Annie Shaw discovers how parents can take an active role in securing – in spectacular fashion – their children’s long-term financial future

Children are dear little things – not just because they are sweet and lovable, but also because they cost their parents a fortune. Anyone with a baby knows how the costs of cots, nappies, prams and toys add up – and the bills only get worse as the child grows older, when parents need to fund everything from school shoes and ballet lessons to sports trips and, eventually, university fees.

Saving for a child’s eventual retirement more than half a century into the future is therefore likely to be the last thing on the mind of a parent or grandparent, but it actually makes more sense than you might think.

An early start
Figures from the insurance company Clerical Medical show that £300 put aside each month for a child by a parent or grandparent between birth and the age of 16 could provide a massive pension fund of around £1.2 million by the time the child retires at the age of 55, without the child ever having contributed a penny during their working life (assuming annual growth of 6 per cent). At current annuity rates, this would provide a retirement income for life of nearly £70,000 from the age of 55, or more than £80,000 from the age of 65 – in addition to any state pension.

So, how can this be? Pension reforms in 2001 introduced the stakeholder pension. This type of pension allows individuals under the age of 75 to make income-related pension savings flexibly and cheaply. The stakeholder regime also allows those with only a small income, or no income at all, to pay up to £3,600 a year into a scheme without reference to their earnings. This has opened the way for higher earners to make payments into a pension scheme on behalf of non-earning family members – such as non-employed spouses or children – who since the reforms can, for the first time, benefit from pension savings in their own right.

A further benefit of the reforms is that contributions are made net of tax, whether the account holder has taxable earnings or not. So, someone paying in the maximum £3,600 that is permitted without reference to earnings would actually hand over to the scheme just £2,880, with the extra £720 being paid in by the government.

This means that fully funding a stakeholder pension for a child with no taxable income would cost a parent or grandparent just £240 a month. Annual management charges are  no more than 1.5 per cent of the fund for the first ten years and 1 per cent after that.

Anyone doubting the benefits of saving over the long term should examine how savings made from birth to age 16 and then left with no more payments until retirement compare with savings made in the direct run-up to retirement.
Bob Fraser, senior wealth adviser at wealth manager Towry Law, says, ‘Contributions made during the first 18 years of life could easily end up being worth more than equivalent contributions made during the 42 years from ages 18 to 60.’

Towry Law figures show that contributions of £3,600 per year between birth and age 18 and then stopped would create a fund at age 60 of £1.31 million, while saving from the age of 18 to 60 would create a fund of less than half that at £659,000, assuming a growth rate of 7 per cent with an annual management charge of 1 per cent. (see table)

Waiting game
Of course, the child won’t be able to access the money for half a century or more, as it is tied up in a pension plan that is not accessible until the age of 55, but that is not necessarily a bad thing.

Fraser explains, ‘The earlier the pension is started, the less pressure there is on the child, once an adult, to make personal pension savings, thus allowing the surplus income to be used to purchase a home or to pay down a student loan.’

The benefits of saving in a pension fund are not, however, just for the child. While there is no income tax relief for the adult donor of the contributions – the tax relief pertains to the child, and will only be at standard rate unless the child is for some reason a higher rate taxpayer – there could be inheritance tax (IHT) advantages for the adult.

‘The reason is that the £2,880 contribution should either fall within the £3,000 annual gift exemption or else might qualify as normal expenditure from income,’ says Fraser.

Jonathan Hill, a certified financial planner at solicitor Milton and Dormor in Chard, Somerset, adds, ‘The “normal expenditure out of income” exemption is often overlooked when people are undertaking IHT planning.

‘These gifts are immediately exempt from IHT and are generally unlimited so long as they are made as part of normal expenditure; the donor is left with sufficient income to maintain their normal standard of living, and the gift forms part of a regular pattern. This makes them ideally suited to pension planning for grandchildren.’

Towry Law’s Fraser explains how this works: ‘A grandparent pays £240 per month in pension contributions for each of four grandchildren out of surplus income. These contributions are increased by immediate tax relief to £300 per month. Five years later the grandparent dies, having reduced his estate by £57,600 in respect of these contributions.

‘The full nil rate band (currently £325,000) is still available, and the grandchildren have £72,000 (ignoring investment issues) between them in their pension plans. The total tax saving is £37,440, made up of £23,040 of IHT at 40 per cent plus £14,400 in pension tax relief.’

The tax avoidance process can be repeated by the parents if they are in a position to take over the children’s pension payments. However, Neil Lovatt, sales and marketing director at Scottish Friendly is strongly opposed to pension vehicles being set up for children. ‘Children’s pensions mean that the investment is locking in basic rate tax relief of 20 per cent. There are equally good tax-free investments for children, including Child Trust Funds and tax-exempt savings plans (TESPs), and an unlimited amount of capital gains tax allowance over their lifetime.

‘By using these other investments the child or guardian has the ability to switch into a pension at a later date when the child has a marginal tax rate higher than the basic rate.’

The right option
One of the major issues that will concern anyone setting up a pension fund for a child will be the matter of choosing funds.Fraser comments, ‘The potential sums involved in these plans are quite large, and investment considerations are important. Given the likely period to maturity – 50 years or more – a largely equity-based approach is necessary. It would be vital to consult a properly qualified wealth adviser in order to obtain good fee-based investment advice, and for this to be subject to regular review.’

Parents wanting more control over their children’s savings don’t have to confine themselves to a stakeholder pension. A personal pension or self-invested personal pension (SIPP) could be used – although charges will be higher.

Sherry-Ann Sweeting, marketing manager at SIT Savings, favours the flexibility of SIPP saving, while Fraser recommends switching from one to the other as appropriate, saying, ‘Initially, the pension pot would be small, and a stakeholder pension would be entirely suitable. However, once the underlying fund reaches more substantial levels, consideration should be given to a self-invested personal pension in order to ensure that the correct asset allocation, diversification, rebalancing, and investment management procedures can be accommodated.’