Self-invested personal pensions (SIPPs) take a further step towards mass-market acceptability on 6 April, when they finally become regulated by the Financial Services Authority (FSA). The FSA will take responsibility for the regulation of all personal pensions on that day, giving disgruntled SIPP customers access to the Financial Ombudsman Service or the Financial Services Compensation Scheme for the first time.

Many SIPP providers already treat this area as a regulated activity, but some don’t. However, the immediate aftermath of this change in regulation could see a major shake-up in the market, squeezing out many smaller players who may struggle to bear the added cost that regulation invariably brings.

The FSA issued its new regulations at the end of September and started accepting applications shortly after, but with less than two months to go, barely half of existing SIPP managers have so far seen fit to apply.

Those that miss the deadline must either sell their business, merge with a SIPP provider that has been regulated or cease trading. As yet, nobody knows what will happen to customers of those companies who simply do nothing - if you are an existing SIPP investor and are worried, speak to your SIPP administrator.

A popular plan

The SIPP market has been growing at breakneck speed. Ask those active in the sector how many plans have been sold and the estimates will vary between 140,000 and 220,000. Likewise, ask how many companies provide them and people will quote a number somewhere between 80 and 180.

Andrew Leggett, marketing and schemes manager at Suffolk Life, puts his best guess at around 100 companies (many of them minnows) and expects the numbers will shrink dramatically following regulation. Suffolk Life was an early entrant back in 1996 and has now sold 8,500 plans: ‘It is a mark of how young this market is that 11 years makes us a veteran. It still has a long way to go,’ he observes.

But as the SIPP market moves towards maturity, it also encounters the problems that come with success. Fears are growing that commission-hungry advisers are sucking customers into costly SIPPs when they could happily get by with a simpler, cheaper form of personal pension; so the advice is to tread carefully.

SIPPs must be set up with a professional trustee to act as administrator and custodian, and to reassure HM Revenue & Customs that the tax breaks enjoyed on the assets in the pension wrapper are being properly supervised.

Stockbrokers, insurers, fund managers, private banks and financial advisers all now administer SIPPs, and the list is growing to include high-profile brands such as Norwich Union, Prudential and Standard Life. Fidelity, Jupiter and Legal & General have all launched plans in the last couple of years.

Other prominent SIPP managers include Alliance Trust, Baillie Gifford, Barclays Stockbrokers, Brown Shipley, Hargreaves Lansdown, James Hay, Killik & Co, Merchant Investors, Suffolk Life and Winterthur Life.

The tax advantages

SIPPs offer all the tax advantages of a standard personal pension. Investors receive tax relief on contributions at their marginal tax rate, and investment growth inside the wrapper is free of income tax and capital gains tax (although you cannot reclaim tax deducted from dividends).

If you die before drawing any retirement benefits, your fund value can normally be paid to your beneficiaries free of inheritance tax. You can also shift between different investments without incurring any tax or penalty charges.

Crucially, SIPPs offer a much wider choice of investments than standard pensions - including direct equities, unit and investment trusts, gilts and corporate bonds, insurance company funds, deposit accounts, commercial property, residential property funds, publicly quoted hedge funds and more complex financial instruments such as warrants, futures and options.

SIPPs can also include commercial property, such as farmland, forestry and development land either inside or outside the UK, and loans to buy or develop commercial property, which means you could buy a property using your pension and run your business from it. You can even include ground rents, public houses, hotels, motels, guesthouses and nursing homes.

David Johnston, pensions technical director at private bank Brown Shipley, says SIPPs appeal to educated investors wanting transparent charges and greater control over their investments. ‘In our experience, only a tiny minority are interested in the more esoteric investments. Most want little more than a banking and investment management service with a personal touch.’

How much do you need?

Traditionally, it wasn’t worth setting up a plan unless you had at least £100,000 in your pension pot - preferably £250,000. Brown Shipley, which provides a high degree of personal service, still adheres to this view. ‘It would be a big mistake to go down the SIPP route with a fund that is too small as even a fully transparent charge may then impact heavily on performance. In our case, £250,000 is the minimum size of fund we seek out,’ Johnson says.

But that isn’t the case for everybody in the SIPP market. Growing competition has driven down charges and it is now cost-effective for savers with relatively modest pension pots to set up a SIPP with a ‘no-frills’ provider.

Set-up charges have fallen to as low as £500, with annual charges ranging from £400 to £600; but you also pay asset management charges on any funds you hold, and fees start to swell once you engage in more complex transactions - such as buying commercial property - so they could easily amount to £2,000 in the course of a year.

One way to keep costs down is to run your SIPP via the internet. Angus Rigby, chief executive officer at stockbroker TD Waterhouse, says technology will make online SIPPs increasingly simple and affordable. ‘You can now get online SIPPs with set-up fees of under £100 and administration charges from as little as 0.5 per cent - far less than you would pay on a traditional pension. Online SIPPs allow you to change the investments within your plan cheaply and regularly, and monitor your portfolio 24 hours a day, seven days a week.’

Rigby says the traditional view - that SIPPs are complex and lack universal appeal - is beginning to change. ‘Anybody who can manage an ISA or a share portfolio would be equally comfortable with a SIPP. Even investors with no experience of direct equities can create their own pension plan, by buying investment funds through a fund supermarket and holding them inside the SIPP wrapper.’

Some execution-only SIPPs can be extremely cheap. Hargreaves Lansdown, for example, has no set-up or transfer charges and no annual charges on cash and investment funds. But that doesn’t mean it is absolutely free: you still pay annual fund management charges (typically around 1.5 per cent) and Hargreaves Lansdown also charges 0.5 per cent on other investments up to a maximum £200 a year. In addition to this, there are sharedealing charges.

A later-stage investment

Mike Morrison, pensions strategy manager at Winterthur Life, says new or younger pension investors shouldn't automatically start with a SIPP, but should keep one eye on their future pension planning: ‘If you only have a relatively small amount to invest, start with a conventional personal pension that allows you to invest in a spread of investment funds; but choose a plan that allows you to graduate to a SIPP with a wide investment choice at a later date.’

Once you have set up your SIPP, consider which investments you might want to transfer in. ‘If you have an employee share-save scheme or windfall stocks, you could boost their value further with 40 per cent tax relief by bringing them inside your SIPP,’ Morrison points out.

But don’t automatically transfer every investment: ‘You might want to keep AIM stocks, for example, outside your SIPP to exploit their inheritance tax advantages.’

SIPPs don’t just give you greater choice over how you build your pension pot, they also give you greater control over how you spend it. Many investors run their SIPP well into retirement to generate ongoing income. As with any other personal pension, you can take money from your SIPP from age 50 (this will rise to 55 by 2010), and take 25 per cent of your pot as a tax-free lump sum.

At retirement you can bundle all your different personal and occupational pensions into a SIPP, withdraw 25 per cent as tax-free cash, and leave the rest invested. Using an “unsecured pension”, a new type of annuity alternative similar to income drawdown, you can then draw on different elements of your plan as you need them.

Morrison says a SIPP can help you make maximum use of unsecured pensions. ‘You could first draw on relatively short-term investments, such as cash or fixed-interest, and keep your longer-term equity investments invested in order to draw on them later.’

Popular choice

‘SIPP-mania’ is gripping the pensions industry - last year, sales topped £3.5 billion. Hargreaves Lansdown has enjoyed annual growth of 260 per cent in its SIPP business, while Aegon has seen a 177 per cent increase. These figures are from relatively low beginnings, but Aegon recently predicted that the total number of SIPP-holders could hit two million within a decade.

However, it is important not to get swept away in all the excitement - ask yourself whether you will really take advantage of what’s on offer.

The vast majority of the money flooding into SIPPs is being transferred from other personal pension schemes, but the FSA recently warned that many transfers are unsuitable and offer little benefit to investors. Once again it seems that commissions could be distorting the market.

Richard Ellis, head of sales and marketing at Merchant Investors, fears the pensions industry is selling SIPPs to people who don’t need them, while failing to exploit their benefits to those that do. ‘Most SIPPs simply invest in the provider’s in-house funds, rather than using the full opportunity for self-investment or commercial property. We agree with the FSA that many transfers are unsuitable and have questionable motives.’

Specialist products

Fee-based adviser SG Wealth Management also condemns the way that SIPPs are being packaged and marketed, saying that the industry’s quest to sell more lucrative pension arrangements is leading to widespread mis-selling.

Executive director Neil Shillito says most people are much better off with a straightforward, low-cost stakeholder pension: ‘The added flexibility - and charges - to include shares, commercial property and other alternative assets are often a waste of time and money. The driver for these sales is simply the commission earned from sales and transfers.’

And he feels that even investors who would benefit from including more esoteric assets in their investments are being ill-served. ‘Many advisers are ill-equipped in terms of both expertise and the necessary systems to exploit the real advantages. A SIPP may be appropriate, but the adviser making the sale may not be sufficiently qualified or able to deliver the benefits.’

Shillito warns against SIPP overkill, dismissing them as ‘too complex, too expensive; a sledgehammer to crack a nut’, and is calling on the FSA to crack down on rogue sales and transfers.

Of course, as a fee-only IFA his company has a vested interest in slamming the distorting effect of commission; but it is hard to disagree with its conclusions. Commission - the single factor uniting every mis-selling scandal - is once again threatening to turn advisers’ heads. So if your adviser recommends you set up a SIPP, or transfer your existing pensions, grill him or her closely to find out exactly how they will use this new-found freedom to boost your wealth. Check their credentials carefully, and use a reputable firm with an established record of selling SIPPs.

Understanding the rules

On the other hand, for those investors with larger portfolios who want a well-diversified and actively managed pension portfolio, there is little doubt that the SIPP provides a flexible means of doing so. However, this flexibility is not without its limitations. For example, investing in commercial property can be attractive because it grows free of income tax and capital gains tax; but the rules can trip up the inexperienced, warns Claire Court, head of self-administered pensions at IFA Origen.

Changes to SIPP borrowing rules in April 2006 make it harder for individuals to gear up sufficiently to fund property purchase. Court explains that ‘previously, SIPPs could borrow up to 75 per cent of the purchase price; which meant they would only need 25 per cent available as a deposit. But now the maximum has been reduced to 50 per cent of the existing SIPP fund value.’

Growing numbers of company directors, solicitors, accountants and other professionals are getting round this by setting up group SIPPs, joining their pension funds together to buy a property to either lease to their own business or use as an investment and lease to a third party. ‘This allows you to pool more than one person’s pension benefits to buy the asset, gear up through borrowing and negotiate competitive terms from the SIPP administrator,’ she adds.

But there are pitfalls. Court warns that anybody entering into a group SIPP to buy property must realise that these investments are relatively illiquid and may take time to sell, which can cause problems if one member wishes to sell a share of the property and the others don’t.

And make sure you know the difference between a SIPP and an SSAS (Small Self-Administered Scheme). The two are often confused, says David Johnston at Brown Shipley. ‘For example, it would be a mistake for a company director to take out a SIPP and expect to lend money to his own company, as this is only permissible with an SSAS.’

From April, SIPP investors will enjoy an extra layer of security, courtesy of the FSA, but they should still check that what they are being sold really does suit their needs. SIPPs certainly have plenty to offer the right investor; but don’t be distracted by the fancy wrapper - make sure you really want to get your hands on the range of investments lying beneath.

This feature is from the April 2007 issue of What Investment.