Time to make your pension less taxing

With the year-end approaching, now is the time to take action if you want to maximise your tax relief on pension contributions

CHASTENED BY the poor performance of Irish pension funds over the past two years, rising unemployment and a fall in incomes, it would not be surprising to find droves of investors foregoing their pension contributions this year.

However, a look at Irish Lifes pension book shows that pension contributions are holding steady, with a majority of people still committed to allocating funding for their retirement.

With the year-end approaching, this commitment needs to turn to action if you wish to maximise your tax relief. So, if you are in an occupational pension scheme, you need to consider making additional voluntary contributions (AVCs), while if you are self-employed, now is the time to put money into your pension to bring down your tax bill for last year before you file your return for 2008 before the end of this month. But is there anything you should be aware of before you write that cheque?

Are pension contributions in decline?

Despite the recession and the hit people’s incomes have taken, the majority of pension holders are reluctant to cut back on pension contributions. According to Irish Life, four out of every five people say they’ll stick with their pension contributions.

However, this means that a fifth of people are either suspending or reducing contributions, which is feeding into the 25 per cent decrease in values the Irish pensions industry has seen this year.

For people just starting a pension, the level of first-year contributions has slid just a little. According to Irish Life’s study, the average contribution over the past year was €8,025, 10 per cent less than last year. However, as a proportion of people’s incomes, contributions have remained steady, at about 15 per cent.

The analysis of Irish Life’s pensions book also shows some significant regional variations in the amount first-time savers are putting into their pensions.

For example, the biggest contributors to pensions were people in Mayo, who made an average premium of €12,802, while Dubliners, who accounted for a third of Irish Life’s first-time pension contributors, paid €10,659. The worst savers, were Irish Life customers in Offaly, Monaghan and Cavan, where the average premiums were less than €6,000. One notable aspect of the recession is that there are now more lump-sum payments to pensions, rather than regular monthly contributions, as investors hold onto their cash for longer.

Do more men have pensions than women?

Women are slowly but surely catching up with their male counterparts in terms of pension coverage. Ten years ago, just two out of every 10 women had a pension, but now women make up almost four in every 10 pensions started, according to Irish Life’s statistics. Moreover, the survey shows that women start saving at a younger age, 35, compared to men who wait until they’re 39 on average, before making the leap.

When you consider that women, who receive lower annuity rates than men, will need a pension fund about 15 per cent larger at retirement to give them the same benefits as men, this is just as well.

However, the average salary for women starting a pension is €40,500, compared to the average men’s salary of €65,000. While this may be explained by the difference in starting ages, it is also likely because more women are working part-time, or have gaps in service, due to raising a family. This means that they are very unlikely to have the necessary funds built up by the age of 65 to ensure an equitable retirement.

Are pension holders getting more cautious?

While there has been a swing away from equities, it hasn’t been as significant as one might have expected. “People aren’t shying away from equities,” says Karl Symes, marketing manager with Irish Life, although he notes that Irish pension funds’ allocation to Irish equities, will be “much lower going forward”.

The Pensions Ombudsman, Paul Kenny, urges pension investors “not to panic”, and says that, just because the recent experience hasn’t been good, doesn’t mean that things won’t turn around again. With markets already on the rebound, he says pension holders should continue to invest in equities when they’re young. “The bottom of a market is the time to buy, not to sell,” he cautions.

To meet the demand for more cautious pension investments, particularly among older investors, managers are launching new products into the Irish market. Standard Life for example, has an absolute return fund, which aims to deliver a positive return regardless of individual market conditions, while Irish Life’s new low risk Safe Deposit Fund invests in a mix of cash deposits.

Standard Life’s Global Absolute Return Strategies Fund (GARS) promises a return of cash plus 5 per cent, and the Safe Deposit Fund offers an interest rate of ECB plus 1.75 per cent.

What should investors have learnt from the downturn?

While Irish managed pension funds are slowly inching their way upwards again, with the average five-year per annum return having finally turned positive, lessons still need to be learnt from the past two years.

Given that Irish pensions were one of the worst performing in the world, largely due to their holdings in Irish equities, pension holders need to be aware of the risks of such concentration.

As Kenny says, you should be looking to diversify. “Don’t put all your eggs in the one basket,” he says.

Also, if you’re not willing to take responsibility for rebalancing your portfolio as you get older, ensure that your pension fund manager is. One of the biggest pension issues of the past few years has been people who hit retirement age at the time of the bust, but hadn’t sold out of equities a number of years previously.

As a result, the value of their retirement funds had crashed.

Generally, it is recommended that you rebalance or “smooth out” your portfolio, some five to 10 years ahead of retirement.

Is tax relief granted automatically on pensions?

Given that it’s difficult to think of pensions, without also thinking of tax relief, it is surprising to find that so many people still don’t avail of the relief they’re entitled to when making pension contributions.

Last month, a survey by Irish Life among more than 1,000 adults, found that one out of every three standard rate taxpayers was not claiming their tax relief, while one out of 10 higher rate taxpayers was missing out.

While investors may be receiving some tax relief, they may not be claiming tax relief on the full amount they are investing in their pensions.

“Many people do claim their tax relief when they first take out a pension, but then don’t claim for higher amounts they invest in subsequent years as their salaries increase,” says Symes.

To rectify the situation, you will need to take action. If you’re a PAYE employee, you will need to check that your payroll division is making the appropriate deductions.

For the self-employed, who are currently completing their tax returns, indicating how much you have invested in your pension this year, or making that allocation before the deadline, is essential

Can I still buy property with my pension?

Given the collapse in property values and the risks of being over-invested in one asset, pension holders have started to consider buying property through their pension option much more carefully.

Nevertheless, Tommy Nielson, a director of Independent Trustee Company, says that he is seeing demand from a “a significant number” of people, who are looking to take advantage of low prices and forced sellers.

The major advantage of purchasing a property through your pension is that you will pay no tax on either the initial outlay, rental income or capital gains tax. You can use funds in your Self-Administered Pension Schemes (SAPS) to purchase the property, and then top this up with bank borrowing.

“In the current market, where cash is scarce, many SAPS have more bankable assets than some of their owners,” Nielson says.

For people who would otherwise struggle to get the finance to purchase property in this environment, Nielson notes that banks are looking more favourably on lending for such investments as the loan to value ratio tends to be low.

Are there any regulatory changes this year?

The Government cut the annual earnings limit for pension tax relief purposes from €275,239 to €150,000 in last year’s Budget, so if you are self-employed or a company director and about to file a tax return, this is the last year you can get relief on the higher amount.

Looking ahead to this year’s Budget, it is expected that some of the Commission on Taxation’s recommendations will be introduced. These include capping the amount an individual can take as a tax free lump sum at retirement at €200,000, with the balance subject to tax at the standard rate of income tax.

Yann Harrison, a qualified financial adviser with Russell Brennan Keane, says his firm has fielded numerous calls from worried pension holders on the issue. It is of concern primarily for higher earners, given that you would need to have a pension fund of more than €800,000, or a final salary of over €133,000, for the proposal to affect you.

If this is the case, Harrison says people who are eligible to draw down their pension, are considering taking their benefits now, in case the proposal is introduced next year. However, with pension values still way off their peaks this option needs to be considered carefully.

“You need to ask ‘how long am I prepared to wait for my fund to rebound?’,” Harrison says, as cashing in now, when investment values are still low, could cancel out the tax benefit of drawing down your pension earlier than you may have planned.

In addition, it is seen as likely that the use of an Approved Retirement Fund will be extended to members of defined contribution occupational pension schemes, so if you’re approaching retirement you should watch the progress of these two measures.

How can I get a better return?

While you can’t control how the markets perform, you can control who you decide to give your money to and how much they charge to manage it if you’re not part of an occupational scheme. Given the impact management fees can have on the performance of your pension – a study by Aidan Mahon of Waterford Institute of Technology last year showed that high fees can wipe out the benefit of tax relief – it’s so important to pay careful attention to the various charges imposed by pension fund managers.

If you have an existing pension fund and are about to make an allocation ahead of filing your tax return, take the time this year to work out exactly how much you are being charged. Remember to ask about all charges, not just the annual management fee, as some managers also charge policy fees, allocation rates, and entry charges, which can reduce your returns.

If you don’t qualify for an occupational pension, and are about to start your own fund, have a look at the range of options on offer before committing. Standard PRSAs can’t charge more than 5 per cent of each contribution and a 1 per cent management charge. While many providers stick to these fees, there are cheaper alternatives.

For example, Rabodirect has just launched a PRSA in conjunction with Zurich Life, with a 1 per cent annual management fee, but lower contribution charges. For contributions of up to €499 a month, the charge is 2 per cent, decreasing to 0.5 per cent for payments of more than €1,000. For once-off contributions of less than €15,000, a charge of 2 per cent is also imposed, falling to 0.5 per cent for payments of at least €30,000.

Alternatively, LA Brokers offers low cost execution-only PRSAs from a range of providers, including Hibernian and Irish Life. The only charge is the 1 per cent annual management fee, as there is no fee on contributions.

Other alternatives include non-standard PRSAs, which can be more expensive, and personal pensions, also known as Retirement Annuity Contracts. Quinn Life’s personal pension offers access to its suite of funds for an annual management charge of between 1-1.5 per cent, while Canada Life’s personal pension platform includes funds with annual charges of as low as 0.675 per cent a year. However, it also imposes other charges such as an allocation rate and a policy fee.

Are there any other ways of reducing pension costs?

While it isn’t directly related to your pension, if you are eligible to hold a pension then you are also eligible to buy pension life cover, also known as pension term assurance. The major advantage of this product over mainstream life products is that it costs you less, because just the same as you can claim tax relief on your pension contributions, you can also claim relief on your premiums.

Given that only 5 per cent of people currently have pension life cover, it means that many people are missing out on the tax benefits. For example, a monthly premium of €100 would only cost €59 for a higher rate tax payer.

Symes says it’s the equivalent of a “death in service” benefit, for those who are self-employed or not members of a company scheme. However, you should note that these policies can’t be assigned to a mortgage, so if you need mortgage protection as well as life cover, such a product mightn’t be suitable. Moreover, as the tax relief element is pension related, if you’re already contributing up to the maximum allowed, then you won’t be able to get additional relief for the life policy.

Retirement options: choosing an approved fund or annuity

LAST MONTH’S Commission on Taxation report recommended that an approved retirement fund should be extended to members of defined contribution occupational pension schemes. This would mean that, instead of having to purchase an annuity within two years of retirement, defined contribution members could instead invest in an approved retirement fund.

Why would this benefit defined contribution members and should you consider an approved retirement fund over an annuity? According to Shane Gill of Key Capital, an “annuity removes uncertainty and guarantees a defined level of income until death but at the cost of the loss of capital”.

An approved retirement fund, on the other hand, also offers the possibility to preserve wealth, he says, while still achieving a reasonable level of income. Take, for example, a 60-year old self- employed man, who, on retirement, buys an annuity with €1 million in his personal pension fund. Given that the current annuity rate is about 6.5 per cent, he will receive a gross annual pension of 65,000 paid monthly, for life, subject to the deduction of income tax.

If he lives for another 20.7 years, as is the current Irish life expectancy, then the life company will end up paying out an estimated €1.3 million, ignoring any investment income earned. If, however, he dies in the early years, this will result in a significant profit for the life assurance company, and a loss for the man’s family, unless he had purchased a guaranteed spouse pension.

Even if he had made provision for a spouse, if his wife was to die subsequently, this would mean that the family’s wealth would not be passed on to the next generation.

On the other hand, if he had invested in a tax- efficient approved retirement fund provided by a qualifying fund manager and had prudently invested the €1million to deliver an average annual return of 6.5 per cent during his lifetime, this would provide a cash flow that approximates to the annuity – while also protecting the €1 million capital.

“In this win/win scenario, the income is drawn down every year, while at the same time preserving the capital which is then available to the next generation upon death,” says Gill.

Another advantage of an approved retirement fund is that you can transfer your existing pension portfolio to it, rather than having to cash it in to purchase an annuity. Given the dramatic decline in stock markets over the past two years, this means that a pension holder could defer their investment decisions until markets improved, rather than being obliged to do so within two years.

Approved retirement funds must be used with due caution however, as, on the downside, unlike an annuity which offers certainty, such a fund brings with it a risk of poor returns.

“A combination of poor investment decisions, coupled with large capital drawdowns, would result in the fund being exhausted long before death, leaving the pensioner reliant on the State, notes Gill.

So, while the widening in the availability of an approved retirement fund would be welcome, some pensioners may still prefer the certainty offered by an annuity.

FIONA REDDAN