A self-invested personal pension (SIPP) differs from a traditional personal pension in that it allows the holder to take more control over their investments. The easiest way to understand it is to think about it being like an ISA, in that a SIPP is a tax-efficient wrapper into which you can place certain types of investments, such as listed stocks, mutual funds or even commercial property.

‘There are two main types of SIPP holder,’ says Hyman Wolanski, head of pensions at Alliance Trust. ‘First are those genuinely making the investment decisions for their retirement fund. Such SIPP holders are happy running their own portfolio, and their ideal product would be an online SIPP. They understand what to do and have the time and inclination to choose stocks and/or funds.’

Wolanski’s second type of SIPP holder tends to have a favourite fund manager. They open a SIPP to invest in this particular fund, but then may also take advantage of additional investments offered by their SIPP provider.

Building your portfolio

Investments permitted in a SIPP include stocks and shares quoted on a recognised UK or overseas stock exchange, Government securities, unit trusts, investment trusts, insurance company funds, traded endowment policies, deposit accounts with banks and building societies, National Savings products and commercial property.

Not all SIPPs will allow you to hold everything on this list – that will depend on the provider. Plus, SIPPs that hold more-exotic investments, such as property or overseas shares, tend to carry higher charges.

‘There are certain things that can be placed in a SIPP but that will be taxed by HM Revenue & Customs (HMRC),’ Wolanski explains. ‘For example, taxable property, which means residential property or tangible, moveable property, such as cars, wine or antiques. In practice, quoted investments and mutual funds, property syndicates and commercial property tend to be the most popular.’

Costs and charges

Tom McPhail, head of pensions research at Hargreaves Lansdown, says, ‘SIPPs are close to being a zero-cost product these days, with investors simply paying the underlying investment charges, such as stockbroking fees and unit trust annual management charges.’

Mike Sargeant, managing director of Lawrence House Fund Managers (which has its own SIPP proposition managed in conjunction with DA Philips & Co) explains, ‘The fee range from the specialist SIPP providers is substantial, starting from £200 per annum upwards. However, the quality of service and advice is also variable, and the cheapest is certainly not the best.

‘The basic fee is usually charged annually, but remember that each investment in the SIPP will carry its own charges and these will depend on the investments selected – from theoretically nil for a deposit account, to the survey, legal, stamp duty and maintenance costs related to commercial property.’

Allowances and contributions

The amount you can put into your SIPP per year is £225,000 for the 2007/08 tax year, rising by £10,000 per year to reach £255,000 by the 2010/11 tax year, according to information from Taylor Young Investment Management (TYIM). This limit applies across all your pension investments if you have more than just a SIPP. Tax relief is then available on up to 100 per cent of any earnings.

There is also a limit on the total funds that you can accumulate in pension savings over your lifetime before tax is charged. Again, this increases on an annual basis. It is currently £1.6 million for the 2007/08 tax year, increasing to £1.8 million by 2010/11.

Any funds over the lifetime allowance are subject to a 55 per cent tax charge if you decide to take the excess as cash. Tax is charged at 25 per cent on the excess if you take it as income, in addition to income tax at the marginal rate.

Upon retirement, up to 25 per cent of your fund should be available as a tax-free lump sum. Any income taken from the remainder is taxed (see box below). However, TYIM recommends investors take advice on SIPPs from an independent adviser. Tax is a complicated issue and your specific circumstances and requirements must be assessed to allow you to build up sufficient retirement savings.

Tax benefits

The tax benefits that you receive on your contributions are the same as for any other type of pension product. Sargeant outlines the main points: ‘Providing you do not offend HMRC’s conditions, contributions to a SIPP gain relief from income tax of up to 100 per cent (to a maximum of £225,000). The investments are also free from tax charges, allowing gross roll-up of investment income and a nil rate of capital gains tax (CGT).’

SIPPs were designed as a catch-all, able to meet the needs of a wide range of investors and savers. ‘It isn’t about age, investment amounts or even investment knowledge, so much as whether an investor wants to get the most out of their pension fund,’ McPhail adds. ‘You can set up a SIPP for as little as £50 a month and some have no fixed set-up fee or annual fee, so they work just as well for £1,000 as they do for £100,000. Similarly, investors can set their investment strategy according to their investment ability.’

So all that’s left is for you to decide on an investment strategy to suit your plans for retirement. And don’t expect to make the same choices as you would for your normal investment portfolio, as Derek Gawne, director of WH Ireland, points out: ‘We find that most of our clients have a different risk profile for their pension than for their private portfolio.’

Gawne advises taking a more cautious approach to your pension investments. ‘If you retire at the age of 60, you have 15 years until you have to buy an annuity, so it is still “long-term” investment. But as you get closer to retirement, and certainly once you are in drawdown, you should be more cautious. That is not to say everyone is, though – some people will always be aggressive investors!’

SIPPs: What happens at retirement?

It’s all well and good building a robust, overflowing pension pot now, but do you know what your options will be once you reach retirement?

First of all, as Hyman Wolanski, head of pensions at Alliance Trust, points out, it is no longer a question of retirement at all. ‘There is no concept of retirement now, there is simply an age at which you can start to claim your pension,’ he explains.

Once you hit 50 years old (and this will change to 55 years old by 2010), you can take 25 per cent of your pension pot as tax-free cash. The rest is income, which you can access by either buying an annuity with the funds (effectively killing the pension), or withdrawing an income (an “unsecured pension”). While the 25 per cent lump sum is tax free, any pension income is taxable. This works in the same way as tax on income normally – you have an annual allowance above which you pay income tax at a rate that depends on your level of income.

Annuities v income

An annuity will allow you to convert a lump sum into an income. In the case of a personal pension, you use the 75 per cent left in your fund (after taking the 25 per cent tax-free lump sum) to buy the most suitable annuity for your circumstances. There are many different types so research is essential to get the best deal for your situation. What Investment runs annuity tables every month (page 108 in this issue).

By buying an annuity, you basically cash in your pension pot. You get a fixed sum for the rest of your life, or for a fixed period, depending on what type of annuity you buy. Once you reach 75 years old, you must buy an annuity, even if you initially opted for the unsecured pension route.

With an unsecured pension, your savings remain invested and you simply draw an income. Therefore, the amount you have saved could still fluctuate according to market movements. ‘The maximum you can withdraw per year is calculated every five years by age, sex, value and interest rates,’ Wolanski explains.

‘In principle, you should almost always speak to an IFA when it comes to arranging a SIPP, especially when you start to take an income as that is when things get complicated. In fact, some providers won’t even allow you to get a SIPP without an IFA.’

This article is from the September 2007 issue of What Investment.