Investing Strategy: ISAs, LISAs and Pensions

A quick check-in on some of the savings vehicles available to UK investors

I wrote this on the T212 forum a few months back but it has recently come up in discussion and I wanted an easier way to share, so I thought I'd publish on Substack, too. Hopefully you will find this useful.

I'm probably encroaching on the space where there are others who are far more informed than me (if this is you, feel free to chip in!), but I've recently been looking at my retirement planning and felt it was worth a post. This post is targeted at UK investors, comparing different Individual Savings Account options with the UK's pension rules, as I understand them.

I must stress that I am not a financial advisor and this is not financial advice. This is my interpretation of the current UK rules and I make no guarantees that I have interpreted such rules correctly. Examples are intended for illustrative purposes only. Please consult a financial advisor to ensure you receive guidance appropriate to your individual circumstances.

It is quite common to see debates between ISAs and Pensions, and each has its relative strengths and weaknesses. I'm going to try and put some numbers around some of these vehicles to show how each can support you. This is just my opinion, based on my own research and analysis. And my maths could be wrong, somewhere.

ISA

ISAs, as most people are aware, are an after-tax savings vehicle that allows the holder to save up to £20k per year without paying (UK) tax on dividends or capital gains. There are several different types of ISA (Cash, Stocks & Shares, Lifetime and Innovative Finance), and you can only save up to £20k per year in total across all accounts / products.

Lifetime ISA

A subset of the ISA category with a maximum investment limit of £4k per year, this ISA is designed to serve one of two purposes - either to buy a home or for retirement support. The government will contribute an extra 25% to your investments. So this is very beneficial! But there are some rules:
🔹️ you must open it and make your first contribution after you turn 18 but before you turn 40
🔹️ you cannot contribute after you turn 50
🔹️ you will give up 25% of the total account (which works out as more than the government bonus ie you will pay a fee) to access the money unless you are: buying your first home; 60 years old or older: terminally ill with less than 12 months to live

Private Pensions

Whether personal, stakeholder or workplace pensions, the government will permit you to save up to 100% of your annual earnings or £60,000 per year tax-free (whichever is lower). There are some differences on whether the tax is removed at source or whether you claim it back, depending on the particulars of your pension scheme, whether or not you are in Scotland, and whether or not you complete a self-assessment for tax purposes.

You will pay tax when you withdraw your pension, but...
🔹️ you can take up to 25% of your total pot up to a maximum of £268k tax-free, usually after you are 55.
🔹️ it is rare that your pension will be as high as your salary, and therefore your tax liability when drawing your pension is generally lower than the tax saving you made while contributing to your pension
🔹️ by being able to contribute tax-free originally, the amount of capital you can commit to your pension is higher and therefore you benefit more from capital appreciation due to market growth over time.

Which is best?

Let's work an example. Let's assume you are 30 years old, already own your home, and in a position to contribute £333 per month (conveniently, £4000 a year ie the limit for a LISA) from your take-home pay to one of these investment vehicles for 30 years. Let's assume that, in each case, your investment grows by 6% per year over that time and let's further assume that you are able to grow your deposits at around 2.5% per year, assuming this is a reasonable level of average wage growth.

After 30 years, you are ready for withdrawal. I assume withdrawals increase each year with inflation, which I assume will be 3%. I will also assume that you want to protect your capital, so you move your investment into lower risk assets with a 4% annual growth rate.

I am using the compound calculator here:

https://www.thecalculatorsite.com/finance/calculators/compoundinterestcalculator.php

The Results

ISA

After 30 years, your investment will be worth £440k. You will pay no tax to access this money. At 3% inflation, this pot is the equivalent of £181k today. If drawing down on this pot for 30 years, assuming 3% inflation and 4% fund growth, this pot could afford you income for each year equivalent to £7,200 today, tax-free.

LISA

Each month, you contribute £333, but the government will give you an additional £83, meaning the actual contribution to your LISA will be £417 per month. After 20 years, your investment will be worth £230k. At this point, you will be 50 and have to stop contributing to your LISA, but your pot can continue to accumulate for another 10 years. Let's assume you now start to invest your £333 per month (which, adjusted for wage growth, will now be £545) in a regular stocks & shares ISA. After those next 10 years, your LISA pot will be worth £412k and your stocks ISA will be worth £98k, giving you total investments of around £510k.

As you will be 60 by this point, you will pay no tax or fees to access this money. If you were to have to pay the 25% penalty for any reason, your LISA+ISA investment would be reduced to £415k, so would be worth less than the standard ISA.

Assuming you can retain the full £510k, you would have a pot equivalent to £210k today. With the same drawdown assumptions as above, this pot could entitle you to the present equivalent of around £8.3k per year, tax-free. This is around 15% more than the standard ISA, but you have to lock your money away until you are 60 for this boost.

Pension

Let's assume you are a standard rate taxpayer, meaning you can only claim back 20% tax on your contribution. Your £333 contribution after-tax would then be boosted by £83, as with the LISA. It is the same boost as the LISA because a 20% tax rate on gross pay is equivalent to 25% after-tax. After 30 years, your investment is worth £550k, with the same spending power as £227k today.

As long as you were willing to fully deplete this fund over 30 years, you could take almost £22k a year under these assumptions, equivalent to around £9k per year today. But you haven't yet paid tax. We will take 25% tax-free, meaning you will be liable for tax on £413k of your original £550k. The £137k tax-free lump can be spread over the 30 years as around £4,600 tax-free per year, meaning you would pay 20% tax on £17.3k of your annual allowance, reducing your take-home to around £18.4k per year, or the equivalent of £7.6k today.

If you are a higher-rate taxpayer, claiming 40% pension relief, your original £333 per month contribution could be worth £555 per month to your pension, meaning your pot after 30 years would be £733k, equivalent to £302k today. This would permit a drawdown of £29.1k per year, or the equivalent of £12k per year with today's spending power. Even including the state pension of £11.5k per year (currently), this would keep you in the 20% tax bracket (assuming tax brackets and state pension move roughly with inflation, which has not been the case recently). After tax, I estimate this pension would provide drawdown of between £24k and £25k per year, equivalent to almost £10.2k per year today.

And what of workplace pensions? If your (gross) contribution makes up at least 5% of your earnings, your employer must contribute a further 3%. So, as a basic rate taxpayer, if your £333 after-tax contributions meet the criteria, your total pension additions could be more like £429 per month. With the same assumptions as before, this could lead to a pot of £566k after 30 years, a before-tax drawdown of £22.5k and an after-tax drawdown of almost £19k, or £7.8k at today's prices.

Conclusions

For the same £333pcm outlay for 30 years from your take-home pay, you could have a 30-year drawdown amount with a present value of:
🔹️£7.2k from your ISA, available when you want (but if drawing down with less than 30 years of contributions, this amount would be reduced)
🔹️£8.3k from a LISA + ISA strategy, only accessible (in totality) from age 60
🔹️£7.6k or £7.8k or £10.2k OR MORE (or less) from your pension, depending on your specific circumstances and prevalent tax rules.

The LISA and pension appear clear winners, especially if you start your LISA early and are (or become) a higher-rate taxpayer.

What retirement planning tools you use?