Pension vs ISA: Settling The Debate

How to get ahead in life

The end of yet another tax year on April 5th is almost in our sights.  As ever, it is a good time to be taking care of some financial housekeeping.  And for most people, this inevitably means making the most of their workplace pension and ISA allowances.

Most of us can sock away £40k in our pensions – and carry any unused contribution room forward for three years.

ISAs also have a generous annual allowance of £20k.  However, once the clock strikes midnight on April 6th, whatever ISA room you have not used up disappears – unless you use this clever trick.

However, the allowances themselves aren’t usually the problem.  Instead, what most people struggle with when it comes to pensions is the ability to access their money. 

Picking On Pensions

The fact that the money is locked away for a long period of time is always a handy rock to be throwing at our pension system.

At the moment, you are only allowed to start drawing on your workplace pension when you turn 55.  And from 2028 onwards, you will have to wait until you are 57 before you are able to get your hands on that pot of gold.

If you are in your forties, the 15 or so years that you’ve got to wait might not seem such a long time.  You have probably (hopefully!) realized by now that being 40-something isn’t as bad as you once thought.

Far from falling apart, you feel relatively strong and surprisingly energetic.  You’ve hopefully now lost most, if not all, of the insecurities of youth and are feeling much more confident in your career and social pursuits.

Slowly, you start to realize that you will probably be alive, kicking and generally not about to kick the bucket when you turn 55.

Unfortunately, you have to live it to believe it.  That’s why, if you are looking to build wealth in your twenties or thirties, it might be much tougher to convince yourself to squirrel money away in a pension.

You are still young.  55 seems – and is – a long time away.  And you are not being entirely irrational if you are uncomfortable locking your money away for such a long period of time.

Unwilling to enter a committed relationship of that kind, you turn to ISAs as an alternative.  No more taxes to worry about, the ability to take your money anytime – what’s not to like?

Math vs Emotion

On a purely mathematical basis, pensions beat ISAs any day of the week.  I could give you the maths here, but I generally dislike writing about things that have been well-covered elsewhere.

Thus, I would rather direct you to this wonderful article by Monevator.  It’s lengthy, but the time it takes to read it is well spent.

You will see that the prize for locking some of your money away in a pension is accelerating your path to financial independence by years, if not decades.

However, you probably already knew that.  So instead of focusing on the maths, let’s spend a few minutes contextualizing the debate.

(Almost) Everyone Gets Old

As of this writing, the average life expectancy in the UK stands at 83 years for women and 79 years for men.

But that’s not the whole story – because the numbers above represent a blended life expectancy for all age groups.

For example, they reflect highly unfortunate things like infant mortality or certain illnesses that generally don’t discriminate between age groups.

So the very fact that you are reading this now means that your own life expectancy is higher than what you see in the table above.  And by the time you live to see 55, it will be higher still.

Planning Your Life Backwards

Assuming you buy into the logic above (which I hope you do), it is clear that life won’t end at 55.  And while the pursuit of an early retirement goal is admirable (hey, that’s why I’m writing this blog!), a good starting point might be to secure the last thirty-odd years of your life.

A workplace pension is your best option for doing so.

Once you’ve taken care of your golden years, you start chipping away at your early retirement goal.  Load up those ISAs.  Add on a rental property or two.

Once you’ve got enough to last you until you are 55 (or 57), you kiss the cubicle goodbye.

But what is the magic number you need to have in your pension account before you switch to ISAs?

The Price Of The Prize

In the article above, Monevator has done a great job outlining the practical considerations around figuring out how much money you will need in retirement.  No need to repeat them here.

The challenge, of course, is figuring out how much money to contribute to your pension every year so that you actually end up with the number you need.

It depends on many factors.  Your age.  Your risk profile.  Your employer match.  The stock markets themselves.

What makes things more complicated still is the fact that pension contributions are mandatory, so you can’t just turn the tap off completely.

You’ll never get a precise answer.  However, I pulled together a simple spreadsheet that can help you answer that question.  You can download it here.

It should be straightforward, so just a couple of observations:

  • Column B represents your annual earnings (you can play around with different growth rates in cell B2)
  • Column C denotes your pension contributions. I’ve assumed you will start with 10% – and get the employer match and tax break on top
  • If you start early enough, it will take about 10 years for your pension to be well on track. That’s when you can reduce your contributions to a minimum of 4% while you focus on loading up your ISAs
  • By the time you retire at 45, your pension pot will be worth ~£450k
  • Thanks to the magic of compounding, it will grow to a neat £1m by the age of 57

Play around with the numbers – but remember inflation before you get too excited.

The Good Times Won’t Last Forever

As I’ve written about previously, you shouldn’t take our generous pension system for granted.  Taking advantage of it today leaves far less room for regrets down the road.

In addition, your personal circumstances might also change.  There may be a period of unemployment, or self-employment.  You may choose to take a career break to look after your children.

All of these things will slow down the pace at which you grow your pension pot.

Alternatively, you may knock it out of the park in terms of earnings – and get hit with the pension taper.  And if you think all of your problems will be solved once you start making more than £150k, then you may want to read this.

Overshooting The Target

Hindsight is always 20/20.  When the time comes, you may well realize you’ve built up more money in your pension – and less in your ISAs – than optimal.

But guess what – that’s not necessarily a bad thing.

Imagine you are 53.  In four years, you’ll be able to draw on a pension pot that’s well north of what you had in mind as a sprightly 25-year old.  Is that really a problem?

Not quite – because knowing there’s a pile of cash waiting for you always gives you options.

You can postpone the renovations.  Prioritize cheaper travel.  And if you just can’t hold off, there’s always the option of (gasp!) using some debt to bridge the gap.

So play around with the numbers.  The future might well be looking brighter than you imagined.

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Banker On FIRE is an M&A (mergers and acquisitions) investment banker. I am passionate about capital markets, behavioural economics, financial independence, and living the best life possible.

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9 thoughts on “Pension vs ISA: Settling The Debate”

  1. The Monevator series has been the most interesting and directly useful piece of personal finance and FIRE literature I’ve ever read.

    Great spreadsheet thank you. I have an almost identical one I use to model when I’m likely to hit the LTA threshold under different scenarios (e.g. max out £40K for several years now, followed by X a month until 57, how different returns change it etc) — so that I can set up for compounding now and turn to ISA filling in my 40s.

    Of course, as you say, the difficultly is uncertainty. Will the government push back the pension age again before I get there; what is a likely rate of return over the next 20 years; what will the LTA be in 20 years time and so on. But it gives me a tiny bit of comfort knowing I’m forecasting within what I can control.

    1. Glad you found the spreadsheet helpful! You are right – there is no perfect answer as the goalposts keep changing. As ever, the best answer under such conditions is to work off a best available set of assumptions, take stock along the way and re-calibrate your contributions based on market returns and government regulations.

      In addition, there are some creative solutions you can employ to take advantage of the pension tax break / mitigate the LTA if you were so inclined:

  2. Pingback: (Belated) Full English Accompaniment – Ways to skin a bear – The FIRE Shrink

  3. Hi, great post. Regarding pension age rising to 57 in 2028 I’m of the assumption this will be at the start of the tax year, April 6th. I’m in the somewhat rare position of my 55th birthday being April 5th 2028 (a Wednesday) and I think this makes it the first day I can retire at 55 and also the last day anyone can retire at 55. Do you know if I’m correct in my assumption? Thanks

    1. Banker On FIRE

      Thank you. It seems that you are really in a unique situation – I’ve tried playing around with some online calculators but they are mostly based on state pension age.

      If I plug your birthday (April 5, 1973) in, your state pension age works out to be 2040 or 67 years.

      A way to find out for sure is to send a quick email to your workplace pension provider. They will be able to give you a definitive answer.

  4. I have a similar spreadsheet that maps out when I might hit LTA with a variety of variables.

    Having aggressively used salary sacrifice for the past 3 years ( I had some carryover ) I think my pension is well funded.

    I’ve got a fully paid off rental property and my own residential property is fully paid off. In order to fully fund my ISA in the current financial year I’d need to be a bit creative and get a money transfer from a couple of my credit cards.

    It will cost me a few percent but I have other investments maturing in May so I think it will be worth doing to avoid missing out on a year’s worth of ISA subscription.

    I recently considered liquidating my ISA’s in order to purchase another property but luckily came to my senses.

    1. I agree – would guard that ISA allowance like a treasure.

      It’s hard to overestimate the power of having a few hundred ‘000s of investments in your ISAs, compounding on a tax-free basis for years to come.

  5. Thanks for the spreadsheet, it is useful tool. I like you, actually enjoy optimising my pension and S&S ISA. I’m in a lucky situation where I have a really generous employer contribution of over 20%. Trying to model/guess when that might disappear is the hard part!

    1. Very generous indeed.

      If there’s one thing you can be sure of it’s that it won’t get better! I am beyond grateful for having maxed out the match earlier in my career before I got tapered out.

      Enjoy it while it lasts!

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