A perfect pension?
What’s the best way to save and invest inside a pension plan? Pension savers benefit from generous tax breaks that automatically give their retirement funds a boost, but to really maximise your income later in life, you need to earn the best possible returns on your contributions. The pension freedom reforms of four years ago add another dimension to this debate. These days, the majority of savers tend not to buy an annuity paying a guaranteed regular income when they want to start cashing in their funds, at least initially, preferring instead to draw money directly from their savings. In which case, you’ll need to have suitable investments in place for this period of your life.
What’s the best way to save and invest inside a pension plan? Pension savers benefit from generous tax breaks that automatically give their retirement funds a boost, but to really maximise your income later in life, you need to earn the best possible returns on your contributions. The pension freedom reforms of four years ago add another dimension to this debate. These days, the majority of savers tend not to buy an annuity paying a guaranteed regular income when they want to start cashing in their funds, at least initially, preferring instead to draw money directly from their savings. In which case, you’ll need to have suitable investments in place for this period of your life.
Before and after
In other words, investing through a pension is now a two-phase process. In the first phase, you’re trying to build up as big a fund as possible for retirement – financial advisers call this the “accumulation” phase. Stage two – sometimes called “decumulation” in the jargon – is to invest in such a way that you can preserve and even build up further capital, while also taking an income from your savings.
Those are two quite different objectives, but this doesn’t necessarily mean you need completely different investments before and after your planned retirement date. It’s often possible to use investments chosen primarily with capital growth in mind to generate an income. Equally, investments that generate generous amounts of income are often good options for growth, since you’ll typically be able to re-invest the income back into your savings.
So, which investments might fit the bill? Well, in a survey published by the stockbroker AJ Bell recently, six of the 10 best-selling investment funds with pensions savers proved to be investment companies – even though there are far fewer of this type of fund around than unit trusts and other similar “open-ended” funds. Investment companies appear to be punching well above their weight when it comes to pension savings.
A fund for all seasons
There are good reasons why smart pension savers are likely to be found using investment companies. Most obviously, independent analysis suggests these funds tend to produce bigger investment returns over the longer term. One study published by Cass Business School last summer showed investment companies had returned an average of 0.8 percentage points a year extra between 2000 and 2016; over 30 or 40 years of saving for retirement, that makes a massive difference.
Once you reach the stage of drawing an income, moreover, investment companies can work very well. Unlike other types of investment fund, they’re allowed to keep back some of the income they earn on their underlying investments each year in order to fund pay-outs to investors in years when less income comes in.
This means investment companies can make reliable – and often rising – income distributions to savers, which is useful if you’re trying to live off your investment income in retirement. In fact, there are now more than 40 investment companies that have raised their dividend in each of the past 10 years; in some cases, that record goes back 50 years.
“There are good reasons why smart pension savers are likely to be found using investment companies. Most obviously, independent analysis suggests these funds tend to produce bigger investment returns over the longer term.”
David Prosser
Save monthly
As per Employees’ Pension Scheme (EPS) rules, an EPFO member who retired before September 26, 2008 could get maximum one-third of his/her pension as lump-sum i.e. commuted pension and remaining two-thirds was paid as monthly pension to an employee for his/her lifetime. As per current EPF rules, EPFO members does not have an option to receive the commutation benefit.
EPFO is an organisation that administers EPF and EPS schemes.
The new notification dated February 20, 2020 will benefit such employees as it would lead to restoration of full (higher) pension after 15 years. Therefore, an individual who retired on April 1, 2005, would be eligible to receive the benefit of higher pension after 15 years i.e. from April 1, 2020.
These sums sound out of reach to many savers but remember that you’ll receive tax relief on your contributions, reducing the cost. You may also be entitled to contributions from an employer. In any case, even small amounts of savings will add up over time, particularly if they’re well invested.
Regular saving works really well with pensions. You’re investing consistently over an extended period, plus you get the benefit of a statistical quirk known as pound-cost averaging. The principle here is that your fixed monthly contribution buys more of any given investment in months when market prices have fallen, swelling your returns during the recovery period. The effect is to smooth out the ups and downs of the markets.
If you already have a SIPP (Self-Invested Personal Pension) set up, you can pick investment companies through an online fund supermarket. You can find out more about SIPPs in the AIC’s guide ‘Taking control of your future’.
Difference between Mutual Funds & Post Office Schemes
| PARAMETERS | MUTUAL FUND | POST OFFICE |
|---|---|---|
| Guaranteed Returns | Returns are not guaranteed because they are exposed to market risks. | Offers guaranteed returns through interest rates of up to 8.7%. |
| Liquidity | Offers liquidity by enabling investors to withdraw against 1% exit charge. | Premature withdrawal is chargeable at 2% penalty. |
| Applicable taxes | Dividends are subject to a distribution tax of 13.84%. When fund units are sold within a year, it is taxable as per your personal income tax slab. For fund units sold after a year, the Long Term Capital Gains (LTCG) tax of 10% is applicable. | Earned interest is taxable as per your personal income tax slab. |
| Investment limit | No upper limit. | No upper limit applicable. |
| Monthly investment option | Easy monthly instalments for Systematic Investment Plan (SIP), starting as low as Rs. 500. | Monthly deposit applicable. |
Why Invest in Mutual Funds?
- There is a wide range of mutual fund schemes that investors can select from, based on their unique investment objectives and risk appetites. Mutual funds are for everyone, be it seasoned investors or beginners. These schemes differ based on their investment tenure, sectors or industries that they invest in, market caps, market risks that they are exposed to, etc.
- Beginners can invest in mutual funds through Systematic Investment Plan (SIP), which offers them the convenience of starting with an amount as small as Rs. 500.
- Enables investors to withdraw the accumulated corpus by paying just 1% as exit charge.
- Dividends are subject to a distribution tax of 13.84%. Units of mutual fund schemes that are sold within a year of them being purchased are taxed according to their personal income tax slab. For fund units sold after a year of their purchase, they attract Long Term Capital Gains (LTCG) tax at an interest rate of 10%.