Does your pension fund need some ‘rocket fuel’?

Known in the pensions industry as "rocket fuel" for your pension fund, additional voluntary contributions (AVCs) allow you to beef up your retirement fund by maximising the tax relief you're entitled to on your contributions.

But, while the logic behind them might make sense, many of us either can't afford to make them, or simply don't know enough about them to do so, which means that take-up rates can be low. Figures from Standard Life for example, suggest that a little more than a quarter of people invest in AVCs. This is up from about one in five back in 2007, but, given overall pension adequacy levels, may still be too low.

Most of us don't start to avail of them until we're in our 50s and retirement is edging ever closer. "But every year you're not doing them [AVCs], you're missing out on those tax benefits, and they are very generous," says Richard Jones, head of corporate life and pensions with Aviva Ireland.

So what do you need to know to help you make a decision?

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What are AVCs?

As the name suggests, additional voluntary contributions (AVCs) are additional contributions you make to the occupational pension scheme you have with your employer to build up an additional retirement fund. So, for example, a typical employer scheme works by the employer offering the employee either a fixed percentage of their salary as a pension contribution, or agrees to match the employee contribution up to a certain level.

If these contribution figures were enough to fund an adequate retirement, there wouldn’t be any need for AVCs; however, pension experts typically suggest you need to be putting away 15-20 per cent (between yourself and your employer) of your income to retire on half your salary. And many of us aren’t reaching these levels.

How much can you AVC?

The limits on pension tax relief are broken down in specific bands which are based on your age. So, for example, if you’re aged 33, you can get tax relief on anything up to 20 per cent of your income that is put into a pension fund.

On a practical level, this means that if you’re earning €50,000, and currently contribute 5 per cent (€2,500) a year into your pension fund, and your employer matches this (bringing the total contribution up to €5,000 or 10 per cent), you’re still only using a quarter of your available pension relief because, as Jones points out, the employers’ contribution does not count towards individuals’ age-related contribution limits.

That means most people have a wealth of tax relief they may not be capitalising on.

If you choose to, in the case above, you could put another €7,500 (or 15 per cent of your gross income) into your pension fund each year until you’re aged 39 and get full tax relief on this. The threshold goes up at 40, and again at 50.

So, if you were aged 51, you’d be entitled to allocate 30 per cent of your income to your pension fund and enjoy tax relief on this.

Remember also, that these AVC contributions grow free of tax until retirement and, as we’ll see below, you may even be able to access them free of tax in retirement.

According to Jones, one of the key things inhibiting people from investing in AVCs is that people don’t understand pensions that well.

That to my mind is money for jam; there's no reason why anyone should turn that down

Another factor is that some people think they can’t afford it – but remember, getting tax relief on your contributions makes them significantly cheaper to you.

For example, if you’re our aforementioned 33-year-old earning €50,000, your existing 5 per cent contribution (€2,500) is only costing you €1,500 as you pay tax at the higher rate (it would cost you €2,000 if you were only entitled to standard rate tax relief).

So, if you wanted to bump this up by an extra 10 per cent of your gross salary, or €5,000, this would only cost you €3,000 once tax relief is deducted. That’s €250 extra a month.

Of course, for many 33-year-olds, even making the basic contributions can be financially challenging, never mind topping this up.

Should I AVC?

The first point to consider, when thinking about AVCs, is to determine whether or not you’re maxing out your pension contributions already. For example, if your employer will give you up to 10 per cent of your salary on the basis that you are contributing 8 per cent, but, in fact, you’re only contributing 6 per cent, clearly the first step is to ratchet up these contributions.

“That to my mind is money for jam; there’s no reason why anyone should turn that down,” says Sinéad McEvoy, a pensions technical manager with Standard Life.

If you have already maxed this out, and you have some spare cash on a monthly basis, it could be time to start making AVCs.

McEvoy started making AVCs herself at the age of 29, and points out that the power of compound interest can help your money – even small amounts – to grow substantially over the long period to retirement.

Those AVCs will make a difference between a bad and a good retirement

She offers the “payrise trick” to help people get started; it means that every time you get a pay rise, you put a quarter into your pension as an AVC. “After all you never had it in the first place,” she says.

However, she says typically, people don’t get moving until their 50s.

“You’re looking at people at age 50 and onwards. They’re asking themselves ‘what do I need to live on when I retire’ and realising their existing fund is inadequate”.

Jones agrees. “For a lot of people, when they start engaging that’s when they start making AVCs. But unfortunately, they may have been working for 25 years or maybe more at that stage, and so will have missed out on a lot of years of potential tax relief contributions and tax-free growth,” he says.

For some people, paying down their mortgage might be a priority with any spare cash they may have, but McEvoy argues that making AVCs can be financially more prudent given the level of tax relief you receive on them.

“It’s important to pay down a mortgage, but you’re getting tax relief with a pension,” she advises, adding, “Those AVCs will make a difference between a bad and a good retirement”.

The downside of investing in AVCs is that you’re locking even more of your money away for retirement, of course.

“I think that’s what puts people off,” says McEvoy, noting that people can no longer access their AVCs early, and they may fear needing that money in the future for an emergency.

Where do I invest my AVCs?

This will likely depend on the terms of your scheme. If you’re a public servant for example, you’ll generally be restricted to investing in a particular scheme.

If you’re in a defined contribution scheme, however, you will often have two options; set up a separate PRSA AVC or keep investing in the group scheme.

There are pros and cons to either approach. According to McEvoy, many people like the former, because it can offer a broader choice of investment options, while it also keeps what you’re doing with your AVCs away from the eyes of your employer.

“Some employees want to take out a PRSA separately because they don’t want employers to see how much they’re contributing,” she says.

The second option, however, will likely be cheaper and charges can have a significant impact on your investment outcome. Many group schemes will have annual management charges of less than 0.5 per cent; but a PRSA can take up to 5 per cent on each contribution, and up to 1 per cent in annual charges. That’s a big difference and the investment performance of your personal PRSA would have to be significantly better than the workplace option to consider it.

“By their nature group schemes are always cheaper,” McEvoy adds.

What happens at retirement?

AVCs have two main advantages; they help you grow your overall pension fund, and they can help ensure that you get the maximum tax-free lump sum at retirement.

According to McEvoy, defined benefit members may not be entitled to the maximum 1.5 times final salary tax-free lump sum at retirement if they don’t have the requisite 40 years service.

If you only have 20 years service for example, you might be entitled to just €60,000 based on a €50,000 final salary. If you have built up AVCs however, you can use these to top up your lump sum to the full 1.5 times salary, or €75,000 in the aforementioned example.

“AVCs can be used to offset that shortfall,” says McEvoy.

If you’re a member of a defined contribution scheme, AVCs can also help boost your tax-free lump-sum. Typically, with a defined contribution fund you’ll be entitled to take up to 25 per cent of the value of the fund tax free, with the residue going into an Approved Retirement Fund/Approved Minimum Retirement Fund or to buy an annuity guaranteeing a set annual income. AVCs will be treated in the same way, which means that you’ll also be able to take 25 per cent of your AVC fund tax free also, with the same residue going into an ARF/AMRF also.

Now, a tax-free limit of €200,000 on lump sums does apply but, as McEvoy notes, given that the average Irish ARF is just €100,000, that upper limit will only impact a small percentage of people.

PENSION TAX RELIEF:

Age          Tax relief you're entitled to (as a percentage of earnings)

<30          15

30-39      20

40-49     25

50-54     30

55-59     35

>60       40

Source: Pensions Authority