Assuming a 13 per cent growth rate, the lump sum would rise to pounds 414,000. However, a 40 per cent taxpayer can put pounds 10,000 into a pension rather than pounds 16,000 into a PEP. At 8.5 per cent pa growth over 20 years, that pounds 10,000 investment would generate a lump sum of pounds 405,000 and at 13 per cent growth a sum of pounds 690,000.

The PEP pension comes into its own if a person has reached his or her pension cap and is not allowed to put in any more additional voluntary contributions. It also has a use when the spouse has no income and cannot benefit from gross pension contributions. The rules governing pensions are more rigid than those applying to PEPs.

Pensions can rarely be touched before a person is 50 years old and then the payout is small. After the initial lump sum, the pension must be used to buy an annuity whose payout is taxed.

Ken Emery, technical director of PEPs at Save & Prosper, cautions that the flexibility of PEPs can be a double-edged sword. He adds that the relative merits depend to some extent on future tax rates. If they are likely to go up, a tax-free income later would be very attractive.

If they are likely to go down, then getting full tax relief on pension contributions now, and paying a lesser tax on income later, is a better bet.

Flexibility can also be a drawback, particularly for lenders, in PEP mortgages. These work on the same principle as endowment or pension mortgages in that the borrower pays interest only to the lender and pays into PEP to be used to repay the capital sum.

Unlike an endowment or pension, there is no contractual obligation to maintain the regular investment. PEPs cannot be pledged to the lender as security as a life policy can, leaving the lender to rely on the security of the property.

Most lending sources ask to see a quotation of projected returns on the PEP, but not all PEP managers are in a position to provide this. The risks of a stock market crash which could wipe out a large part of the PEP portfolio, make many lenders wary. However, the Bradford & Bingley Building Society provides PEPs and PEP mortgages and has no qualms about the security aspects.

If the PEP was one of the B&B stable and was shown not to be growing fast enough to meet the eventual lump sum, the society would advise increasing the amounts put in. It expects mortgage holders to monitor their PEP investments closely and take independent financial advice. The decision on which PEP to invest in and which fund manager to use are left to the mortgage holder.

PEP mortgages cannot be taken out on a joint basis and life cover has to be bought separately as with repayment mortgages, The biggest plus point is the possibility of substantial financial gain above the amount of the mortgage. Cash can also be taken out at any time to pay off all or part of the loan.