Saving for children: pensions vs Isas

Taking out a pension for your child may seem like delayed gratification, but they could end up sitting on a pot of more than £500,000 by age 55 if you start paying in now - an investment they are likely to thank you for in their later years. Pensions are among the most generous savings vehicles around due to the large chunk of tax relief awarded to any investment, and so a good way to make the most of any income you put aside for them. As children do not earn income, your investment on their behalf into the pension will be capped at £240 per month, an annual limit of £2,880. However, when basic rate tax relief of 20 per cent is added, that sum rises to £300 a month - or £3,600 per year - a £720 top-up.

According to Hargreaves Lansdown, putting aside £300 a month from your child or grandchild's birth until they are aged 18 could leave them with a pot worth £579,000 by age 65 - at a cost of just £52,000. Paying in £50 a month would build up a pot worth £96,000 by age 65 and cost just £9,000. As the account is under the child's name and not yours, any payments in will not count towards your own pension allowance.

The fact that you can use your annual gift exemptions to make the payments translates into a major inheritance tax saving, too. Petronella West, chartered wealth manager and co-founder of Investment Quorum, says: "We can all give £3,000 a year away as a gift. Do that for 20 years and you end up with £60,000, and with investment growth added you are saving tens of thousands of pounds in inheritance tax because it never gets added back to the estate."

Stakeholder pensions vs Sipps

The two main options are a self-invested personal pension (Sipp), bought via a broker or platform, or a stakeholder pension from a large pension provider. Savers keen to choose their own investments often opt for Sipps over stakeholder pensions, which only tend to offer the provider's own funds. But brokers charge annual fees as well as passing on fund charges, and the fees may not make sense when the initial size of the pot and lack of need for flexibility is considered. Stakeholder pension funds are capped at an annual management cost (AMC) of 1.5 per cent.

"The child Sipp option is like using a sledgehammer to crack a nut," says Patrick Murphy, managing partner of Zen Wealth. "You have to question how much flexibility you really need when saving for a child and the impact of those additional costs. They are likely to be just as well served by having a simple low-cost fund."

Ms West says: "I would want to be buying an off-the-shelf product for a child pension because with small amounts of money cost is really relevant. With Sipps, you will have underlying fund charges as well as the account charges."

But Patrick Connolly, chartered financial planner at Chase De Vere, argues that investing in a very low-cost tracker fund via a discount broker could end up being cheaper than a stakeholder pension. Low-cost options include AJ Bell YouInvest, which charges just £5 per quarter on holdings below £10,000 and no set-up fees. Tracker funds can have low ongoing charges of under 0.1 per cent when purchased on platforms. That compares with a Legal & General stakeholder pension, which charges an AMC of 1 per cent on holdings up to £25,000.

Junior Isas vs pensions for children

The clear downside to the pension route for children is the fact that the money will be locked away for a very long time. Currently the earliest you can access the money is age 55, but this is likely to be set at a much higher age for your children's generation. That means they will not be able to use it for university costs or buying a home.

Jason Witcombe, chartered financial planner at Evolve Financial Planning, says: "I disagree with putting money in a pension for a child. We are talking about tying money up for decades upon decades, while children are likely to need the money sooner. For the vast majority of people, a junior Isa, at least, has the benefit of being accessible at age 18, and it can be a good route for grandparents."

The junior Isa limit is higher than the pension limit - you can pay in up to £4,080 in the 2015-16 tax year and the tax benefits are still positive, as the funds in the Isa are free of capital gains and income tax.

You could save a higher amount into a junior Isa than a pension by the time your child is 18, but benefit from more tax savings with a child pension. According to Ms West, a parent could have paid a maximum of £51,840 into a child's pension starting at age one and paying until 18. With tax relief that is bumped up to £64,880 and could accumulate to a value of £106,340 when compound returns are considered. In contrast, a junior Isa could be worth £137,657 at age 18, but at a cost of £86,077 to the parent or relative. Both scenarios assume a 5 per cent a year compound return.

But Mr Witcombe is also sceptical about Isas for children and says you should first use your own allowances. "A lot of people will blindly assume that junior Isas have to be the mechanism for saving for children," he says. "But I think for most people, doing things tax-efficiently in their own names and ear-marking some of that for their children, while maintaining control over how much is actually given and when, is a better route.

What should you put in your child’s savings?

An Investors Chronicle reader who has already taken out a Sipp for his eight-year-old daughter says: "I have decided to open a Sipp for her, with the expectation that investment will be one of the best things I can do for her over the next 60-70 years."

But he wants to know if he is striking the right balance when it comes to his fund choices. The Sipp, worth over £3,500 and purchased from Hargreaves Lansdown, is invested in three funds: Lindsell Train Global Equity* (IE00BJSPMJ28), Man GLG Japan CoreAlpha* (GB00B0119B50) and Marlborough UK Micro Cap Growth* (GB00B8F8YX59), but the reader wants to be sure he is striking the right balance.

He asks: "Given the very long timespan involved, the powers of compounding and my acceptance of a mid to high level of risk, how should I build the portfolio from now onwards?"

Our reader already has a significant amount in this Sipp, but when you start investing you will not need a large number of funds. With a small investment amount you are to accrue unnecessary costs or dilute your returns with a large number of funds.

Mr Connolly says: "You should be investing in the equity market either through a low-cost tracker or global equity fund. Witan Investment Trust* (WTAN)."

Since you have a long period of time to save, you should be taking a robust attitude to risk and be mainly invested in equities. Jason Hollands, managing director at Tilney Bestinvest, says: "This is a very long time horizon over which to be invested, and one during which you should be able to tolerate higher levels of volatility. I would suggest pursuing a global approach."

He says a "one stop shop" funds that does this is Scottish Mortgage Investment Trust* (SMT), a long-standing favourite of ours which has a fairly high-octane approach, investing in growth companies from the US and China.

Mr Hollands adds: "For a split investment approach, I would consider funds such as Fundsmith Equity* (GB00B41YBW71) and Ardevora Global Long Only Equity (IE00BBGT3P34) for developed market exposure (75 per cent) and Fidelity Emerging Markets (GB00B84Q8M70) or JP Morgan Emerging Markets Investment Trust (JMG) for the emerging markets component."

Adrian Lowcock, head of investing at AXA Wealth, says: "I would initially begin a junior Sipp with a global equity income fund. Fidelity Global Dividend (GB00B7GJPN73) is a fairly concentrated global equities fund with about 50 holdings and is focused on large companies. Manager Daniel Roberts targets income and long-term capital growth from the fund."

Platform junior Sipps cost comparison

Source: Company websites

Stakeholder pension cost comparison

Source: Company websites

Pensions vs Isas for children: How much could you save?

Assumes 5% pa compound return and £2,880 paid each year from ages 1 - 18

Assumes 5% pa compound return, £2,880 paid each year from ages 1 - 18 and Isa subscription increases with inflation at 2% pa.

Source: Investment Quorum

*IC Top 100 Fund