Value of pensions

21 June 2010
Although my cynical view is that pensions basically will not exist by the time I retire, I still took the time to find out whether they had any value compared to other forms of investment. Although there are still significant tax benefits, so far pensions seem to be dependent on stock market trading, and that is something you should not really trust others to do on your behalf..

The good bits

Contributions tax relief: In short, pensions are paid out of gross income, not nett income. This is either via a pre-tax PAYE deduction, or in the case of personal pensions, via a top-up reimbursement. There is a cap on how much can be contributed tax-free, but this is the lower of either 100% of annual salary, and £255,000. If this cap actually affects you, chances are you've already got an accountant advising you.
Contribution matching by employers: Employers, up-to a certain amount, will match any pension contributions you make. Formulae used are company-dependent, but typically are matching the proportion of income deducted as a pension.
No Capital Gains Tax: If the underlying assets which a pension fund invests in gain value, this increase in value is not taxed. A good thing as increase in asset values is how pensions work.

The bad bits

Dividend payments are taxed.: Although no tax is levied as the result of capital gains (i.e. shares gaining market value), tax is levied on any dividend payments that result from those shares. This has been regarded as a disaster, particularly as dividends are the sure-and-steady cash stream that comes from shares. price.
Pension payouts are taxed income: There are some tax breaks, such as up-to a tax-free 25% jump sum on retirement, but otherwise pension income is taxed. This is a red light to anyone who thinks future tax rates will be higher than today, and somewhat wipes out some of the benefit of pensions compared to alternative money schemes (e.g. ISAs).

And the really ugly bit: Reliance on share price gains

On the stock market, the big profits are from buy-low-sell-high, which is approximately a zero-sum game. That means your gain from an increased share price is someone else's loss. Throw in a few stock market crashes, and you soon see that stock trading can corrode away an asset base very quickly.

The problem is that pension funds are not really much more than glorified managed investment funds, and from personal experience investment funds are notorious for losing their clients large amounts of cash. The stock market is basically a dead loss for anyone who is not hands-on investing, and hedge funds are adept at making mincemeat of these managed institutional investors. Not good news when getting a decent pension is reliant on pension funds making big profits at other stock market players' expense. Taxing of dividends makes this situation worse, as it increases the need for stock market bull-runs.

Guess why 'defined benefits' are rare..

Defined benefits (i.e. final salary schemes) are where your company plugged any shortfall between pension fund assets, and what you are contractually due to receive. With defined contributions, if your fund's asset base is eroded, you're stuffed. Defined benefit schemes are pretty much extinct in the private sector, and one can see why public sector unions would riot at any prospect of having to switch to such schemes.