Sipps: Your designer pension

Self-invested personal pensions (Sipps) are the hottest number on the pensions catwalk today. Previously, they were out of reach to many people. However, just as Versace ranges are nowadays sold on the high street, Sipps are now being promoted to Joe Public as well as to Fred Fat-Cat. They're being marketed as an affordable and effective way to build the largest possible amount of wealth for your retirement.

A Sipp allows you to get directly involved in the design and construction of your pension. You can build a portfolio of assets that reflects your particular goals, circumstances and appetite for risk. And because you have the freedom to invest in a broader range of investments through a Sipp than through a company, personal or stakeholder pension (SP), you could end up with a fatter pension pot.

Specifically, a Sipp can allow you to invest in individual shares, bonds, derivatives, exotic funds and commercial property. This is a far richer variety of fabrics than those on offer to the holder of a personal pension (PP). With a PP, you are typically confined to buying whatever collective funds the provider will allow you access to.

Of course, not all Sipps offer access to the same array of assets. You have a full spectrum to choose from, ranging from execution-only Sipps that offer a fairly narrow choice of investments to full Sipps that offer the complete caboodle. But the further away from mainstream assets like plain-vanilla funds and shares you want to stray, the more you end up paying.

Be your own designer

Expert advice costs money. What's more, you might not be happy with the results it produces. So, if you're a confident investor with a good grasp of asset allocation, you may feel that you are able to run your own Sipp without much outside help. In this case, the direct, execution-only Sipp could be the right solution for you. It's a bit like designing your own suits – you know your own measurements and the cut and fabric that you want. You simply submit your plans to someone who stitches and sews to your instructions.

Low-cost Sipp providers simply carry out your wishes, usually via online communication. You decide to buy a certain fund or share and simply click away as you would for any other internet share purchase. This can be a very effective approach for those investors only interested in buying funds or shares. The cheapest option is to buy certain funds only. However, this can be rather limiting, especially since you might be able to do the same with another type of pension for less.

Leading providers of low-cost Sipps include Alliance Trust, Hargreaves Lansdown, Killick & Co and Sippdeal. If you're interested in buying the more exotic stuff, such as commercial property, these sort of Sipps won't fit the bill. But they will allow you to get your hands on a wider selection of funds than other personal pensions. And you will probably be able to invest in main market-listed and Alternative Investment Market (Aim)-traded shares, investment trusts, convertible securities, government and corporate bonds, and warrants.

"There's this enduring myth that Sipps are expensive and that you need a lot of money to go into one," says Tom McPhail of independent financial adviser (IFA) Hargreaves Landsdown. "But they really aren't necessarily dearer than personal or stakeholder pensions. We set up Sipps for contributions of just £50 a month or a lump sum of £1,000. We do everything on a percentage basis, with no flat fees: no set-up charges, no annual administration costs. Because it's done proportionally, it's just as efficient for £50 as it is for £50,000."

While low-cost Sipps may be broadly similar in terms of cost to PPs and SPs, they probably still work out slightly dearer overall. This is not surprising, given that they allow greater freedom than those rival options. Costs aside, there are many investors who don't need the ability to invest in individual shares and the other freedoms that this sort of Sipp confers. For them, a selection of funds is appropriate for their requirements.

That said, low-cost Sipps may be just as competitive in certain situations. "You can buy the HSBC FTSE All-Share tracker fund through a Sipp for annual management costs of 0.25 per cent. But through HSBC's own stakeholder fund, the same tracker would cost you 1 per cent in annual management costs," says Mr McPhail.

Of course, having a direct, execution-only type Sipp doesn't stop you from obtaining advice as well. Many investors are doing just that, which represents a middle way between running the entire show yourself and having a full Sipp. "Our fastest-growing product is the advisor-introduced Sipp," says Andy Bell, chief executive of AJ Bell, a leading Sipp provider. "Most IFAs favour unit trusts for their clients' portfolios. Holdings within these Sipps tends to be around 90 per cent in collective funds, with the rest in other products."

Personal pensions in disguise

As dedicated followers of fashion, the insurance companies have launched their own Sipps. These products offer good deals on the insurers' own in-house funds, as well as some access to outside funds and individual shares. However, investors ought to be wary of insurers' Sipps as, in many cases, they are really little more than personal pensions in drag. That is to say, they tie holders to a relatively limited range of funds whose performance is often underwhelming. But while they may not offer the same freedom as other Sipps, they can be just as expensive, leading to the worst of all worlds.

Be suspicious of advisers who plug these products, as they may well be receiving chunky commissions for doing so – at the expense of those who sign up.

Savile Row selection

Continuing with the tailoring analogy, full Sipps are the equivalent of a Savile Row suit. They allow you to invest in the broadest possible range of assets. In particular, full Sipps are usually the only way to hold commercial property directly. But the privilege of being able to choose from the finest fabrics comes at a price, especially if you're investing in commercial property.

A typical investment in commercial property is one's business premises. As well as your Sipp enjoying a capital gain in the property's value over time, it also grows via untaxed rental payments from your business. Moreover, it is possible to use a mortgage to purchase property within your Sipp, which adds flexibility and potentially boosts returns.

As well as a hefty fixed annual administration charge running to hundreds of pounds, the costs of dealing can be substantial in a full Sipp. A commercial property transaction can run to four figures, even before solicitors' and surveyors' fees. We’ll look more closely at the implications for your investment performance in the section below on costs.

Unlike an execution-only Sipp, where you can more or less run the show for yourself, a full Sipp will probably require you to take professional advice. In fact, most full Sipp providers will only do business with people who have an independent financial adviser (IFA). On the plus side, an IFA should be able to help you pick a good full Sipp provider, as well as assisting with more arcane purchases. But this is yet another layer of costs that need to be considered.

Not all full Sipps will allow you to invest in exactly the same things, though. For example, some providers have refused their customers access to offshore hedge funds. Other products, such as unquoted shares and gold bullion, have caused similar disputes. So it is absolutely essential to check beforehand that your provider will definitely permit you to hold whatever assets you have in mind.

"We get quite a bit of business from clients who took out a full Sipp elsewhere and then found they couldn't actually do the things they wanted to do," says Martin Tilley of Dentons. "The moment of truth comes when you want to do something unusual. We help find solutions. Clients come to us with something they want to invest in, but with an inappropriate structure. We come up with a suitable structure for them." Mr Tilley cites recent cases where Dentons has assisted in investments in commercial property developments in South East Asia and the Caribbean, and unquoted shares in foreign companies.

Revamp your pension wardrobe with a Sipp

Getting a Sipp can be a great way to rationalise the jumble of retirement plans you may have built up over the years. For example, you may have a couple of company pensions from former employers as well as a personal pension. Bringing them together is a very common way of launching a Sipp.

If you have a company pension to which your employer is currently making contributions, it would make no sense to transfer that into a Sipp just yet and lose out on your employer's cash injections. Also, you need to watch out for other exit penalties and charges. Final-salary schemes should be left intact, though, as the benefits are usually generous and the employer bears all the investment risk.

Look at the price tag, not just the label

Costs matter enormously in Sipps, as in all other pensions. A percentage-point reduction in annual returns – be it from administrative costs, dealing charges, or any other source – may not sound like much.

But over a working lifetime, such reductions add up to substantial sums, shrinking the amount you'll have to live on in retirement.

A study published last May in Money Management – a sister publication of Investors Chronicle – underlined in detail how much more a Sipp could potentially cost. It compared the results of investing £100,000 in various pension wrappers over 20 years. The results can be seen in the table below. Assuming a 7 per cent investment return across the board, a higher-charge Sipp would result in an eventual pension pot only four-fifths of the size of one invested in a standard stakeholder pension.

One rejoinder to this is that, with a Sipp, the added investment freedom could potentially result in superior returns, thus helping to offset the impact of higher charges. This is especially true for full Sipps, which can allow investment in the broadest range of assets. But, remember: it requires significant skill, discipline and perhaps also luck to achieve consistently superior returns.

Future Sipp fashions

Since rule changes in April 2006, the number of Sipps in existence has increased dramatically. There are now around 400,000 in existence. And this is likely to rise even further over the coming years, at least according to the many cheerleaders for Sipps.

There will be a big change this October, when the money tied up in 'protected rights' is expected to become eligible to be put into Sipps. Protected rights are funds accumulated as a result of contracting out of SERPS, the second state pension. According to some estimates, there may be as much as £100bn tied up in protected rights.

"This October will prove to be a watershed moment," says Hargreaves Lansdown's Mr McPhail. "Once all that protected rights money is freed up, personal pensions' one remaining advantage over Sipps will be removed. As a result, you're going to see outflows from PPs start to exceed inflows. That's not to say that lots of money won't stay in PPs, particularly money tied up in with-profits funds. But not much new money is going to go in to PPs."

Companies are also likely to start offering Sipps to their employees. GlaxoSmithKline (GSK) recently made headlines by becoming the first FTSE 100 firm to offer Sipps to its workforce. A big attraction of a group Sipp for a company like GSK is that employees will be able to transfer the shares and share options they receive as part of their pay into their Sipps and receive substantial tax benefits in the process. Several other leading blue-chip companies are thought to be contemplating offering group Sipps.

While GSK's move generated plenty of excitement in the press, not everyone is convinced of the merits of group Sipps. "There's a danger of ending up with a personal pension masquerading as a Sipp," says Andy Bell of AJ Bell. "You can't sell a 3,000-man group Sipp, it just doesn't work. The cornerstones of Sipps are transparency, control and flexibility. But with group Sipps, transparency is out of the window as you can't work out what you're paying for, control is an illusion, and flexibility doesn't really exist."

Looking further out, the government is keen that the workforce should be making more provision for retirement. From 2012, it is proposed that all workers should automatically receive a 'personal account', a low-cost vehicle for pension saving. This will represent a culture-shift, where, for the first time, people would have to make special arrangements to get out of a pension plan, rather than arranging to join one. While there's no guarantee of an enthusiastic response from the public, it could gradually encourage a change of behaviour.

Thanks to increasing competition, the costs of Sipps should fall over the coming years, potentially narrowing the gap with PPs and other pension products. "I think you'll see continuing downward pressure on prices, with administration fees falling and perhaps disappearing entirely," says Mr Bell. "In this way, Sipps will become more commoditised, rather like Isas. All of us providers are going to have to learn to live off less money."

Sipps at a glance

• Self-invested personal pensions are retirement-savings vehicles. They allow the saver to take a much greater role in the investment process than other pensions allow

• Sipps enable you to invest in a wide range of assets. As well as a large array of funds, individual UK and foreign shares, unquoted shares, offshore hedge funds, derivative products and commercial property are some of the main choices

• Full Sipps allow the most freedom but cost a lot more to run

• Execution-only direct Sipps offer less choice but are much cheaper

• Sipps offer significant tax relief. For every £1 you put in, the taxman refunds tax up your marginal rate. You can receive relief on contributions of £225,000 a year, rising to £235,000 in the 2008-09 tax year