Three big drawbacks of saving into a pension

Working out the best way to fund your retirement can feel like something of a minefield.

While pensions tend to be the ‘go-to’ vehicle – in no small part due to the generous Government tax relief applied to your contributions – they also come with lots of restrictions and potential tax traps you might want to avoid.

For one thing, the age at which you’re allowed to access private pension funds is due to increase from 55 to 57 in 2028, and there’s no guarantee it won’t increase further in the future. This might not fit with your personal retirement plans. 

There’s also the risk your pot won’t grow enough to fund retirement in full, so you might not want to rely solely on this method of saving for your later years.

For this reason, some people instead turn to property and Isas. Here, Telegraph Money sets out each pension problem to see whether these alternatives can ever measure up.

1. You can’t access your money until age 55

One of the big drawbacks of saving into a pension is that once funds are committed, you can’t access the money until age 55 (rising to 57 from 2028).

Alice Haine, personal finance analyst at Bestinvest, said: “If you pay in more than you can afford, you could put yourself at risk of being short of ready cash for more immediate needs.”

By contrast, assets such as Isas can usually be accessed at any time, which might work out better for you if, say, you’re planning to retire early. 

The anomaly is the lifetime Isa which, if you use it to save for retirement, will impose a 25pc penalty charge if you access your savings before the age of 60.

You might be tempted to put your money into buy-to-let property instead, but this also has its drawbacks.

Helen Morrissey, head of retirement analysis at Hargreaves Lansdown, warned: “A rental property could prove useful in times of financial difficulty, though it is fair to say the costs associated with running a buy-to-let, such as maintenance, and covering the mortgage during periods when the property is unoccupied, can also mount up, and cause their own stress.”

Add to that higher mortgage rates being seen at the moment, changes to the tax treatment of buy-to-let landlords, rapidly declining capital gains tax exemptions, and tightening energy efficiency demands, and it’s easy to see why many landlords think property investment is now less attractive than it once was. As a result, we are witnessing many of them sell up as higher costs and loss of tax relief narrow profit margins.

2. Contributions limited to £60,000 a year

Another potential drawback to saving into a pension is the fact you are restricted to contributions of £60,000 per year by the “annual allowance”.

Ms Haine said: “This can be restrictive for high earners, or those who suddenly come into a large amount of cash through an inheritance, for example, and would like to contribute more.”

If you chose to invest in property instead, you wouldn’t be held back by such limits. You can also sell the asset if you need to. And, given the stellar returns we’ve seen from the housing market in recent years, you may be tempted to declare that “property is your pension”.

But you need to tread carefully before relying on bricks and mortar to fund your retirement.

Ms Morrissey said: “Property investment may feel more dynamic, but you need to balance potential returns against the costs of buying and selling, such as capital gains tax and stamp duty on second homes. You also need to recognise that what has gone up can come down.”

With the property market coming under real pressure at the moment, the reality is, many owners are looking at making losses this year. At the same time, market activity has been muted by the ongoing cost of living crisis, and you could find it harder to sell your property than you first thought.

Equally, while you might think of the £60,000 as a “limit”, you could try looking at this another way.

Gary Smith from wealth manager, Evelyn Partners, said: “The pension-funding measures announced in the last Budget, including the increase in the annual allowance to £60,000 tends to weigh in favour of pension saving. The £60,000 ‘limit’ is, for example, a lot greater than the £20,000 Isa allowance.”

3. Having to pay tax on drawdown income

If you are drawing an income from your pension in retirement, another issue to navigate is the likelihood that once this income is added to your state pension, you will find yourself paying income tax.

Compare this to an Isa, which is free from income tax, and you may feel as though an Isa is a better bet.

Ms Haine said: “Those who max out the tax-free allowance of £20,000 a year, have no tax to pay when they withdraw the money. So, if someone has been savvy enough to max out their Isa allowance year after year, they will have a handsome sum to play with.”

According to analysis by Bestinvest, someone who contributes £20,000 to an Isa this year, and then maximises the allowance in full over the long-term, could become an Isa millionaire in just 25 years, with £1,019,601.73 to their name. (This is based on an investment of £500,000, and 5pc compound annual growth).

But this can still be outweighed by the tax relief you get on pension contributions.

Mr Smith said: “The tax benefits are greatest for those who receive tax relief at the higher or additional rates of 40pc and 45pc. This can be hugely beneficial. Even as a basic-rate taxpayer, you are only paying 20pc income tax in retirement.”

Further to this, don’t forget that in most cases, you can take up to 25pc of your pension tax-free.

Do the alternatives cut the mustard?

If your other investments are hit by a sudden market shock, property income can be an effective fallback, according to the experts.

Ms Haine said: “This may be the case, but ultimately ditching pension saving would be unwise. A more sensible retirement strategy would potentially include a variety of options, such as pension savings, an Isa pot and property income.”

Equally, it’s worth pointing out that for certain individuals – such as the self-employed who don’t get a workplace pension with employer contributions – one of the better alternatives, or additions, to a pension might be a Lifetime Isa.  

Save into one of these vehicles, and the 25pc government bonus works like tax relief on a pension – although you can only pay in up to £4,000 a year, and the previously-mentioned withdrawal penalty can be quite restrictive.

With a Lifetime Isa the key, as with all the options which can potentially have a role to play in retirement planning, there are both pros and cons which you need to weigh up.

So pensions still come out on top, then?

While pensions undeniably have their drawbacks as well as their benefits, in reality they are hard to beat as a retirement vehicle.

Rebecca O’Connor from Pension Bee, said: “Pensions offer a unique combination of incentives that other savings products can’t match. Namely, tax relief and employer contributions. Think of it this way: your savings are the ice cream in a cone, the tax relief is the strawberry sauce, and employer contributions, the flake on top.”

As these elements add extra cash to the money going into your pension, this makes your contribution much more valuable than it would if it went into an Isa or savings account.

Ms O’Connor added: “The reason pensions have these incentives is precisely to encourage people to save for retirement – and to increase the chance of having a decent income when you give up work. 

“Pensions also arguably offer your best bet at beating long-term inflation, as the funds are designed to generate investment growth that will be, on average, higher than inflation, over the long term.”

Employees of companies that offer particularly generous schemes could be even better off, as some employers ‘double-match’ beyond the auto-enrolment minimum.

In addition, if your pension is paid via salary sacrifice, so not only do you get tax relief, you will also save on National Insurance contributions.

Ms O’Connor added: “While pensions do have some limitations, no other savings or investment product offers free money in this way. Not having one is the definition of looking a gift horse in the mouth.”