PEP mortgages work in a similar fashion to endowment or pension mortgages, in that the borrower pays interest only to the lender and pays into a PEP to be used to pay off the loan. Their advantage is the tax-free income which can boost performance when reinvested. Charges are also declared and lower than charges for endowment mortgages.
Not all home loan providers like PEP mortgages, because of the risks of a stock market crash, which could wipe out a large part of the PEP portfolio, and because of the lack of security. PEPs cannot be pledged to the lender as security for the loan as a life policy can, so the lender has to rely on the security of the property.
Not all lenders, however, are deterred. The Bradford & Bingley Building Society, a significant provider of PEPs, does not ask for endowment policies to be assigned to it and has no problems with security aspects of PEP mortgages. Provided the PEP meets the society's requirement in growth rates and is with a reputable fund manager, the B & B is happy to lend.
If the PEP was one of the B & B stable and was shown not to be growing quickly enough to meet the eventual lump sum, the society would advise increasing the amounts put in. It similarly expects mortgage holders to monitor their PEP investments closely and take independent financial advice. The decisions on which PEPs to invest in and which fund manager to use, however, are left to the mortgage holder.
The possibilities exist for substantial financial gain above the amount of the mortgage. Cash can also be taken out at any time to pay off part or all of the loan.
The stockbroking firm Henderson Crosthwaite worked out that pounds 6,000 paid in annually over 20 years, assuming a conservative 8.5 per cent growth rate and deducting typical PEP charges, would generate a lump sum of pounds 243,000. With a 13 per cent growth rate, the lump sum would be pounds 414,000.
PEP mortgages cannot be taken out on a joint basis. Life cover also has to be bought separately, as with repayment mortgages. Because of the risk element, they are only recommended for the more sophisticated investor and not for the first-time buyer.
The PEP pension has its attractions, but is seen as a complement to a traditional pension and not as an alternative: although the fruits from a PEP are tax-free, the original investment is paid out of taxed income; the reverse is true of a pension. Richard Twydell of Henderson Crosthwaite says that for this reason it is hard for a PEP to outperform a pension. A 40 per cent taxpayer putting pounds 6,000 a year into a PEP can put pounds 10,000 a year into a pension. At an 8.5 per cent growth rate over 20 years, that pounds 10,000 a year investment would reach pounds 405,000 and at 13 per cent would reach pounds 690,000, some 67 per cent ahead of the comparable PEP investment.
The PEP pension, Mr Twydell says, can be a very useful addition if a person has reached his or her pension cap and is not allowed to put in any more advanced voluntary contributions. It also comes into play when the spouse has no income and cannot benefit from gross pension contributions.
The great benefits of the PEP for retirement income is its flexibility. Keith Crowley, a director of Invesco MIM, said pensions can rarely be touched before a person is at least 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. With PEPs, the investor can decide the level of payout and change it whenever circumstances vary.
Invesco MIM has lobbied the Government, without success so far, for a separate pension PEP allowance over and above the existing PEP allowance and a scrapping of the single company PEP. With the ballooning cost of state pensions and the simplicity of PEPs, Mr Crowley believes pension PEPs make sense when added to a traditional pension.
Ken Emery, technical director of PEPs at Save & Prosper, points out that the flexibility of PEPs is a double-edged sword, if the investor is tempted to raid the honeypot before retirement or to take too much out. He says 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.
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