Key Post "Should I just save money or contribute to a pension?"

[LDFerguson]

This is a question that comes up a lot. Actuary Tony Gilhawley has written this piece for Standard Life. It's a very good analysis of the pros and cons.

Would be interested to hear any views.

 

[Jim2007]

Let me start by saying that I have very little exposure to the Irish pension industry, as I have lived in Switzerland since the late 80s, but through my work experiences I've had a fair bit of exposure to the pension funds operations in most mainland European countries.

Now having keeping that in mind, the one thing that always surprises me article about Irish (and UK as well for that matter) pensions, is how they all turn in to the same thing - a discussion on taxation!

In contrast, most Germanic publication I read, would start out with a discussion on how much you need to save in order to have sufficient funds to provide for a pension in your old age and so on. Somewhere buried in the article will the points about tax savings on the contributions and so on, but unlike Ireland, the suggestion will be that any savings on taxes should go into the fund, since it represents some of the gains on the pension, thus the entire premiums are expected to come out of the net salary!

This always leaves me wondering what is wrong with the Irish/UK funds, that they can only sell themselves as tax schemes??? I mean most mainland European countries offer tax credits for pension contributions, allow certain lump sum withdrawals, and tax the pension as income when you start to draw it down... so what am I missing???

 

[DerKaiser]

This always leaves me wondering what is wrong with the Irish/UK funds, that they can only sell themselves as tax schemes??? I mean most mainland European countries offer tax credits for pension contributions, allow certain lump sum withdrawals, and tax the pension as income when you start to draw it down... so what am I missing???

There's plenty of non-pensions business in Irish/UK funds, but pension vehicles are a huge part of the market also.


Once the decision has been made to save disposable income, the big decision in Ireland/UK is whether to save for retirement using non-pensions savings vehicles (contributions from net of tax income, funds subject to exit tax on gains only) or to use pensions vehicles (contributions tax deductible, funds roll up gross of tax but proceeds are subject to income tax).

It has become less clear of late that the benefits of tax relief on contributions and tax free investment income/fund growth will always outweigh the taxes payable later due to the fact that pension proceeds are treated as taxable income.

 

[orka]

I had pretty much decided not to do any future contributions because of the issues discussed in the article - that there may actually be a tax cost in the long term if you contribute to a pension scheme - but the reason I will definitely never put another cent into a pension product is the 0.6% government levy being applied for at least 4 years. This has the same effect as a permanent 2.4% income tax surcharge when I draw down the pension and there is absolutely no way for me to avoid it on my past contributions. I can, however, ensure that the government don't get the chance to steal my future pension savings by keeping them in easily accessed investments that can be moved if necessary. A levy on locked-up-for-30-years pension contributions was such an easy steal for the government that it's hard to see them not keeping the levy going indefinitely.

 

[DerKaiser]

Hi Orka. I gave some consideration to your comment above on the levy and looked at figures for a 30 year regular premium pension with a 0.6% levy over its entire lifetime versus a 30 year regular premium savings policy with no levy.

Straight away you are in a situation where you can invest €100 into the pension for every €59 you would have put into the savings policy.

Assuming a modest return per annum (about 2%), the proceeds of the savings policy (allowing for the levy on the pension only) will still only be 59% of the pension. About 8% exit tax is payable on the savings policy, almost the exact same cumulative impact as the levy has on the pension policy.

So at retirement you still benefit from the full value of the tax relief on the contributions, the levy has simply eroded the advantage of having no exit tax.

Finally you have to look at the fact that the savings proceeds are tax free whilst the pension income will be treated as taxed income. Obviously if there is no tax free lump sum and you pay an average tax of 41%+ on your retirement income, there is no advantage to the pension.

If you allow for a 25% lump sum, as is allowed in most cases, the pension is still gives a tax advantage provided it is not taxed at 55%.

In short, a 0.6% levy will not come near eroding the value of the tax relief on contributions. It will make the case for pensions investment less compelling, but should only tip the balance away from pensions where the tax free lump sum is limited and practically all the proceeds of the pension are taxed at the higher rate in retirement.

 

[Jim2007]

There's plenty of non-pensions business in Irish/UK funds, but pension vehicles are a huge part of the market also.


Once the decision has been made to save disposable income, the big decision in Ireland/UK is whether to save for retirement using non-pensions savings vehicles (contributions from net of tax income, funds subject to exit tax on gains only) or to use pensions vehicles (contributions tax deductible, funds roll up gross of tax but proceeds are subject to income tax).

It has become less clear of late that the benefits of tax relief on contributions and tax free investment income/fund growth will always outweigh the taxes payable later due to the fact that pension proceeds are treated as taxable income.

We have exactly the same situation here: You get tax credits on your contributions each year and yes you are going to be taxed as some unknown rate in the future when you start to receive a pension...

But I've never seen anyone use this as a reason for not contributing to a pension..... and I don't see why it should be!

 

[Jim2007]

Finally you have to look at the fact that the savings proceeds are tax free whilst the pension income will be treated as taxed income.

Given that savings in most other EU country are subject to wealth taxes and given that we are clearly moving to a much more integrated Eurozone, I would expect that by the time it comes pension time, savings will be subject to some form of wealth tax....

That is why I find this whole tax angle so very iffy, people are making very significant financial decisions on the weakest of assumptions.

 

[Jim2007]

I had pretty much decided not to do any future contributions because of the issues discussed in the article - that there may actually be a tax cost in the long term if you contribute to a pension scheme - but the reason I will definitely never put another cent into a pension product is the 0.6% government levy being applied for at least 4 years. This has the same effect as a permanent 2.4% income tax surcharge when I draw down the pension and there is absolutely no way for me to avoid it on my past contributions. I can, however, ensure that the government don't get the chance to steal my future pension savings by keeping them in easily accessed investments that can be moved if necessary. A levy on locked-up-for-30-years pension contributions was such an easy steal for the government that it's hard to see them not keeping the levy going indefinitely.

So what is your alternative??? Over a 30 year period it is hard to see how you can be certain about any course of action...

 

[Ember]

This always leaves me wondering what is wrong with the Irish/UK funds, that they can only sell themselves as tax schemes??? I mean most mainland European countries offer tax credits for pension contributions, allow certain lump sum withdrawals, and tax the pension as income when you start to draw it down... so what am I missing???

Perhaps the best way of explaining, is by giving the example of my pension. I was paying into my private pension scheme for 32 years and when I retired my total fund was worth about the same as the total contributions that I had made to the scheme. There was no growth in the value of my fund at all, it had been eroded by the running costs of the scheme, bid-offer spreads, annual fund fees, administration fees and recently, taxes etc., etc.


Therefore, the pension companies to not want to focus potential customers on the lack of growth and high costs associated with pensions, they focus on the tax relief.


It should not be a choice between a pension or a saving account. Everyone should be allowed to have a pension savings account, one that gets the usual tax relief, earns interest, but has no charges, just like all other saving accounts.

 

[Baracuda]

He makes a good point and I have to agree that pension plans are not always the answer for everybody. I whole heartedly agree with Jim 2007 that we should be focusing at the end result and perhaps having the comfort of guaranteed annuity income in retirement instead of looking at what tax relief we are currently getting.

I tend to blame the industry itself for putting all/much of the focus on the tax efficiencies of pensions rather than focusing on actual Retirement Planning. Retirement Planning is a more logical way at looking at retirement benefits, in whereas income is derived from a number of investment vehicles including pension, regular premium investment accounts, property, deposits etc.. Gilhawley is intimating this somewhat in his article all be it from a Life product sales point of view.

Perhaps the article could have included a piece on inheriting pension funds as this should certainly be a consideration for the 41% tax payer. If a person dies before retirement age, the funds in a pension can be inherited at a lower tax rate or indeed by a spouse’s tax free.

The reality is in most cases a person getting tax relief @20% will likely pay little or no income tax on their annuity income and the high earner that is getting tax relief @41% and will most likely pay tax at the higher rate on annuity income, is using their pension fund as an investment vehicle for deferring income and will most likely invest in AMRF/ARF or combination of both.

Then there is the group in the middle where pension funding if not planned in conjunction with their other assets could actually be a costly liability to hold. This group can be very hard to identify especially if they start pension planning early in life as a pension would often be one of their steps. As the years pass a person’s assets and wealth can accumulate to the extent where a pension is no longer a cost efficient retirement vehicle.

The other side to all this is what has happened over the last 5 years where this segment of society has been pushed and squeezed by pay cuts, increased taxation unemployment etc.. and are now using up all their savings and assets, now their pension fund is one of their last remaining assets that they cannot liquidate until their 60…Now that pension was not a bad idea overall even it did not look that tax efficent a number of years ago.

Your thoughts?

 

[Baracuda]

Perhaps the best way of explaining, is by giving the example of my pension. I was paying into my private pension scheme for 32 years and when I retired my total fund was worth about the same as the total contributions that I had made to the scheme. There was no growth in the value of my fund at all, it had been eroded by the running costs of the scheme, bid-offer spreads, annual fund fees, administration fees and recently, taxes etc., etc.


Therefore, the pension companies to not want to focus potential customers on the lack of growth and high costs associated with pensions, they focus on the tax relief.


It should not be a choice between a pension or a saving account. Everyone should be allowed to have a pension savings account, one that gets the usual tax relief, earns interest, but has no charges, just like all other saving accounts.

So is this a symptom of poor performance or poor/lack of advice? I would say probably a combination of both.

You may have a point in your second paragraph but pension companies have many funds to choose from some have performed exceptionally well over that period so it could be poor/lack of advice and information that is the problem as well as the costs that you mentioned.

Everyone can have a pension savings account but whoever would run this let it be a bank or credit union would still incur large operation costs in the setting up costs and ongoing admin and financial regulation of pensions especially considering that a lot of people move jobs and stop their pension's and move to different providers over their working life time. There is a lot of competion in the market as it stands with countless companies offering various pension products so even if the banks etc entered the market it would do little to drive down the standing costs

I do think that there is room to reduce costs in the pension market however and this is happening at the moment with the sale of online excution only pension products where you do not receive any advice on product, funds and company, but this of course this can be a risky option unless you know what you are at.

 

[Ember]

So is this a symptom of poor performance or poor/lack of advice? I would say probably a combination of both.

Hi Baracuda,
You are correct, it was a combination of both. The managed fund that was recommended to me had a magnetic attraction to the bottom of the annual performance tables.
Another important factor for pension should be "predictability". The original documentation supplied by the pension scheme predicted a doubling of the value of the fund after 20 years. This was wildly inaccurate, to say the least. A deposit account would have delivered a compound rate of interest of between 3 to 10% over the last 32 years. This would have provided a very good return, as long as there were no fees.....

 

[Jim2007]

Everyone can have a pension savings account but whoever would run this let it be a bank or credit union would still incur large operation costs in the setting up costs and ongoing admin and financial regulation of pensions especially considering that a lot of people move jobs and stop their pension's and move to different providers over their working life time. There is a lot of competion in the market as it stands with countless companies offering various pension products so even if the banks etc entered the market it would do little to drive down the standing costs

Actually to me, it is beginning to look like health care in the US - there appears to be choice and competition etc... and yet people end up with either the same or less than when they started! The tax break seems to be the only thing on offer and since most people work on net figures, they end up spending the tax saving!

As a comparison let me give you a summary of the Swiss situation:
- The state contributory pension will only cover about 20% of your living expenses in retirement.
- Because the state pension is so low, a private pension is mandatory for all workers and is either run by the employer themselves or run by a pension fund on their behalf. This pension is expected to cover the next 60% of your living expenses in retirement.
- The remaining 20% is expected to come from personal savings over your working live. And to this end you can make contributions of up to 5Kpa into a tax free savings account
This is usually known as the 3 pillar system in Switzerland.

When it comes to the pension fund, the min and max holds of each asset class are mandated by law, as is the quality of instruments selected within each class, so you will not find Facebook on the list for instance. There are no fees charged on transactions etc... and the fund must pay a minimum return of the net assets to the contributors each year before the management fee can be applied. The management fee itself is usually less than 0.40% pa.

The third pillar - the retirement savings account is usually run by the banks and there are no charges for this account and of course the income there on is tax free until the account is accessed on retirement.

From a tax point of view you get tax credits on contributions to both the 2nd and 3rd pillar during your working life and on retirement you pay taxes on the pension you receive just as you would on any other income. If you take out a lump sum on retirement it is taxes as income in the year you withdraw it.

From my experience of the industry over the years, this mix give people a pension of around 70% of their final annual salary on average.

Now given this anti-market system, you'd be surprised to discover that there are hundreds of fund management companies in operation and in 23 years here, I've yet to hear of one of them going under!

So I would expect that there is a lot of room for reform in Ireland....

 

[Jim2007]

The original documentation supplied by the pension scheme predicted a doubling of the value of the fund after 20 years. This was wildly inaccurate, to say the least.

On the contrary I would consider this to be unimpressive and the big question is why they couldn't even manage that!

 

[Alexmartin]

I had pretty much decided not to do any future contributions because of the issues discussed in the article - that there may actually be a tax cost in the long term if you contribute to a pension scheme - but the reason I will definitely never put another cent into a pension product is the 0.6% government levy being applied for at least 4 years. This has the same effect as a permanent 2.4% income tax surcharge when I draw down the pension and there is absolutely no way for me to avoid it on my past contributions. I can, however, ensure that the government don't get the chance to steal my future pension savings by keeping them in easily accessed investments that can be moved if necessary. A levy on locked-up-for-30-years pension contributions was such an easy steal for the government that it's hard to see them not keeping the levy going indefinitely.

I'm with you on this.
I've stopped all contributions to my pension.

Constant moving of goalposts. No clear indication of how your pension is going to be treated over the years.
The Levy. Robbing my pension and I can do absolutely nothing about it.

So now the choice is to look after it myself, or lock it away in a pension. But locking it away only locks it away from myself, not the greedy hands of the government.

Then you have fees which are as clear as mud.

It used to be that I could plan for retirement. You can't plan if the goalposts move part way through that plan.

 

[Greco]

I worked in the pension business in
Germany and agree with you - the focus here is all about tax efficiency and while this is important it takes the focus off where the fund is being invested - I like the idea that the tax saving should be put back in to the fund - I would reccomend a broad spread for future pension planning at the moment ie cash, gold, equities (all privately managed if you have the time) as well as having a pension but have a really close look at what the fund managers are proposing to do with your money and NEVER rush in to a pension fund as most Irish people do in the weeks leading up to the tax deadline

 

[DerKaiser]

In short, a 0.6% levy will not come near eroding the value of the tax relief on contributions. It will make the case for pensions investment less compelling, but should only tip the balance away from pensions where the tax free lump sum is limited and practically all the proceeds of the pension are taxed at the higher rate in retirement.

Update from the budget:

The 0.6% levy is not being continued beyond 2014 and restrictions being brought in on the level of contributions that can be made should actually protect people from investing in a tax inefficient manner.

This gives more certainty to retirement savings than has been the case for years i.e. if you are a middle income earner, you will receive tax relief at the higher marginal rate on the way in to build up a fund for a modest retirement income that will be taxed at a much lower rate on the way out

 

[Bronte]

Update from the budget:

The 0.6% levy is not being continued beyond 2014 and restrictions being brought in on the level of contributions that can be made should actually protect people from investing in a tax inefficient manner.

You cannot rely on that. Next governement or next budget might change that back again.

 

[Bronte]

the When it comes to the pension fund, the min and max holds of each asset class are mandated by law, as is the quality of instruments selected within each class, so you will not find Facebook on the list for instance. There are no fees charged on transactions etc... and the fund must pay a minimum return of the net assets to the contributors each year before the management fee can be applied. The management fee itself is usually less than 0.40% pa.


and in 23 years here, I've yet to hear of one of them going under!

So I would expect that there is a lot of room for reform in Ireland....

That sounds like an excellent transparent system.

I think the problem with pensions in Ireland is that they are too complex, it's nearly impossible for an ordinary person to figure out which will perform well, have no comeback if it performs abysmally (Ember's exact situation) and doesn't perform at all (Waterford Glass). These dreadful situtaions that people find themselves in at retirement when it's too late to do anything don't do the industry any favours.

My take on Irish pensions are they are a system designed to take money off you, not give it back.

 

[LDFerguson]

You cannot rely on that. Next governement or next budget might change that back again.

...and in one line Bronte has summed up the reason why the "temporary" pensions levy was such a monumentally stupid idea - not because of the actual amount of money deducted but because of the level of mistrust it placed in people's minds about how existing savings can be ransacked.