Funding the future: The options for your long term savings

David Prosser unravels the options and opportunities in the growing pensions vs ISAs debate

Ros Altmann insists private pensions have a future (Susannah Ireland)

Ros Altmann, the campaigner appointed pensions minister by David Cameron, insists private pensions have a future, despite speculation that some in the Government think individual savings accounts (ISAs) could be a better way for people to save for retirement. George Osborne said last year that the ISA model is worth considering, but if the Chancellor wants to move in this direction he will find Baroness Altmann opposing him. “I do believe turning pensions into ISAs would be a disaster – it would destroy them,” she warned this week.

Still, the reforms announced by the Chancellor in last month’s budget are already changing the debate for savers. Private pensions have always offered tax relief on contributions – currently worth 25 per cent and 40 per cent respectively to basic and higher-rate taxpayers – but then taxed the income people draw down from their savings in retirement. By contrast, ISA savers get no upfront tax relief but pay no tax on withdrawals.

However, in the Budget, the Chancellor announced the launch, next April, of the Lifetime ISA (Lisa). It will be available to savers under the age of 40 and, crucially, the Government will top up people’s contributions. You’ll get a 25 per cent bonus on each pound paid in, up to a contribution level of £4,000 a year. That’s the equivalent of 20 per cent upfront income tax, since it will cost £4,000 to make a £5,000 Lisa contribution.

In other words, for people under 40 at least, there’s now an opportunity to save £4,000 in an ISA and get almost as much tax relief as they would from a pension even though they’ll pay no tax on the money when they retire.

There are some caveats to consider. Unlike ordinary ISAs, savers won’t be able to just cash in a Lisa whenever they want – the money is supposed to be used either for a deposit on a first home or for retirement and there will be penalties to pay if it is used for another purpose. Also, private pensions do allow you to take 25 per cent of your savings tax-free when you cash them in, so on this chunk of money at least, you’re getting tax relief at both ends, as with the new Lisa.

Nevertheless, taking into account tax at both ends, many people will be better off saving for retirement via a Lisa than a pension. Whether the sums add up for individual savers will depend on what tax rate they currently pay and what tax rate they end up paying in retirement. For example, for someone who is a basic-rate taxpayer both today and in retirement, the value of the current pension tax break, even taking into account the 25 per cent tax-free concession, is equivalent to a 6.25 per cent top-up to their savings – so the 25 per cent offered by a Lisa is far superior. But for someone moving from higher-rate tax to basic-rate tax on retirement, the current system is equivalent to a top-up of almost 42 per cent and therefore remains more generous.

The detail of such sums will change over time, as tax rates change or the Chancellor tweaks the rules on either pensions or ISAs. But if Mr Osborne does decide he prefers the ISA route, there are plenty of changes he can make to tilt the playing field. A higher age limit, more generous contribution allowances, and bigger top-ups, for instance, would all increase the number of people for whom Lisas represent a better deal.

Why would the Chancellor want to move in this way? Well, the £34bn annual cost to the Treasury of private pension tax reliefs is a pretty enticing incentive. Switching from a system built on private pensions to one organised around ISAs wouldn’t save all of that money – Mr Osborne would still have to finance the top-ups, for example – and would have a bigger cost in the longer term, with people in retirement paying no tax on their savings. But for a Chancellor desperate to plug the deficit by the end of this Parliament, pensions must be a tempting target.

Politically, it will be difficult to make this switch overtly – not least given the opposition of people such as Baroness Altmann. But if the Chancellor makes the ISA system attractive enough to persuade large numbers of people to use it rather than private pensions, he’ll achieve the same effect.