The IC Guide to Sipps

Rarely a week goes by without pension scare stories in the press about how the pension funding shortfall is getting worse. There are many reasons for this: the decline in final-salary pension schemes, an increase in life expectancy and very low interest rates coupled with inflated assets lowering expectations of future returns. 

The pandemic has dealt an extra blow. More than 5.5m workers cut or completely stopped their pension contributions owing to the impact of Covid 19, according to pension provider Scottish Widows. Insurer LV= estimates that 211,000 people aged 55 to 64 have accessed some of their pension savings early to supplement their income because they have been made redundant or their earnings have been reduced. AJ Bell, meanwhile, says that one in 10 people aged over 55 have accelerated plans to access their pension as a result of the pandemic.

All this reflects a need for people to be as careful as possible about their financial planning to make their future as comfortable as possible. 

Fortunately, self-invested personal pensions (Sipps) provide a great way to grow your pension, and have been increasingly popular since pension freedoms came into effect in 2015, as people take more responsibility for their finances. Becky O’Connor, head of pensions and savings at interactive investor, says the number of new Sipp accounts being opened on the platform more than doubled year on year in the last quarter, with half of the transfers from life companies which, as she puts it, reflects customers seeking “to take advantage of the huge savings to be made”.  

Find out more: Sipps under the spotlight

How do Sipps work?

A Sipp is effectively a pension ‘wrapper’ that holds investments until you retire and enables you to invest in a wide range of assets including stocks, funds, bonds and property. It gives you the same tax benefits as a standard personal pension, which means normally 20 per cent is automatically added to your contributions by way of income tax relief. Higher and additional-rate taxpayers can claim their additional tax of 20 per cent or 25 per cent back in their tax return the following year.  

The key thing if you are in the accumulation phase of your Sipp is to pay in as much as possible as early as possible, within the permitted allowances. This will allow you to benefit from the power of compounding, which can be very powerful over time. 

The 2021-22 allowance for pension contributions is £40,000, which includes any contribution paid by an employer. If you pay into your workplace pension, you can always top up into a Sipp when your employer contributions are maxed out. However, if you are a high earner, your annual allowance will reduce by £1 for every £2 that your adjusted income exceeds £240,000, to a minimum allowance of £4,000. If you earn less than £40,000 a year, you can only put in as much as your income, but if you have no income you can still pay in up to £3,600 a year and receive tax relief.  

You are not able to access your Sipp until the age of 55, rising to 57 from 6 April 2028. You can continue contributing to your Sipp until the age of 75, but if you start to draw down from your Sipp you trigger the money-purchase allowance, which means you can only pay in a maximum of £4,000 a year.   

How much do I need to save? 

There’s a general rule of thumb that says you will need about 25 times your retirement expenses if you want to retire at 60. So, if you plan to spend £30,000 a year, you’ll need about £750,000 in savings. You probably need to build up a pot of at least £500,000 to give you a good standard of living in retirement, assuming you are not paying a large mortgage.

However, most people can claim the state pension from the age of 66 (rising to 68 by 2037), which currently provides a maximum of just over £9,000 a year. You’ll need 35 qualifying years of National Insurance payments to get the full amount. 

What assets should I invest in?

Research from Man Group shows that a portfolio with 60 per cent equities (as measured by MSCI World Index) and 40 per cent bonds (Bloomberg Barclays Global Aggregate) delivered an average annual return of 8.08 per cent from 1960 to to August 2020. However, with interest rates currently near record lows and inflation fears looming, bond prices look vulnerable to falls over time. Equity growth stocks that have seen tremendous growth until earlier this year also look vulnerable to any increase in interest rates as it would make putting capital to work elsewhere look more attractive. Experts say a 3 to 5 per cent return for a balanced portfolio might be a realistic expectation going forward.

Gary Smith, chartered financial planner at Tilney, suggests that those who have had to reduce pension contributions over the past year, and who aren’t able to increase their pension contributions, might consider increasing the level of investment risk they take to try to maximise growth moving forward. 

When do I need to be wary of the lifetime allowance?

The lifetime allowance is currently £1,073,100. In the March 2021 Budget, Chancellor Rishi Sunak announced that it would be frozen at this level until 2026, instead of rising in line with inflation as it previously has. 

If you are at risk of reaching the lifetime allowance, it might be worth trying to manage contributions so you don’t go over it, and paying into other tax-efficient vehicles instead. If you go over the allowance you will generally pay a tax charge on the excess of 55 per cent for a lump sum, or 25 per cent for income. The lifetime allowance test is applied every time you access your pension, and on your 75th birthday whether you are taking benefits or not.

What do I need to know about drawdown?

Drawdown presents some of the most tricky pension decisions. First, you have the option to withdraw a 25 per cent lump sum free of cash, or opt to have 25 per cent of each payment free of tax. This can be beneficial if your pension rises, but the most suitable option will depend on your circumstances. The big challenge is maintaining a sustainable withdrawal plan throughout retirement. This has become even more difficult in an environment where dividends, the lifeblood of many retirement income strategies, have been thin on the ground.

Tom Selby, senior analyst at AJ Bell, says for a healthy 65-year-old, an old, rough rule of thumb suggests that a withdrawal rate of 3 to 4 per cent of the initial value of the fund, rising each year in line with inflation, should be sustainable in most economic circumstances. 

When you draw down on your Sipp, you pay tax at your marginal rate. Sipps can be an integral part of succession planning because they do not form part of your inheritance tax (IHT) estate. You can pass on a Sipp to your beneficiaries free of tax if you die before the age of 75. If you die after age 75, the people who receive your Sipp pay income tax at their marginal rate on any withdrawals they take from the pension but there would still be no IHT to pay.

Self-employed: what are the benefits?

Sipps can be particularly helpful for self-employed people, after all part of the reason they were created in 1989 was to support those without access to a workplace pension scheme. You can pay a profit directly from your company into a pension as an employer contribution, and your company won’t have to pay tax or employer National Insurance on the contribution.

Unfortunately, recent research by interactive investor has found that of the 4.3m self-employed people in the UK, 3.5m are not making any pension contributions whatsoever.   

Key Sipp benefits

• Take charge of your retirement savings with the same tax advantages as a traditional pension
• Use a Sipp to combine all your old workplace pensions into on easy-to-use online account
• Chose exactly what you want to invest in - such as individual shares, property, funds or following your own ethical mandate  
• Manage your pension costs by choosing a low-cost Sipp provider 
• Pass money to heirs free of inheritance tax

Key things to watch out for

• No access to your Sipp until the age of 55, rising to 57 from 6 April 2028
• Annual allowance £40,000 or 100 per cent of your earnings, whichever is lower
• Pensions exceeding lifetime allowance of £1,073,100 incur additional charges
• Higher or additional-rate taxpayers have to claim additional boost from HMRC
• Money-purchase allowance triggered after you take money out of your pension