Pensions remain vital to contractors’ short-, medium- and long-term financial health, according to an expert independent financial adviser (IFA).
“The performance of financial markets in recent years has led many savers to choose non-pension investments, such as Individual Savings Accounts (ISAs),” notes the IFA expert. “However, pensions still remain the single most effective option both for financing a contractor lifestyle during retirement and as a tax mitigation strategy. So they should continue to form a core element of a contractor’s investment efforts.”
The expert adds that, with pension auto-enrolment starting to be rolled out from 1 October 2012, compulsory pension contributions will become an increasingly important topic for both umbrella and many limited company contractors.
Why prioritise pensions over alternative investments?
“Ideally contractors should have a diversified investment portfolio that could include a range of investments, such as property, cash savings in ISAs, bonds and gilts and even assets such as gold or works of art,” says the IFA expert. “As part of their strategy, they also need to consider paying down debt, such as mortgages.”
But contractors putting cash into ISAs for instance use their net income and gain no tax relief on the asset purchase. Of course, limited company contractors can choose to invest company cash into investments, but may fall foul of the Close Investment Company (CIC) tax rules resulting in higher corporation tax bills.
There are alternative investments offering tax relief, but these may have their own disadvantages. The IFA expert explains: “Investments such as venture capital trusts (VCTs) can offer 30% up-front tax relief, but are narrowly focused and higher risk when compared to a pension scheme, which will access a myriad of investments to spread risk.
“Pensions offer contractors an immediate tax saving because contributions are deducted from gross income. This up-front boost courtesy of the taxman can deliver considerable returns over the long-term, which is how pension investments should be viewed. Personal investments such as ISAs don’t offer this up-front boost.”
Pensions can be a contractor’s ‘get rich slow’ scheme
And it is the long-term nature of pensions that adds to their attractiveness. According to the IFA expert, although the financial markets may be depressed at present – hitting those closest to retirement – the life of a pension plan is usually measured over several decades.
Not only can contractors’ pension pots grow rapidly after market corrections, but good pension fund managers will choose a range of investments to insulate pension investors’ funds from the worst of market volatility.
“Investing when financial markets are depressed allows contractors to buy a greater number of investment ‘units’ for their money. As a result, when the markets experience an upswing, these investment units are then worth considerably more to a contractor. So market volatility is a positive feature when a pension is in its accumulation stage and gaining value.”
Pensions still remain the single most effective option both for financing a contractor lifestyle during retirement and as a tax mitigation strategy
IFA expert
If a contractor is also making pension contributions tax efficiently via their limited company, or via salary sacrifice in the case of umbrella contractors, that ‘double whammy’ could result in a well funded retirement.
A good pension scheme allows greater investment flexibility
“A good pension scheme will enable contractors who prefer to have greater control over their pension plan to choose their own investments,” says the IFA expert. “A ‘Self-Invested Personal Pension (SIPP) option or Small Self-Administered Scheme (SSAS) allow the same tax efficiency as a managed scheme, with the contractor having the flexibility to choose their own investments.”
A SIPP or SSAS allows contractors to select specific equities, bonds, gilts, property investments and other asset classes according to their own risk profile and personal preference.
Pensions can mitigate the impact of IR35
The flexibility of pensions also allows contractors caught by IR35 to mitigate the impact of the legislation. The IFA expert explains: “Ideally, contractors should maintain regular and consistent pension payments to maximise the value of their pension pot.
“For contractors inside IR35, pension contributions are a great method of diverting their income into their own pockets and not the exchequer’s. That’s because pension payments are considered outside of the 5% expenses allowance, allowing contractors to increase their contributions when working on contracts caught by IR35.
“In this way even if a contractor deems him or herself outside of IR35 but is then subsequently found by HMRC to be within the tax rules, any pension investment will help reduce the tax due.”
The IFA expert concludes: “There is now even greater scope as to how a retiree draws the benefits from a pension, allowing you to avoid annuity purchase altogether and even pass part of your pension down through the generations on death.
Pension schemes still offer most contractors a flexible and tax efficient investment that delivers benefits many other investments do not. A well-funded pension can provide a good income during retirement, at a time when the state’s retirement provision is shrinking, annuities are delivering less, and retirement ages are increasing.