Do it yourself

Changes to the pensions regime introduced on A-Day will open up self-invested pension plans to a wider range of investors, enabling more and more people to construct their own investment portfolios. Simon Hildrey reports.

To achieve the best possible risk-adjusted returns from a portfolio, an investor would not want to constrain himself by limiting the number of funds and asset classes he can access.

It is therefore unsurprising that many investors want to take control of the management of their pension fund rather than leave it in the hands of an insurance company. The wide choice of asset classes and funds has made self-invested personal pensions an attractive option for an increasing number of investors.

Sipps were introduced through the Finance Act 1989 to provide greater freedom to personal pension holders. They used to be the preserve of the wealthy but fees have been reduced substantially, making them not only accessible but also potentially cheaper than stakeholder pensions once a fund rises above 50,000, and particularly in excess of 100,000.

The tax benefits of Sipps are the same as for other pensions. They offer income tax relief on contributions and are free from capital gains tax, and generally from income tax.

Patrick Connolly, of John Scott & Partners, says Sipps have become attractive to a greater number of people. “Traditionally, Sipps have had monetary fixed upfront and annual fees,” he says. “If an investor had a small pension fund then it was expensive to use a Sipp that had a 300 to 500 upfront charge and a 300 annual fee. This was only appropriate for investors with large pension funds.

“But Sipp providers have now introduced charges that are a percentage of assets within the Sipp. This has opened up the Sipp market to a lot more people.”

In deciding whether clients should invest in Sipps, Connolly says it depends on which pensions wrapper is appropriate for their requirements. “For people who want great flexibility over their investments, Sipps are attractive,” he says.

“But if investors do not require much flexibility and a wide choice of investments then they have to question whether they need to take out a Sipp.”

Tom McPhail, head of pensions research at Hargreaves Lansdown, says Sipps are appropriate for almost any investor. “It is easier to talk about the people for whom Sipps are not relevant,” he says. “These are people who want a simple pension and are happy investing in default funds.”

Julian Palmer, head of pensions at Rathbones, says the minimum assets required for Sipps have come down with charges but clients should have a pension fund of at least 30,000 to 50,000. “The average size of Sipps with Rathbones is around 250,000,” he says. “Some Sipps are much larger than this but few are very small. Sipps are best suited for people who want and can take advantage of investment flexibility. They also appeal to people who want to invest in a particular asset class, such as commercial property, that they cannot access through anysion schemes may want to top up their funds by using a Sipp.”

One of the main attractions of Sipps is the greater investment choice they provide compared with traditional pensions. “Rather than be limited to a handful of funds under an AVC [Additional Voluntary Contribution], investors can have a wide choice of funds via a Sipp,” says McPhail.

He adds that Sipps can provide diversification across pensions as well, so investors are not reliant on their company pension scheme. “People may not want to be reliant on their company pension to provide an adequate income in retirement,” he explains. “There are questions over whether the same benefits will be in place when they reach retirement.”

Jamie Fergusson, pensions development manager at Jupiter, says Sipps should be regarded as another pension product on the table but with greater investment flexibility. “The frenzy surrounding the possible inclusion of residential property in Sipps has been good in the sense that it has sparked greater interest in pensions,” he adds. “This is because residential property is an asset class that people understand.”

He says Sipps are not a cost-effective vehicle for investors, for whom the charges account for more than 1% of assets. Therefore, he says, for middle-market Sipps, investors require at least 40,000 to 50,000 in their pension fund.

“Sipps are not ideal for individuals who are in their first job and just beginning to pay 100 a month into their pension,” says Fergusson. “If an investor is likely to choose default funds only, a stakeholder pension may be more appropriate. There is no point paying for the investment flexibility of Sipps if they are not going to be used.”

The investment strategy within Sipps should be similar to portfolios outside of a pension, according to advisers and product providers. “Investors generally do not take as much risk with their pension portfolios as they could,” says Fergusson.

“Investors can afford to take on greater risk as they are likely to have up to 35 years until they retire. They can afford some volatility over the short term and therefore can have exposure to emerging markets and other, more aggressive, asset classes.”

Mark Dampier, head of research at Hargreaves Lansdown, says: “People tend to be too conservative when running Sipp portfolios. If an investor is aged 35 to 40, they should not be worrying about having fixed interest exposure.

“They can afford to have volatility in the short term, as long as they have selected good fund managers who will generate growth in the long term. They should also not worry too much about diversification while they are building their Sipp and they have a long way to go until retirement.”

There has been a traditional view that as investors approach retirement, they should increase their exposure to fixed interest and reduce the amount invested in equities. But some advisers and product providers believe investors should consider retaining a significant proportion of the Sipp portfolio in equities.

Fergusson says that Jupiter is promoting the concept of a “layer cake” approach to investment. “Following A-Day, investors have not had to buy an annuity when they reach 65,” he says. “Rather than shift their exposure towards fixed interest, investors can retain large exposure to equities.

“Take an investor who wants to receive 7% income a year. He should allocate around 20% to cash so this will supply income for the first threeyears after retirement, allowing for a little bit of capital growth.

“Another 20% can be allocated to fixed interest to provide income for another three or four years. The first 40% of the portfolio should provide income for the first seven years of retirement.

“Around 40% of the portfolio can be allocated to equity income funds. This provides dividend income and capital growth so is a good core holding for a Sipp.

“This should provide income between the seventh and 15th years of an investor’s retirement. The final 20% of the portfolio can be invested in more aggressive investments, such as emerging markets, for which greater volatility can be tolerated.

“In the first few years of retirement under this approach, investors will eat into their capital. But the idea is that the other end of theportfolio is generating growth to compensate for the loss of capital in the early years.”

Jason Day of Allenbridge says the investment approach within Sipps should be similar to non-pension portfolios. “One of the main differences from non-pension portfolios is the fact that Sipps are not as liquid,” he says. “We have couples as clients who have built up Isas and Peps of 600,000, for example. One advantage is the fact that this money is in tax-efficient wrappers, which can be accessed at any time.

“The key is for the Sipp portfolio to be robust and well diversified across the different asset classes. If you are in your mid-30s, you can afford to take more risk with a greater exposure to equities, including emerging markets and volatile developed markets like Japan. If you suffer a loss, you have time to make up the losses.

“But as Sipp holders approach retirement, they need to give greater thought to income requirements. This will depend on the bigger picture for the client. Among the issues to consider are the client’s attitude to risk, how much wealth they have outside the Sipp and how much income they will require.”

Day says that a fairly standard asset allocation can provide sufficient income to clients as they reach retirement. “A cautious allocation may have 40% in equities. The core of this could be in equity income funds, which should provide income of at least 3% a year,” he says. “Other assets including fixed interest and commercial property also provide a yield. Alternative investments and commodities can provide diversification by having low correlation with other asset classes.”

Day says that Sipps require active management of the asset allocation. “The allocation cannot be made and then simply left,” he warns. “It needs to be rebalanced on a regular basis as profits are taken from certain asset classes.”

Rathbones’ Palmer says the main distinction from non-pension portfolios is the need to plan for income. “With portfolios, there is not usually a requirement to deliver income at a particular age,” he says. “But with Sipps you need to plan for income, whether that is when people are aged 55 or before they take out an annuity.”

Sipps are an attractive personal pension for many investors. But they are simply a wrapper with wider investment flexibility than traditional pensions. The key to success is the construction and management of the underlying portfolio.

Choosing a Sipp provider
Once a client has decided to set up a Sipp, it is not the end of the work. The next step is to choose a provider, of which there are more than 55. The difficulty in selecting a Sipp provider is that the comparison is not on a truly like-for-like basis.

As Tom McPhail of Hargreaves Lansdown says, the difficulty is that Sipps are not all the same and offer different services and quality of services. “If you want a bespoke service or greater flexibility, it will be more expensive,” he says.

In selecting a provider, the first step is to decide what a client wants from a Sipp. Two of the main decisions are which investments they would like to hold and how frequently they expect to trade assets within the Sipp.

It is important to decide which investments clients will hold within a Sipp rather than those that they might hold. Advisers say there is little point in selecting a more expensive Sipp to allow a client to buy commercial property if they are unlikely to do so. This includes how many times they really will buy and sell funds during a year. If they trade frequently then it will be expensive to have a Sipp that charges for each transaction.

One of the main reasons for choosing a Sipp is the wider range of investments available over traditional personal and occupational pensions. Not every Sipp provider, however, will allow you to hold all these investments. According to Moneyfacts, you cannot invest in commercial property via a number of Sipps. These include Charles Stanley, Hargreaves Lansdown, Harsant Services, James Hay, Pilling, GE Life, Alliance Trust, American Express and Baillie Gifford. Another investment that a number of providers do not allow is traded endowment policies.

Even if a Sipp provider does allow the investments you want, advisers recommend you choose a specialist provider for certain asset classes, such as commercial property, because of their greater experience of administering the assets.

Generally, costs for Sipps have been falling, making them more accessible to a wider number of investors. But you still need to check all the charges carefully before selecting a Sipp. The headline costs may constitute the initial charge and annual administration fees. But there may be many other costs, including a dealing charge every time you buy or sell an investment.

Furthermore, if you want to buy a commercial property, some Sipps may insist on you using their appointed solicitor, mortgage lender or property management company. If you do not, they may impose an extra charge.

The set-up charges vary from nil up to 765 plus VAT, charged by Mattioli Woods. Some will have varied set-up charges. Norwich Union, for example, has no charge if you invest in its funds, but a fee of 290 if you also invest in third-party funds.

The annual administration charge may be a fixed fee or a percentage of the assets within the Sipp. Norwich Union has a fixed fee of 290 for a Sipp with less than 100,000, but this declines to nil for a Sipp with more than 250,000. The highest fixed annual administration charge is about 650.

In deciding on a type of charging structure, you need to consider how many assets you are likely to have in the Sipp. Rathbones, for instance, has a charge of 0.5% for up to 500,000, and then 0.2% for assets in excess of this amount.

Greyfriars Asset Management charges 0.25% of the Sipp value but has a minimum charge of 650 and a maximum fee of 1,290 plus VAT. Hargreaves Lansdown does not have set-up fees and only has an annual 0.25% administration fee up to a maximum 200 plus VAT. The highest percentage fee in the market is 0.75%.

Some fees are less easy to determine. Mattioli Woods charges a fee of 375 plus the time it spends on administration and VAT. Some providers offer an estimate of costs upfront.

You also need to keep an eye on other fees, especially dealing costs, as they can vary significantly. James Hay has no set or annual administration charges but does have a dealing charge of 30 per transaction, up to a maximum of 300 a year. It also charges 60 to purchase second-hand endowments. Standard Life has a dealing fee of 10 for funds and unit trusts but 50 for other investments, up to a maximum of 300 a year. Many Sipps, however, do not have dealing charges, which are more attractive if you are likely to buy and sell shares and funds frequently.

Costs do not end there. Sipps may charge for property and annuity purchases. There can also be extra fees for phased retirement, transfers in from occupational or personal pensions, transfer-out costs and additional fees for income drawdown.

Potentially, the cost of transferring policies into a Sipp could be significant. One of the attractions of Sipps is the fact that you can consolidate existing occupational or personal pensions into one wrapper. The range of charges is from nil up to 750 plus VAT per transaction for occupational pensions with Charles Stanley.

But this is not necessarily a reason to decide against using Charles Stanley. Your clients should consider the big picture when selecting a Sipp. All costs should be taken into consideration and if your client does not plan to transfer pensions to their Sipp, the 750 fee is an irrelevance.

The final charge to check is whether the provider has an exit charge. If your clients feel they made a mistake in their choice, they do not want to face a penalty for switching provider as well.

Arguably, one of the more surprising differentials between Sipp providers is the interest rates they pay on cash deposits. Richard Mattison of Pension Associates Limited says they can vary by as much as 2%. “The significance of rates on cash deposits is shown by the fact that a 1% differential on an average annual cash balance of 30,000 is 300, which is the same as our standard Sipp fee,” he says.

One of the hardest factors to evaluate is the quality of administration and service you will receive. It is said that the quality can vary significantly. The speed at which assets are transferred into Sipps can also vary.

As far as possible, check how committed the provider is to the Sipp market. Some providers may have launched Sipps because their competitors did so. It is better to be with a provider who will remain in the market for the length of time the Sipp will be held.

A-Day changes and Sipps
As with other pensions, the rules governing Sipps changed from A-Day, April 6, 2006. One of the rule changes has enabled a greater number of people to access Sipps. Before A-Day, people could not contribute to a Sipp if they were a member of an occupational pension scheme unless they earned less than 30,000 a year or had another source of income. These restrictions have now been removed so that anyone can have a Sipp regardless of whether or not they are a member of another pension scheme.

Before A-Day, the amount of money that people could contribute was determined by their age and earnings. From A-Day, people have gained tax relief on contributions of up to 100% of their UK earnings, up to a maximum of 215,000 a year. This limit will increase for the next five years to 255,000 in 2010/11. Any contributions in excess of these limits will be subject to an annual allowance charge of 40%.

There is also now a lifetime allowance of 1.5m for the tax year 2006/7. This will increase over the next five years, reaching 1.8m by 2010. If the pension fund is greater than these lifetime allowances when the benefits are taken then the excess will be subject to tax.

After the government’s U-turn, which has prohibited residential property being held within Sipps, the permissible assets have changed little since A-Day. It is now possible, however, to invest in unquoted shares for the first time. Among the other assets that can be held in Sipps are shares, open and closed-ended funds, insurance company funds, traded endowment policies, futures and options, structured products, hedge funds, deposit accounts and commercial property.

The borrowing rules have been changed. Prior to A-Day, people could borrow up to 75% of the value of commercial property to fund acquisitions. Since A-Day, it has been possible to borrow up to 50% of the net value of the investments within a Sipp.

When Sipp holders take their benefits, they can take up to 25% of their pension fund as a tax-free cash sum. People can also take income drawdown up to the age of 75. Since A-Day, it has been possible to take a maximum income of 120% of a single life annuity based on the Government Actuary Department’s annuity rates, in what is known as “unsecured pensions”.

Since A-Day, it is no longer compulsory to take an annuity by age 75. Instead, an alternatively secured pension is available, which allows people to draw an income directly from their fund. The maximum income allowed is 70% of the relevant annuity for a 75-year-old, regardless of their age. They can then purchase an annuity at any time.

Unlike an annuity, an ASP will have the potential for funds to be passed on to other members of the scheme, including adult children. This can occur where there are no surviving dependents but where the fund still has a residual value. In this case, the remaining fund could be paid out as cash to a nominated charity, or alternatively passed as a pension fund to other members of the scheme.

There are inheritance tax (IHT) implications, however. There is no IHT liability for someone in income drawdown who dies before age 75 under normal circumstances. But there is a 40% IHT charge on ASPs when they are passed on to dependents’ pension funds.

The choice now is whether individuals take out an annuity and not pass on the pension fund to heirs or use an ASP and pass the assets on but with a 40% IHT charge. The tax is paid out of the pension fund, which means beneficiaries do not need to find cash to pay the IHT bill. If there is a surviving spouse, the ASP must be used to provide them with an income.

As the ASP is passed on to another pension fund, usually a child’s, the dependents need to ensure their own pension fund will not be pushed over the lifetime allowance, which is currently 1.5m.

The Budget in March also confirmed plans to introduce rules to prohibit the potential for recycling tax-free cash by returning the tax-free lump sum to the pension scheme. This means anyone who takes income out of their pension will have to be careful about future sizeable contributions. People will need to keep years of records tracking the ebb and flow of their wealth, says Richard Harwood, head of pensions at Grant Thornton.

Sipp investors can invest in assets jointly with members of their family or co-directors. On the death of a Sipp member, the assets can be passed on to any surviving dependents. If there are no dependents, the funds can be passed on to any member of the same Sipp nominated by the member before their death, or to a charity of their choice, says Hyman Wolanski, head of pensions at Alliance Trust Savings.