Understanding the Lifetime ISA
Written by Janette Rutterford
Tuesday 18th April 2017
There’s a new kid on the block. The Lifetime ISA, or Lisa as it’s commonly known, allows 20 to 39 year olds to invest up to £4,000 a year until they are 50 and, for each £100 invested, the government will add £25.
The catch is that it either has to be used to buy a first home, worth up to £450,000 in value, or accessed after the age of 60, to help fund retirement.
So how does this age group get its head round the new savings vehicle? Is it in competition with Help to Buy ISAs and/or conventional defined contribution pensions? Well, the first question is easy to answer.
Lisas are more generous than Help to Buy ISAs and, in any case, these are being phased out from 2019. Comparison with pension plans, such as auto enrolment, is a little trickier. For example, it depends on your income tax rate, and, as the Financial Times commented in a recent article, a survey of just over 1,000 eligible UK adults, revealed that 17% did not know which tax band they are in.
Tax bands matter. If your tax rate is 20%, the net cost of saving into a pension plan or a Lisa is the same. For example, if you want to contribute £100 a month to a pension plan and your marginal rate is 20%, the £100 contribution you make is effectively £80 from your net income plus £20 from the government in tax relief (20% of the £100 pension contribution) since pension contributions can be deducted from gross income before tax is calculated. With a Lisa, it is a bit clearer. You pay £80 into the Lisa and the government pays in £20, adding up to the same £100. The pendulum swings one way if you are a higher rate taxpayer (the pension plan is more attractive) and the other way if you are a non-taxpayer.
Of course, there are other factors affecting the comparison. The employer - as well as the government - contributes to the pension pot. And the age at which you can access a pension is 55 not 60. That should make pensions more attractive. But the majority of people in the FT survey preferred a Lisa to a pension plan. Probably that’s because we all know what ISAs are, and a lump sum hand out from the government has to be a good thing. So, the main reason why interviewees preferred a Lisa is that it is easier to understand than a pension product.
The Lisa is a hybrid investment product. Those saving through a Lisa to buy a house are likely to have a fairly short time horizon – say five years. Those saving through a Lisa for a pension will have a twenty to forty year time horizon. And time horizon matters.
Those saving for a house should pick a low risk investment strategy, minimising the risk of not being able to afford a first home. Those saving for the long term should favour a riskier investment policy since short term fluctuations will get ironed out.
The majority of those interviewed by the FT said they would treat Lisas like cash ISAs. That may be fine for short term saving for a house deposit. But it is pretty disastrous for a long-term investment objective. A mix of investments including shares and bonds helps to diversify risk and offers a higher annual return over the long term.
And, with the government planning to pay the lump sum monthly from April 2019, it is vitally important to reinvest the income to get the benefit of compounding. 56% of the FT’s sample did not understand what compound interest was. It’s clear that the government is not meeting its responsibilities. Not only should it offer simple, easy to understand savings and investment products, with tax benefits, but it should also educate those for whom the products are designed. It is not enough to leave it to the investment institutions’ piecemeal approach.
*Professor Janette Rutterford is Research Professor of the True Potential Centre for the Public Understanding of Finance (True Potential PUFin)
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