A lot of people that we talk to are not aware that a minor can own a pension and they are often even more bemused when we speak about the possibility of paying into one for someone who may still be a baby!
However, as we always point out to clients, the longer the time period over which you are able to make an investment, the more you are able to benefit from the effects of compound growth which is one of the most powerful forces in terms of growing your money. This way, investment growth does a lot of the saving for you, meaning that you are able to use more of your income to enjoy your life in the present rather than having to put all of your income aside for later on.
Children’s pensions are an extreme form of long-term savings and the investment term can be spread over 60 years or more. Over such a long period, the savings made early on are compounded over many years and this means that not only does the money that you save benefit from investment growth but the growth achieved on those savings will also then benefit from future investment growth each year for many years. This means that even a small investment can grow to a substantial future value in monetary terms.
So, the fact that growth will be compounded over many years is a great reason to save on its own, but due to the fact that tax relief is available on pension contributions, the government will pay part of the contributions for you and this tax relief will also benefit from compound growth! Even those with no earnings at all (as is the case for most children) can pay in £2,880 p.a. (£240 p.m.) to a pension and HMRC will automatically add basic rate tax relief of £720 p.a. so the total amount invested each year will be £3,600. Under current legislation (As of April 2021), when pension benefits are taken in future, 25% will be payable tax fee and tax is only paid in the remaining 75%. This means that basic rate tax relief is added at 20% when making the contributions but a basic rate taxpayer only pays an effective rate of tax of 15% on pension withdrawals later on due to the 25% tax free element.
A further benefit is that for those with an inheritance tax (IHT) liability, regular pension contributions to another individual are classed as “gifts” and if these are from excess income that is not needed to maintain your own standard of living, the money is instantly outside of your estate for IHT purposes. Furthermore, if you continue to pay into your child’s pension and they become a higher rate taxpayer when they get older, they are able to claim higher rate tax relief on the contributions that you make which will reduce their tax bill in the present whilst also benefitting them in the future! Many people worry about making children’s investments as part of their inheritance tax planning as they are worried that if the child is able to access the money whilst they are still young, they may not make the wisest spending choices with it. Pension contributions are the perfect answer to this as they would not be able to access the pension funds until they reach age 57 (assuming they are in good health).
This all sound good but what does it all mean in monetary terms?
As an example, let’s imagine that you begin paying into a pension for your child as soon as they were born, maximising the annual allowance of £2,880 for non-earners. This means that £3,600 is added to their pension each year after tax relief. If you were to do this for the first 18 years of their life until they are potentially old enough to get a job and make their own contributions, you would have paid in a total of £51,840 over this period. However, a total of £12,960 will have been added by the government in addition, giving a total investment of £64,800. Such long investment timescales tend to lend themselves to a more adventurous investment approach with the majority of assets being invested into equities as these have historically produced a higher investment return over the long term than other asset classes. Over the past 30 years, the MSCI World index (which captures equity representation across 23 Developed Markets countries and has 1,585 constituents) which is a good proxy for global equity returns has returned 8.77% p.a. (as of 29/04/2021) so equity returns can be very high over the long term. However, if we assume a return of 5% p.a. after charges, the total value at age 65 would be £1.03m, although the actual cost of the investment was just £51,840! This shows the value of long-term compound growth as at age 65 the investment amount of £64,800 (including tax relief) makes up just 6.29% of the value – the remaining 93.71% is made up entirely of investment growth! Of course, this is in nominal terms and does not take into account inflation, but it still represents a very good start towards an individual’s retirement savings!
As with all investments, there are some potential drawbacks. For example, legislation could change in the future meaning that (among others) the rate of tax relief could be reduced, the tax-free element could be reduced or even withdrawn and tax rates could increase. In addition, pensions currently have a Lifetime Allowance (LTA) of £1,073,100 and any savings in excess of this incur an LTA charge which could limit that amount that a child is able to pay into a pension during their working life. If they are a higher rate taxpayer during their working lifetime then this could limit the amount of pension planning they are able to do themselves to manage their own tax position whilst working. However, they will still have access to other tax efficient investment options such as ISAs etc for their savings.
Of course, pensions are just one option for long term savings and the same factors would apply to a Junior ISA or General Investment Account held in trust, just with a shorter timescale, more access but no tax relief. The key rule is that the earlier you begin to save towards a major outgoing, the less effect it has in terms of the amount you need to put away on a regular basis. For example, a child’s future university costs of £50,000 at age 18 would only require a saving of £145 per month if you began putting money away when they are born (assuming returns of 5% p.a.) but if you were to only start to save for this expense five years before they are due to start University, the amount of saving required increases to £735 per month which would have a much bigger effect on how much expendable income you are able to keep for yourself.