Is it better to invest in an ISA or pay more into my pension?

ISAs and pensions – SIPPs, workplace pensions, SASS, GPPs – are the simple route to financial independence. Anyone can use them and – if they pay into them – will probably achieve financial independence at some point. They work. Logically, if they didn’t, no-one would be able to retire; and yet you meet a lot of retired old people.

This post is less about the retiring early side of FIRE, more about the idea of retiring at some point. I’ll do a quick financial independence retire early summary at the end, I promise. You should also be aware that I have given my opinion on these as a person trying to achieve financial independence and you should draw your own conclusions.

Disclaimer: this is for information only and is not financial advice. If you want a recommendation tailored to your personal circumstances, seek independent financial advice. Don’t blindly trust some random on the internet, do your own research.

ISAs

We’ll start with an ISA, because it’s the easiest to understand. Well, I say “easy”…

At the time of writing, you can have a combination of ISAs if you so choose. However, you can only pay into one of each type in a tax year (beginning of April to end of March). The most you can pay in between all your ISAs each year is £20,000: that doesn’t include any interest or growth or dividends that’s made within the ISA, it’s just what you can pay in from wages.

ISA stands for “Individual Savings Account”. This is a bit of a misnomer because you can (and probably should!) use them for investing in ETFs, shares, bonds, commodities – that sort of thing. It’s just a wrapper for an account type, but it’s awesome because any gains made in the account are tax exempt. Aww yes. There’s no limit to how much an ISA can build up to either, so you could conceivably have millions in ISAs from being built up over years of paying in the maximum amount and investing well, effectively earning you tax-free passive income.

Ah, one other thing – these are Individual Savings Accounts. If you’re married, you can both have one of each. That’s £40,000 a married couple can potentially put away each year.

If you start an ISA of a certain type but later see a better offer from a new provider – maybe a welcome bonus or lower fees – you can switch the account without penalty. At the time of writing, I’m switching my Wealthsimple robo-investing account to Trading 212 because of the fees and portfolio balance that I want, as per my 2021 FIRE campaign plan. In this case, all I had to do was print a form, fill in some details, then scan it and e-mail it to my new provider. My old provider, Wealthsimple, reckons they’ll have moved it within 3 weeks.

Let’s have a look at the types of ISA you can open as a UK citizen.

Cash ISA

The simplest ISA you can have is a cash ISA. A no-nonsense type of account: you put in money, it earns interest as the bank loans it out/ performs witchcraft.

These are good for if you know that you’re going to need the money soon. Conventional wisdom suggests that investing over less than 5 years isn’t a smart move. It might be one of the options for you to put an emergency fund I guess.

I… don’t use cash ISAs. At all. This is because at the time of writing a “good” interest rate on an easy-access cash ISA is about 0.5%. Given that the target rate of CPI inflation set by the UK government is around 2%, that means your money is losing buying power at 1.5% a year. Yup, cash gets worse over time.

Here’s a table I lovingly stole from Moneysavingexpert.com. It’s worth checking them out, but remember that they’re a savings website and don’t discuss investments. The contents of this table might be obsolete by the time you read them, so if you’re looking for a cash ISA, shop around.

It’s possible to use non-ISA cash savings accounts to get a better interest rate. Yes, they’re taxable, but unless you’re an additional rate taxpayer or keep hundreds of thousands in cash you’re not going to get taxed at these low interest rates. It also frees up more room in your £20,000 annual ISA allowance for the other types of ISA.

There’s a special subcategory of cash ISA that you should know about.

Lifetime cash ISA

If you’re saving to buy a house or want to hold cash until age 60, there’s a Lifetime ISA. This is basically a cash ISA with a perk and some extra rules. Not all providers (banks and building societies) offer a lifetime ISA.

You’d want one of these to take advantage of the government-backed scheme. If you pay into one, the UK Government will top up 25% of your deposit, up to £1,000 per year. Not bad if you want the cash for that first house purchase!

There are strict rules on it though.

• You can either use it as a first house deposit… or wait until you’re 60. If you take the cash out early for any reason other than buying your first home, that 25% deposit is taken back off you.
• You can only pay in £4,000 a year.
• You can only open one between the ages of 18 and 40.
• When you hit 50, you can’t pay in any more – you just have to leave the cash in the account and hope for interest.

So, great if you want to buy a property… average at best for anything else unless interest rates rise. I don’t see that happening within 10 years, so my financial independence campaign plan doesn’t factor one of these in.

Innovative Finance ISA

Innovative Finance ISAs are basically peer-to-peer lending ISAs. That said, they’re not all created equal. Some have a bad reputation but some seem to be built on a reasonable business model.

The general premise

Despite IF ISAs being labelled as “peer-to-peer”, they don’t necessarily lend to individuals. Businesses can borrow from these providers too. A good example of this is the platform Funding Circle, which ordinarily lends to small businesses. You’ll note that if you click the link, however, that the UK Government’s coronavirus bounceback loan scheme has pretty much killed this platform and it isn’t taking on new investors: more on that later. Of course, some providers lend to individuals with bad credit.

The point is that Innovative Finance ISAs aren’t all created equal and all of them come with some element of risk.

One of the IF ISAs I considered – but didn’t take out – was Loanpad. They lend to developers, who use bridging loans to start a development before the property is developed enough to get a mortgage. Loanpad claim that your account money is divided over a portfolio of loans to reduce risk. What I liked was that Loanpad lend on secured debt, so the risk is reduced (but there is always risk in investments… even cash). However, that reflects in their currently low rates. Still, 3-4% is a lot better than a cash ISA, the interest is paid regularly and could be a nice tax-free income stream. Something to consider for when I’ve achieved financial independence, perhaps?

Why IF ISAs are risky investments

I’ll repeat: all investments have an element of risk. With cash, the risk is that inflation is bigger than your interest rate. With shares, the market might drop due to economic panic at the point you want to sell them. With IF ISAs, you’re lending money to one or more borrowers, who may default on the loan and not pay you.

They’re also quite hard to diversify. A peer-to-peer lending platform that specialises in loans to high-risk individuals isn’t going to start investing in real estate loans. Similarly, a real estate investing platform isn’t going to fund the next Amazon. This means that if the market they’re lending to suffers, your money starts to look a lot more precarious. This is known as concentration risk, i.e. putting all/ more of your eggs in one basket.

Ironically, with ETFs being so common and cheap, I’d argue that IF ISAs are more risky than a Stocks and Shares ISA. This brings me on to my next one.

Stocks and Shares ISA

The darling of UK financial independence questors everywhere, the stocks and shares ISA (S&S ISA) is my personal favourite of the bunch.

The “ISA” wrapper doesn’t mean as much as you’d think: an S&S ISA is basically just an investment/ sharedealing account which is legally hidden from the tax man. This means that you get all the benefits of investing in shares, bonds and ETFs, but any growth or dividends is excluded from tax. That’s right: you, too, can be a legally-sanctioned tax dodger!

There are two main types of S&S ISA that you should know about.

Pre-designed portfolio

You can get a pre-designed portfolio of shares/bonds/ETFs, ready and waiting, through either a financial advisor or a robo-investing platform. This means that if you don’t trust yourself and want to dip your toes into the waters of stock market investing before you leap, you can simply throw money into an account and the algorithm/ manager will invest it for you in a pre-designed structure that should perform reasonably well.

I have used both Wealthify and Wealthsimple as robo-investing platforms [neither of these links gives me any benefit, by the way!]. They’re not the only ones out there, so shop around if you’re the fire-and-forget type of investor. I hear good things about nutmeg and there are eco-friendly investment platforms like Clim8 coming out, which is a welcome trend. My partner uses Wealthsimple and has reasonable performance out of it; she doesn’t want to learn how to invest but is happy to be an investor, which is what the platform offers.

If you want to achieve financial independence but are terrified of setting up your own portfolio, you could do a lot worse than a pre-designed portfolio. Fees should be less than 1% of your holdings to be competitive at the time of writing.

The disadvantage is that you’re beholden to whatever rules the platform has set, and some of the financial wisdom is aimed at a long-term, risk-averse investor. For example, I am now leaving a Wealthsimple “growth” (high risk) portfolio that insisted on 20% being in gilts and bonds. This just doesn’t fit with my campaign plan! I was also unhappy that around 25% of the pot would be invested in UK companies or the UK government, which is quite a lot of home bias for such a small market. However, I can’t argue that my portfolio achieved reasonable growth over time and the service was exactly as described, so if you’re not willing to read up on investing then it’s a great option.

Execution-only S&S ISA

The basic account: you pick everything, you meet the platform fees. Famous examples include Hargreaves Lansdown, Interactive Investor and so on. [Again – no sponsored links in this section, I’m not getting anything from these companies.]

Some of the platforms can cost you money to operate and demand fees for each transaction. Some allow you to buy into a selection of ETFs and funds for free, but charge you for individual share purchases. Some allow you free or heavily-discounted regular drip fed investments but bill you for instant trading. The important point here is to shop around for the fees that suit you if this is the route you go down.

There are now “free” trading platforms that offer S&S execution-only ISAs. Freetrade famously doesn’t charge you for trading but bills you £3 a month to keep an ISA open (which is on the low side!). I haven’t used it but I hear positive things. I’m switching my account to Trading 212, which I have trialled with a non-ISA investment account. They don’t charge you fees per se unless you buy a share or fund in a foreign currency (e.g. US$ or EUR), when they add a 0.15% foreign exchange fee. I’ve heard mixed things about their platform reliability and getting your money out of the platform when you want it, but as my pot is still tiny and there are some cool features on the app it’s a reasonable trade off for the low fees.

If you want to use Trading 212 and want us both to benefit, you can use my referral link so that we both get a random free share as a bonus. Don’t feel pressured though and definitely make sure that this is something you want to do before you sign up.

I’m now reasonably well read into investing, so I’m using an execution-only S&S ISA as part of my plan.

RECAP: what’s good about ISA investing

This is a feature-length post, so let’s quickly recap the benefits of ISAs before we look at pensions and before we work out what’s better.

• Tax free gains. Your capital gains, interest, dividends and so on are completely and legally hidden from the tax man. Hooray!
• Your can take money out when you want. Obviously, a lifetime ISA has a penalty for this, but you can at least demand money. Also, it sometimes takes a couple of days for money to clear after selling shares, so you may need a few days’ notice.
• You can squirrel away up to £20k a year in it. That’s right: you can technically save £20,000 each year and invest it through one of these.
• You can have a mix. You can have up to one of each of: cash ISA, S&S ISA and IF ISA.

Investing in Pensions

Pensions are a funny beast. There are a few species of pension, but the general rules are the same:

1. You can invest up to £40,000 a year or your annual income, whichever is lower.
2. You can have as many as you’d like. The total value of all of them counts, however, as a single pension for pension rules. What this means is that you can have a workplace pension and a personal pension if you’d like.
3. You can transfer them into a single account. If you end up with a dozen pensions from different employers, you can get them all transferred into a single pension that you’re happy with. Nice and convenient.
4. Tax benefits. This is actually quite complex and I’ll explain more later.
5. Up to 25% lump sum at the end. When you finally decide to retire, you can take 25% of the pot out as a tax-free lump sum. Maybe you could top up an ISA with that and add some tax-free income to your pension, hmmm?
6. Age limit. You can’t draw from your pot until age 55/57/10 years before State Pension Age. So, if you achieve financial independence, you won’t get into that pension money until quite late.

Species / Types of Pension

In theory, there are two types of pension. However, as will become clear later, I’m pretty much going to ignore the first type because for most people under the age of 50 these are dead or soon-to-be-dead.

Defined benefit pension schemes

This is where you pay in as part of your wage and the amount you’re going to get at the end is decided well in advance. It’s usually a monthly income that’s a proportion of your average wage or final salary. These are employer schemes, paid by certain jobs.

Defined benefit schemes should in theory be paid by your employer investing the money that they would’ve paid you into assets and growing the pot, so that there’s enough in there to cover your defined benefit and make a nice profit for the scheme. One of the problems here is that in the private sector a lot of companies didn’t invest enough to grow the pot, to keep up with growing life expectancy of employees, meaning that some of them are underfunded and can’t really pay the benefits due. This is partly because of poor investment choices (seriously, if you read Benjamin Graham’s The Intelligent Investor, he recommends a 50-50 split of government bonds and shares, which doesn’t make sense any more), but mostly due to the scheme relying on more people dying sooner than they actually do. Genius.

As a result, very few of these still exist that take on new members. You might find some older people that still have them. The one exception to this is the public sector. For example, I have an armed forces pension with a defined benefit; several civil servants I know have a defined benefit scheme, too. Even then, my assessment is that these are going to start to die out now.

We’ll ignore these from this point onward. If you’re lucky enough to have one, good for you – read the scheme rules.

Defined contribution schemes

Unless you’re self-employed and always have been, these are the more common option and you probably have one of these.

The idea is that you pay in money, the tax benefit is added/ no tax is taken, then this gets invested (usually, but not exclusively, in shares and bonds, but you can invest in all sorts of things in a pension). At the end, your pension pot has a value and you can start drawing down from it.

Most workplace pensions are now a defined contribution scheme. If you’re employed, your employer generally has to pay some money into one of these, too. All Self-Invested Personal Pensions (SIPPs) are defined contribution, as are the funky Small Self-Administered Scheme (SSAS) pensions that business owners can set up.

From this point on, we’re going to talk about defined contribution pensions. They’re the most common and when you’re talking about investing and making overpayments, you’re usually talking about these.

To look at the benefits of paying more into a pension – and there are some awesome benefits – we need to think about the sub-species of pension and what you can do with them.

Workplace pensions

There have been a few versions of these, starting with the stakeholder pension scheme that has now rebranded and come under a slightly different regime. However, they all basically work the same way, which is:

1. You pay in an amount of your pay, usually subject to a minimum amount; and
2. Your workplace pays in an agreed amount, which can’t be lower than 3% of your salary.

The actual arrangements vary and you should check your scheme for details of who pays what.

Commonly, your employer will match an increase in contributions. For example, for every 1% you pay in, they might also pay in an additional 1% up to a set value. Some schemes can be quite generous: I’m fortunate that my job pays 6% of my salary as long as I pay in 3% minimum.

Technically, you can opt out of workplace pensions. Technically. However, unless you’ve hit the lifetime allowance on pensions and have over £1million in your pot, opting out is generally a bad move. How many other investment accounts double the money you put in? Even if you make some terrible investment decisions with the pension fund, you can be pretty confident of at least doubling your money when you pay into a workplace pension.

Most workplace pensions have an element of choice over investments, but you’re usually limited to whatever funds the provider has to offer.

Group Personal Pensions

There’s a hybrid workplace-personal pension called Group Personal Pensions or GPPs. These basically work as a workplace pension for contributions from your employer (nice!) but the selection of funds and the performance of the pot is entirely your business and your employer doesn’t want to know any more about it.

When I studied this on my Legal Practice Course, these were classed as personal pensions; however, when you look at the key bit – “does my boss pay in, too?” – they’re effectively workplace pensions.

Personal Pensions – SIPPs etc.

Personal pensions are ones that you set up yourself and pay into with your own cash. This means that you can usually get a lot more control over what’s in your pension, as you can choose your provider to find one that invests in whatever you want your pension to buy as an investment. The most common one is a Self Invested Personal Pensions (SIPP). Like an S&S ISA, a SIPP can be invested in using a robo-investor or a pre-designed portfolio if you don’t want to make the decisions. I’m presently using Vanguard’s SIPP platform for my additional pension, which allows me some choice in funds to invest in, provided that they’re managed by Vanguard; my partner invests in a Vanguard pre-designed portfolio that seems to perform reasonably well.

Anyone can open a SIPP and there’s no limit on the number of SIPPs you have, provided that you don’t contribute more than £40,000 into pensions each year.

SSAS Pensions

If you’re the director of a limited company, you can have a Small Self-Administered Scheme pension.

They’re basically a SIPP (as you run the company, so even though you’re technically employed you’re also the boss!) but they can buy pretty much anything.

With a SSAS, you can also do crazy stuff, like take a loan against the value of your pension pot. Yup, that’s right, you can borrow against it. This means that you can use a SSAS pension to take out a mortgage on rental property, for example. If you run a limited company, it might be worth speaking to a specialist in SSAS pensions as they can do some other cool stuff.

Tax breaks on pensions

Pensions are super tax-efficient.

Your wages come in after tax (or before tax but with tax owed on them if you’re self-employed). However, pension contributions into the pot are paid in before tax and national insurance. This means that the money you pay in is worth more in the pot than in your wallet. Instead, the tax is taken off when you start to draw down the pension, billed as income tax.

If you pay into a SIPP yourself, the provider will automatically write to HMRC and get a 25% top-up from the tax man for that tax you’ve already paid in. If you’re a higher rate taxpayer, you can then apply to get the extra tax you pay added back on.

When you draw down, the first 25% of the pension pot can be taken as a tax-free lump sum. There’s nothing to stop you dropping £20k at a time into an ISA to make some tax-free passive income on top of your pension draw down. The draw-down is then taxed as income, so the first £12,500 (today’s personal allowance) per year is tax free, with income tax being added on whatever is above that.

Basically, you’re going to pay very little tax. Here’s an example with a small pension pot of £200,000.

Total in the pot at retirement = £200,000
We take the tax-free lump sum of 25% = £50,000. That leaves £150,000 in the pot.
This £150,000 stays invested and we cream off 4% of this value from dividends/ growth/ interest.
As a result, we get paid £6,000 from our pension in income, which we draw down. This is lower than our personal allowance of £12,500, so it’s completely tax free and we still have £6,500 we can earn before the tax man comes knocking.

Being financial independence geniuses, we invest that £50k lump sum:
£20,000 goes straight away in an S&S ISA, giving us £800 of tax-free money at 4%.
The other £30,000 goes into a general investing account for now, but next year we’ll sell up £20k and add that to the ISA, too. Then, the year after that, we’ll move the last £10k until we have £50k earning tax free growth. In the meantime, it’s still earning around 4%, i.e. £1200, quite reasonably.

In total, we’ve earned £8k a year from this small pension pot and we’re not paying a single penny in taxes on it!

Now imagine that you had a decent ISA portfolio built up over the years to add to this…

Investments you can make in a pension

Like S&S ISAs, you can invest in shares, bonds and ETFs. However, unlike S&S ISAs, you can also invest in Open-Ended Investment Companies, funds that aren’t listed on a regulated investment exchange (such as the London Stock Exchange), private real estate investment funds and even things like physical gold bullion.

That’s a pretty huge spread, right?

A note on workplace pension investment funds

This is not financial advice. However, it’s worth checking with your workplace pension where your money is being invested into, as they are seldom optimised for your benefit. My mum had an old workplace pension scheme that was targeting a measly 1% nominal growth per year! Needless to say, she has since transferred this into a much more aggressive fund.

I found with my workplace pension that the default setting was incredibly conservative and only targeted 2% real growth. However, if you spoke to the pension provider, you gained access to a whole host of investment funds that you could choose from within the same scheme. I’m now on a much more aggressive workplace pension plan that even includes some commercial real estate investments, with a targeted return of 5-7% real return. That’s a big difference, all for the sake of doing a bit of background reading and optimising the portfolio strategy. Might be worth checking yours out!

Salary Sacrifice

It’s entirely possible to have your pension paid by salary sacrifice. This means that the money you get paid never sees your bank account and goes directly into the pension pot.

This is a good thing because it means that national insurance contributions are factored in. To give you an indication, paying £100 by salary sacrifice as a basic rate taxpayer is currently only reducing my payslip by £68. Bargain!

The obvious downside of pensions for financial independence

So, pensions are awesome. The tax breaks make them incredibly efficient, you can get loads saved up at very little personal cost, and you’re probably not going to pay much tax on the draw down if you’re smart about it. What’s not to love?!

Well, timing.

You can’t get at your pension for a looong time. If you’re aiming to achieve financial independence from age 55/57/whatever, that’s not a problem for you. However, I’m aiming to hit financial independence by age 43, and my SIPP/ workplace draw down can’t begin until age 57. I need to have enough to live on until then!

Which brings us to our killer point, the whole reason for this post:

Would I be better investing in an ISA or paying more into a pension?

The answer is simple to this depends on four factors:

• When do you expect to achieve financial independence by?
• Will you get any more contribution-matching from your employer?
• Do you need flexibility? and
• Have you already hit your lifetime pension allowance?

If you’re already in your 40s and financial independence isn’t achievable before age 55/57, a pension is probably a better vehicle for you. The tax benefits mean that unless you’ve hit your £1.073m lifetime pension allowance you’re probably going to get more bang for your buck with the pension. On the other hand, if you’re 33 and aiming for financial independence in 10 years, you’re going to need to live off something before your pension kicks in, and that’s probably going to mean an ISA!

If you haven’t maximised the payment matching benefit from your employer, you’re wasting an opportunity for free money. When you factor in the tax breaks on your payment in, are you sure you can’t save an extra £68 a month from your expenses?

Pensions don’t offer much flexibility. If you have an emergency change of circumstances, that money is still locked up until you’re older. With an ISA, you can liquidate when you want to. It’s like an additional layer of protection.

If you’re close to your lifetime pension allowance, more pension payments won’t help! Might as well commit to the ISA.

What I’m doing

If you look at my financial independence campaign plan, you’ll see that I do both.

I pay £200 per month into my workplace pension (costing me £136 from my pay packet) which my employer generously overmatches. I’m also paying £200 (topped up to £250) per month into a SIPP. That gives me, after tax and employer contributions, £650 per month going into pensions, i.e. £7,800 per year going towards long-term retirement.

Now, at the moment, that’s a lot bigger monthly contribution than I make to my S&S ISA. There’s a reason for that: I’m investing in myself to try and double my wage in the next 3 years.

As I plan to hit at least coasting financial independence within 10 years, I have no plans to overpay any more into the pension. In fact, I may reduce my payments into my SIPP if my pay increases and I pay more into the workplace pension, purely on the grounds that this money will be needed in the ISA to bridge the gap from achieving financial independence to hitting pension age.

This means that I’m personally better off investing any additional surplus into an ISA to achieve my financial independence objective, rather than paying any more into pensions.

Remember: this isn’t financial advice. Just because the numbers work out for me at a level I’m happy with, doesn’t mean that it’s necessarily a good idea for you. If you need help, seek out a specialist financial advisor and don’t trust your future to some random on the internet!