CHAPTER 11 PENSIONS - THE MOST TAX EFFICIENT INVESTMENT

FOUR SITUATIONS WHEN A PENSION FUND MIGHT NOT BE ADVISABLE

IF YOU AREN'T CONTRIBUTING THE MAXIMUM TO YOUR SPECIAL SAVINGS ACCOUNT
The Special Savings Account is more tax attractive than contributing to a pension. Don't contribute to a pension if you are not putting in the maximum €254 per month into your SSA.

IF YOU DON'T OWN YOUR OWN HOME
Your first investment priority has to be to own your own home. Many people start off a pension in their early 20s frightened by salesman's mantra : "You cannot be too young to start a pension". This should be rephrased "You cannot be too young to start saving". You will need all your money for a deposit on a house and that takes priority over everything including a pension.

IF YOU HAVE A BIG MORTGAGE OR OTHER BORROWINGS
After buying a house, your next priority is to get your mortgage down to a comfortable level. What is comfortable depends on a number of factors: The security of your job, your career prospects and the value of your home in relation to your mortgage. As a general guide, if your job is reasonably secure, anything over twice your salary is uncomfortable. Don't start a pension until your mortgage is down to less than twice your salary.

IF YOU ARE PAYING TAX AT THE LOWER TAX RATE
Pensions are only attractive if they save you tax at the top rate of 42%. If you are on the 20% band, don't bother with a pension. You might end up in a situation where you save tax at 20% only to pay it at 42% on your retirement.

A PENSION IS A VERY EFFECTIVE WAY OF SAVING

The government gives great tax relief to encourage us to contribute to pension schemes. You should think of this relief as a tax deferred, rather than tax saved. You will pay tax when you come to draw down your income after retirement (subject to tax credits etc). However, the major advantage is that your fund will grow without any tax deductions, and the compounded growth will help to increase the value of your fund.

You get full tax relief on every contribution, so a £100 contribution only costs a top rate tax payer £58 ( £100 - 42% tax). The cost is even lower for employees who save PRSI as well as tax.

HOW MUCH SHOULD YOU CONTRIBUTE TO ENSURE A COMFORTABLE RETIREMENT?

Pensions salesmen will give you illustrations which show you that if you start a pension now at 25 , you will have £1m when you are 65. But if you don't start until you are 30, you will retire a pauper. Forget about these projections - the future is just too uncertain for them to have any meaning whatsoever. You cannot predict how your salary and personal wealth will develop over the next 10 years, never mind over the 40 year life span of a pension. You cannot predict how inflation will go . You cannot predict how the underlying investments will perform.

Look at your need for cash now and in the near future. If you have cash which is surplus to requirements for the foreseeable future, put it all in a pension fund. If you need cash now to pay down your mortgage, use it for that purpose. Don't sacrifice essential expenditure now for an uncertain payoff in 40 years time. If you will need cash in 10 years time for your kids' education, you might be better contributing as much as possible to your pension fund now and then taking a contribution holiday when you need the money.

However, there are some potential disadvantages to deferring your pension contributions.
1) For most people, there is a certain maximum percentage of salary which they can contribute e.g. 20%. If you don't make your 20% contribution this year, you cannot double your contribution to 40% of your salary next year. So you lose out on an opportunity to contribute.

2)The tax advantages of pension contributions might change. Instead of getting tax relief at your marginal rate, it might be changed to tax relief at the basic rate.

3) This year you get tax relief at 42%. If the marginal rate drops to 40% next year, the tax relief is less valuable.

In summary, contribute as much as possible without sacrificing your current standard of living too much.

COMPANY PENSION SCHEMES

(Many thanks to Rainyday for contributing this section on Company Pension Schemes)

If you are an employee of a medium/large sized company, you will probably find that your company provides a pension scheme for your staff. In this case, you will not be able to get tax relief for contributions to a private pension scheme. If you want to make tax-effective pension contributions, you will have to go with your own company's scheme. [This situation may change with the introduction of PRSA's in 2002].

There are two main types of company pension schemes - Defined Benefit and Defined Contribution. Defined Benefit (DB) schemes are typically found in older established companies or state related organisations. When you retire as a member of a Defined Benefit scheme, you get a fixed level of benefit (usually a percentage of your final salary) for each year of membership of the scheme.

Defined Contribution (DC) schemes are more common than Defined Benefit. With Defined Contribution schemes, you will contribute a specific amount (usually a percentage of your salary) to the pension fund and in many cases your employer will contributed a related amount to the fund on your behalf. These contributions are invested on your behalf by the fund manager, and the resulting value of your invested contributions makes up your pension on retirement.

If you wish to contribute more than the maximum level permitted by your scheme for normal contributions, you can usually make 'AVC's (Additional Voluntary Contributions). These contributions are not matched by your employer and are usually invested in a separate fund to your main contributions.

Most DC schemes have a specified 'vesting period'. This can vary from zero to two years. This means that you have to be a member of the scheme for the given period to benefit from the employer contributions.

If you leave your employer before the vesting period has expired, you have three options;

Use the contributions to buy a 'retirement bond' from an approved insurance company - This bond will be invested on your behalf until you reach retirement age.

Transfer the contributions to the fund of your new employer - This will be at the discretion of the trustees of your new employer's fund - In some cases, this method can be used to shorten the 'vesting period' in your new employer's fund.

Have the contributions refunded to you in cash, after a 20% deduction for tax - This can be a very tax-effective method of saving for the medium term if you are a top-rate taxpayer and you are 100% certain that you will be leaving your employment before the vesting period expires - This is because you save the top rate of tax (currently 42%) on all contributions and you lose 20% when they are returned to you, resulting in a net 22% tax saving.

If you leave your employer after the vesting period has expired, the first two options are still available to you, but the third option of a cash refund is not.

You may find that the amount that your employer will contribute to the fund depends on how much you are prepared to contribute. One large American multi-national operates on the following basis;

If your company scheme works like this, it makes sense to contribute the maximum amount you can afford as your employee contribution, in order to maximise the matching contribution which your employer will make.

INVEST YOUR PENSION FUND IN THE STOCKMARKET

Pensions are a long term investment and as such are perfectly suited to 100% equity exposure. If you are putting your money away for 20 years or more, the interim crashes and slumps in the stockmarket won't affect you.

Don't bother with balanced funds or with-profits funds - you don't need the stabilizing influence of such funds.

Some will argue that as you approach retirement, you should gradually reduce the exposure to equities and increase the gilt proportion of your fund. This might be true if you are obliged to buy an annuity on retirement. But if you are planning to buy an ARF, then remain 100% invested in equities.

SELECTING A PENSION FUND

You have two decisions to make. Firstly you must decide whether you want to invest your pension fund in the stockmarket, in a with profits fund or in property. Then you must decide which of the pension providers offering your choice, gives the best value. You should completely ignore the past performance of a pension provider. It just says nothing about future performance.

If you are a member of a company pension scheme, you will probably be offered a limited 'menu' of choices for your investment fund.

You will not be able to buy a pension with lower charges directly from an insurance company. However, if you are investing large sums, e.g. over £20k a year, you may be able to get a better deal through a discount broker - try www.prsa.ie or www.ferga.com.

QUESTIONS

Because of the variety of pension schemes, there is an infinite variety of questions. Most of these have been addressed in the Pensions Forum on Askaboutmoney. We can only deal with the most frequently asked questions here.

I am in a defined benefit scheme and I am changing jobs. I can take a transfer value or I can freeze my pension with my current employer. Which should I do?

It is impossible to be definite about such a question. This depends on so many factors: what assumptions your employer is making about salary growth: what return might you get from a PRSA. As a rough rule of thumb, if the transfer value is less than £10,000 transferring it into your PRSA is probably the most convenient and clear cut. If your pension is more than £10,000 you should probably pay for professional advice from an actuary.

Actuaries are expensive. You will get a list of them in the phone book. Not all of them will deal with such assignments. A typical review of a change of job option will cost you around £200. One who does welcome such business is :

I am a teacher and I took a ten year career break. I now have a choice of buying back years or contributing to an AVC from Irish Life and Permanent. Which should I go for?

Well you certainly should not go the AVC route. The charges are extraordinarily high - £575 to set it up and an ongoing charge of 1.75%. You should either buy back years or wait until the PRSA is introduced. Which is better depends on a range of factors and there is just no simple answer. Pressurize your trade union to have an independent actuarial survey of the various options done. In the meantime, my guess, and it is only a guess, is that the PRSA is the preferred option.

I am a company director. I have heard that I can buy a property through a pension fund?
If you are a proprietary director, you can set up a Small Self Administered Pension Scheme. You will need a minimum fund of £100k to justify the costs of setting it up. When it is set up you can invest the money directly in shares or property or other appropriate investments. There are rules to ensure that you don't abuse the system e.g. you cannot buy the office which your company occupies.

APPENDIX 11 PRSAs FAQ

When will PRSAs be available?

Probably at some time in 2002. The Pensions Bill needs to be published and passed into law. Then the various pension providers will have to launch their products.

Until the law is passed we don't know the exact details of the schemes, but the outline was published in the http://www.welfare.ie/dept/reports/prsa.doc Framework Document in April 2001.

The following answers assume that the final details will be in line with the Framework Document

What should I do in the meantime?

If you want to start a pension in the meantime, make sure that there are no exit or entry charges, so that you can transfer it to a PRSA without penalty. The Quinn Life Freeway has no initial or exit charges for lump sums and charges £3 per contribution for regular savings.

You should also make sure that you are contributing the maximum to a Sissie before you start a pension.

What advantages do they have over the current regime?

A maximum level of charges. ( 5% initial charge and 1% annual management charge)
Complete flexibility - your employer can contribute, you can contribute, and you may be able to transfer in your current arrangement.
If you are not currently employed, you can contribute to a PRSA and get tax relief when you return to employment.

What will be the contribution limits?

Younger than 30 15%
30 to 39 25%
40 or older 30%

This applies to the total contribution from you and your employer. For example, if you are 25 and your employer is contributing 10%, you can only contribute 5%.

Certain occupations e.g. jockeys and athletes can contribute 30% at any age.

I am in an AVC Scheme at present with my employer. Can I take out a PRSA instead?

Yes - probably. And it is likely to be a good idea as the charges on a PRSA will probably be lower.

When can I retire?

What can I do with my PRSA fund when I retire?

When you retire you can take a tax free lump sum and put the balance into an Approved Retirement Fund. The ARF continues to accumulate tax free. You pay income tax at your marginal rate when you draw it down.

Why is the PRSA attractive to the unemployed and people taking career breaks?

If you don't have a taxable income, you can contribute to a PRSA and carry the contribution forward and claim tax relief against it subsequently.

I don't have a pension scheme. What does my employer have to do?

If your employer has more than 8 employees, he must provide you with access to a PRSA and facilitate you by making deductions from your salary..

This is advantageous to you in that you will make your contributions before tax and Prsi. If you take out a PRSA directly , you will get tax relief but not prsi relief.

Your employer does not have to make any contributions, but if he does, the combined maximums are as per the contribution limits above.

Further information

APPENDIX 11 A Why an SSIA is more attractive than a pension for most people

We recommend that you contribute the maximum to a Special Savings Incentive Account before you start a pension. This confuses people as the there is 42% tax relief on pensions, so surely this is more attractive than the 25% added by the government to an SSIA?

What people forget is that when you retire, the entire pension,( excluding any tax free lump sum) will be taxed at your marginal rate of tax. By comparison, the SSIA will pay an exit tax of 23% on the growth only.

If you are very close to retirement and your pension fund and other income is such that you will not be in the top tax bracket, then there is a marginal advantage to contributing to the pension scheme. You should however make the minimum contribution to the SSIA, so that after you retire, you can raise it the maximum contribution.

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