David Harbage Blog

A perennial enquiry put to financial advisors surrounds the relative merits of two prime long term savings vehicles: which is the more attractive, an ISA or a pension policy?

In this article, the writer seeks to answer this question against a backdrop of looking at the Week Ahead which features several leading companies that, boasting a high immediate dividend yield, might feature in the stock and share variety of Individual Savings Account (commonly termed an ISA). Back to the query surrounding retirement planning

Is planning for retirement an unpopular or outdated notion?

Although one could assume that intelligent and prudent individuals probably have a deliberate plan is in place (aided by taking advice from a qualified professional) to provide for their retirement, the reality is that many do not. One reason for such apparent neglect is the ever-changing nature of company pension schemes – notably the demise of employer-funded, defined benefit (typically based on final salary/pay) schemes – and another is the anticipation that retirement per se is being deferred, as the working life is being extended. Low confidence in the likely performance of self-funded (defined contribution) pension plans, prompted by mediocre returns - which have been diluted further by policies with high initial or annual management fees – over the past decade, may be another.

Undoubtedly, the future is uncertain

“What represents the long term?” could be answered by “how long is a piece of string’?  But, perhaps such a response is not flippant, but the realistic assessment of many who are struggling to save for ‘a rainy day’ (unexpected essential expense), let alone put monies aside on a regular basis for retirement. If the future is uncertain, which it undoubtedly is (“the only thing that does not change is change itself”, said the Greek philosopher Heraclitus), making some provision for that future undoubtedly makes good sense. However small, a monthly contribution can eventually grow and provide a significant boost towards easing finances in a post working life environment. Be it invested in cash, bonds (some of which might be perceived as long term interest rates), company shares (stakes in business), property, commodities or other kinds of asset.

Short term might turn out to be long term, and vice versa

The above truism – probably borne out of necessity, rather than choice – might be the prime factor when assessing the investment universe (of the differing asset type), as well as the favoured investment product (pension policy or other savings vehicle, such as the ISA). The latter allows the qualifying investor (who must be resident and ordinarily resident, for taxation purposes, in the United Kingdom) to place £11,280 in the current financial year (6 April 2012 to 5 April 2013) in a tax ‘shelter’, where exemption from income tax and capital gains tax is legally allowed, on specified stock exchange investments. This is the ‘stock and share’ ISA, available to qualifying investors aged over 18 years; as an alternative (not an addition to the £11,280) half of this allowance £5,640 can be placed in a cash ISA (available to qualifying investors over 16 years). The prime feature of an ISA, and a prime differentiating point relative to the pension policy, is its ease of access. Should circumstances or needs prompt, the ISA can be liquidated and encashed.

Approved pension plans are also legitimate tax havens

Pension policies, typically offered by life insurance and other fund management institutions, also offer tax attractions as income and any capital gains made within the plan are exempt from income and capital gains tax. Contributions made by UK taxpayers out of their taxable income are enhanced by a ‘refund’ of income tax at their highest marginal rate (40% and 50% tax payers will have to make a claim), subject to a maximum of £50,000 (termed the annual allowance, this is a dramatic contraction from previous years) in the current financial year. However, by contrast with the ISA, the tax incentives to aid the growth in a pension plan’s worth are (as ‘stated on the tin’) exclusively for the period to the date of retirement with, critically, the earliest date that pension scheme members can take their retirement benefits being 55 years of age. This was increased (from 50 years of age) in April 2010 and, readers should be mindful that changes in tax legislation and rules of savings & pension schemes are regularly revisited and changed (for better or worse), by politicians, other authorities or their successors.

As ever, no recommendations from this writer

These blogs are intended to provide information, often with a view, but primarily written to provoke interest and personal investigation into investment or financial subject matter. Different individuals will have various objectives and appetite for risk; for example the higher rate tax payer, close to his or her intended retirement date, may choose to maximise contributions into a pension fund (in part to reduce their tax bill), while a risk-averse monthly saver may seek out the best rates offered on a cash ISA. As regards the latter, the basic rate or non-tax payer might even find that the best cash rates offered by banks and building societies are not ISAs, but plain vanilla monthly savings accounts. Although as indicated in the example above there will always be obvious exceptions, as a generalisation the writer would favour full utilisation of the ISA vehicle – for its ease of access – before the pension scheme.

If the ISA is for long term growth, read on

Subject to the investor having a long term view (here defined as foreseeable, but probably a minimum of ten years), and being comfortable with the risk-reward aspect of stock exchange investment, and taking advantage of the higher allowance proffered, the stock and share ISA has appeal. When determining which asset is best suited to the ISA, the greater certainty surrounding income yield (over potential capital appreciation) argues for making higher yielding bond or company share assets the priority selections. One can calculate the prospective tax benefit of the ISA by reference to the individual’s financial circumstances: outside of an ISA, the basic rate tax payer does not suffer any additional income tax and may be more appreciative of the opportunity to avoid capital gains tax (although private individuals can make gains of up to £10,600 – known as the ‘annual exempt amount’ - before incurring the tax at either 18% or 28%, according to one’s income tax position). By contrast, the person who suffers higher rate income tax may appreciate the clear opportunity of sheltering high yielding corporate bond, or company share, income by owning such assets in an ISA.

High yielding company shares are a favourite within stock and share ISAs

The current dividend payout on UK equities (expressing such income, relative to its capital value, equates to a percentage yield) is high, relative to the alternatives of cash, gilts (British Government backed bonds) and domestic inflation. An earlier blog highlighted the attractions of blue chip high yielding shares and, amongst the companies providing a trading update this week, utility businesses are prominent – these companies which tend to have limited growth prospects and, partly as a consequence, pass much of their earnings straight on to shareholders in the form of dividend. We look at some of those well-known businesses in the next paragraph, but if the reader prefers to minimise individual company or stock-specific risk then a collective investment that seeks to capture the higher yielding segment of the UK stock market may have appeal. A fund whose objective is to deliver above average levels of income from UK equities might ‘fit the bill’, as could an exchange traded fund that seeks to replicate this segment of the market – perhaps based on the 50 highest yielding company shares within the FTSE350 index (for instance the i share FTSE UK Dividend Plus yields 5.2%) or one that covers the FTSE350 High Yield index index.

A number of big, high yielding company shares report this week

In particular, the mobile telecommunications giant Vodafone is due to announce its interim results, for the half year to 30 September 2012, on Tuesday. Boosted by an exceptional distribution from its US joint venture business, Verizon Wireless, this company was the biggest dividend payer on the London stock exchange last year. While there are a number of uncertainties surrounding the shorter term prospects for some of its regional operations – notably in mature developed markets, and especially amongst its southern European subsidiaries – the longer term outlook for its dividend paying capacity remains encouraging. In particular, the consensual forecasts of 26 industry equity analysts suggest that in the current year (ending 31 March 2013), 15.6 pence of earnings per share are likely and 79% of this will be paid over to share holders via a dividend of 12.3 pence dividend. In the following year, profits and the dividend are expected to rise by 4.5% and 2% respectively. The medium term future of this business – which might object to the author’s ‘utility’ descriptor – and its heady dividend in particular, probably resides in its relationship with Verizon. Less material, but interesting nonetheless, will be any comment on the integration of, and current trading within, the recently acquired Cable & Wireless Worldwide business. Also on Tuesday, another high yielding telecom peer, whose share price performance has almost mirrored the international mobile giant, the FTSE250 index constituent Talktalk is scheduled to advise investors of their interim trading results.

Beyond high yielding VOD, more traditional utility businesses update investors

Two of the highest yielding stocks within the FTSE100 index, Scottish & Southern Electricity and National Grid, are due to produce interim results for the half year to end September 2012, on Wednesday and Thursday respectively this week. The electricity companies have been capturing headlines following their recent price hikes, but the market will not join in the inevitable ‘shock and horror’ that will greet the revelations of high profits. As evidenced by last weekend’s focus on three privately owned water companies (which pay little corporation tax, as a consequence of high investment and capital expenditure), industry analysts will be quizzing company management on their discussions with the industry regulator Ofgem. An announcement on the new price-setting regime is due in December and, with new rules governing the calculation of how just much these businesses will be allowed to earn (accompanied by significant debate surrounding the cost and provisioning of ‘greener’ fuels), a number of prominent fund managers have disinvested.

Bottom line, NG and SSE’s attractive dividends are well covered by earnings

Notwithstanding such heightened regulatory uncertainty, the underlying financial health of these two industry leaders is robust. In particular, consensual forecasts of the 15 industry equity analysts who cover National Grid suggest that, in the year ending 31 March 2013, 54.7 pence of earnings per share are likely and 74% of this will be paid over to share holders via a dividend of 41.1 pence dividend. In the following year, based on the same analysts’ projections, NG’s profits and the dividend are targeted to rise by 0.5% and 2.0% respectively. A perusal of the expectations of the same analysts who monitor SSE suggest that, in the year ending 31 March 2013, 113.9 pence of earnings per share are forecast; again, 74% of this will be paid over to share holders via a dividend of 84.2 pence dividend. In the following year, based on these analysts’ projections, SSE profits and the dividend are targeted to rise by 3.9% and 4.6% respectively.

Dividend seekers can look beyond the utility industries, to the likes of Sainsbury

Diversification of income sources is always helpful, and this week’s company reports feature a breadth of decent income producers from a number of well-known medium or larger businesses. The quality (or the reliability) of dividend payout may be dictated by the relative resilience of the underlying business activities, and prospective investors should certainly search for evidence of a progressive dividend policy, (noting any other means of returning value to shareholders) and look further out to expectations of 2013 and 2014 payouts. Amongst other smaller firms, we get to hear from the interdealer broker ICAP (whose shares appear unloved at a currently yield 7.0%, ostensibly covered 1.5 times by earnings) and the supermarket group Sainsbury (whose share of the grocery market has risen to 16.8% this year, and whose offer includes a 4.6% yield, covered 1.7 times) on Wednesday. On the following day, investors get a further deluge of interim results, ranging from fund manager Investec (shares yield 4.6%, covered 1.8x), to private equity business 3i (yielding 3.8%, but barely covered) and finally the support service business of WS Atkins (whose stock yields 4.7%, covered 2.6 times). Chances are, most of these companies’ equity will already feature in most pension plans.

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.