Saving for retirement is a sensible piece of financial advice. But compared to investing in high-quality UK shares, it may not be the smartest approach to building a sizable pension – even with higher interest rates.
Following the recent rate hikes by the Bank of England, savers now have access to accounts that can yield up to 6%, or more! Considering these accounts are insured for up to £85,000, that’s a pretty impressive risk-free return. And far more alluring than the FTSE 100’s current higher risk yield of 3.8%.
However, savings accounts still pale in comparison to a well-constructed investment portfolio. Even more so during periods of volatility when stocks are cheap. Let’s explore how.
SIPPs vs savings
Much like ISAs exist for savers, investors have the same special type of tax-free investing account. However, suppose the end goal is building a pension? In that case, a Self-Invested Personal Pension (SIPP) account might be the better option for investments.
Whenever depositing capital into a SIPP, tax relief is paid directly into the account. And any capital gains or dividends received are tax-free, allowing compounding to do its magic uninterrupted.
While taxes eventually re-enter the picture once pensioners start drawing on funds, the same is true for any interest earned from savings accounts outside an ISA. And the latter doesn’t get the initial tax relief benefits.
But what sort of gains can investors expect versus savings? Looking at the FTSE 250, the UK’s flagship growth index has delivered returns close to 11% each year since inception. That’s nearly double what most savings accounts currently offer. And when investing £500 a month, that can easily lead to a seven-figure nest egg.
Let’s assume a retirement saver is in the basic 20% tax band. Placing £500 into a SIPP each month gives them a 20% tax relief, meaning they end up with £600 (£500 + £100). Providing the FTSE 250 continues to deliver an 11% return, after 30 years, the retirement nest egg could be worth roughly £1.68m. And following the 4% withdrawal rule, that translates into a pre-tax retirement passive income of £67,308 per year!
By comparison, putting £500 a month into a high-interest savings account at 6% without the tax relief for the same period only translates into £502,260, or a £20,100 annual passive income.
Taking a step back
After income taxes on the £67k, investors still take home roughly £53k each year. That’s more than double what a savings account can provide. And can obviously provide a far more comfortable retirement lifestyle.
However, as wonderful as this seems, there are some caveats. As the last couple of years abruptly reminded everyone, the stock market can be quite a volatile place. Another crash or correction is almost certain to happen within the next three decades. And depending on the timing of these events, the average return on an investment portfolio could be far lower than expected.
As for taxes, policies are constantly in flux. Income taxes could rise or fall, as could the policies surrounding ISAs and SIPPs.
All of this is to say unlike the stability provided by a savings account, investing in the stock market can be quite a rollercoaster ride. But given the potentially enormous difference in wealth it can generate, it’s a risk worth taking, in my opinion.
