In my view the term ‘investment income’ is synonymous with ‘retirement income’ or to be more precise ‘additional income in retirement’.

When an individual prepares for retirement they normally receive a state pension, occupational pension and a personal pension if an individual’s circumstances have allowed this. It is a fact of life that in many instances ‘pension income’ alone will be insufficient. Figures on mortality are collated and published by the Governments Actuaries Department (GAD). The GAD tables show that a male celebrating his 65^th birthday in 2011 can expect to live for another 18.6 years.  That’s over 20% of his entire life spent over 65 – and in retirement.

The position is even better (or worse depending on your view point) for women, who can expect an additional 20.8 years if they reach 65 in 2011.

It follows therefore that additional steps need to be taken throughout an individual’s lifetime. This is to ensure that they can retire with an acceptable level of income rather than settle for a lower standard of living – or even worse – continue having to work until retirement is affordable.

The concept of saving for retirement is very simple:

You defer spending (i.e. save) when your income is higher (i.e. when you’re employed) to enable you to spend it when your income is lower (i.e. after you’ve stopped work).

The alternative is to have a lower standard of living when your income “falls off a cliff” at retirement. When you have to start thinking about ‘cutting back’ to be able to live in retirement then you run the risk of living in poverty.

So how can we do something about this? The earlier people start planning the better. At 18 it is possible to invest into investment ISAs (cash ISA’s are available from 16). The important word here is “invest” – not “save”. Saving is for unexpected emergency expenditure or planned short term spending (an initial deposit for a house, purchase of a car or perhaps getting married). In this context cash is most appropriate.

However, what would be the most appropriate type of savings vehicle? In my view it would be a high interest, instant savings account with a building society. It may seem strange but I would not utilise a cash ISA for this purpose.  Although this might initially be counter intuitive, cash also has risks:

Inflation
If inflation is greater than interest earned on cash then the purchasing power of the cash will be eroded over time. If a bank account is paying 2% (gross) and inflation is running at 4% then the purchasing power of £100 deposit is reduced by 2.47% over 12 months for a basic rate tax payer – even with the net interest added.

Interest rates
A prolonged period of low interest rates (as we have seen recently) will reduce the income available from cash deposits. To compound this problem, the actual rates offered may not be competitive. Recently the banking institutions have embarked on a period of “balance sheet repair” following their exposure to toxic mortgage debts.
Some banks and building societies have exacerbated this problem still further by trying to entice savers with rates that appear attractive but are significantly less so when the small print is examined.

Defaults
As unlikely as it may seem banks can go bust. If the UK Government hadn’t intervened in the banking crisis in 2009 at least one UK High Street bank would have folded – with the loss of savers cash (or at least some of it).

Taxation
The Government may choose to increase taxes on savings at any time. For a basic rate taxpayer this is currently 20%, rising to 40% and 50% for higher rate taxpayers.

So what’s the alternative? Planning for longer term expenditure (i.e. retirement income) is best achieved by a controlled exposure to a range of different assets.

The Government gives precious little away so when it does, then it is important to grasp the opportunities as and when they arise. This is where the investment ISA comes into its own.
The limit for this tax year is £10,200 under current legislation. This amount will be maintained in real terms when deciding on the maximum limit at the start of each tax year.

It is important to remember that investing is for the medium/long term. So when it comes to making provision for increasing your income in retirement it seems ludicrous to ignore ISAs.  They are free of income tax and also capitals gains tax and remain 100% accessible at all times. 

When looking at reviewing your provision for income in retirement think very carefully before you discount Investment ISAs – it could be a costly mistake.  What better way to supplement your retirement income than with tax free investment income.

Richard Witcombe is a Partner and Financial Planner at Proposito