Are DIY pensions really a good idea?

At times of market turmoil or below-par investment fund performance, it might be tempting to look at alternative investments to pension funds as part of your retirement savings, but the only reason why should you consider such alternatives is to have greater flexibility to access cash during your lifetime, according to financial planning experts.

Alternative investments that might form the basis of a “DIY pension” could include your own basket of cash, property, investment funds, shares or bonds.

Eoin Redmond, head of financial planning at Goodbody Stockbrokers, says clients often ask about alternatives to pension funds, but running through a few basic calculations will quickly show them the “massive benefit” from the tax relief on pension contributions and from capital gains tax on pension investment growth, not to mention the tax-free lump sum at retirement.

For instance, if a 49-year-old starts saving €36,000 a year from their wages over a 16-year period into a savings plan, they would have paid in a total of €576,000 in gross contributions, but after tax that savings fund would be reduced to €413,000.

Massive differential

“Whereas if you put the same €36,000 from your earnings before the deduction of tax into a pension, you have got €968,000 to call upon, because there’s been no deduction of income tax and there’s been no deduction of taxation on the growth all the way through the those 16 years,” says Redmond. “So it’s a massive differential.”

Then there’s the tax-free lump sum. “There’s very few exemptions like that, where you get €200,000 out of a vehicle and you don’t have any tax to pay on it. And then the next €300,000 is only taxed at 20 per cent. So you essentially walk away with up to €500,000, and all you pay is €60,000 in tax on that.”

If the same person was saving €18,000 a year over the same period, the gross contributions of €288,000 would fall to €206,500 after tax in a non-pension savings plan, but would be worth €484,000 at retirement.

It’s often assumed that the relief on contributions provides the biggest single tax-saving benefit to pensions, but it’s actually the exemption on investment income. “That has the most powerful compounding factor over the lifetime of the plan,” says Redmond.

Jim Connolly, head of pensions at Standard Life, says there is no savings vehicle that can beat the tax-efficiency of a pension if you are a middle-income earner, but even if you are averse to investment risk, you can still benefit from the tax relief and put your money into deposits or lower risk funds.

“Ideally people save every month so the averaging effect of these regular investments will balance out over time,” he says. “If anything, a market correction after a good long bull run in equities could well provide a good long-term buying opportunity.”

For younger people and those on lower incomes, “20 per cent income tax relief is still very valuable and well worth getting into the habit of monthly saving as it will avoid the pressure of large catch-up saving when they are typically earning more in their 30s, 40s etc,”, says Connolly.

It’s a compelling case for making pension funds your main retirement savings vehicle, but that doesn’t mean that other investments can’t play a role in providing access to cash when you need it.

“We would always promote the idea of your pension income as being a combination of all the sources of income you get in retirement – from your State benefits to income from your savings to income from pension products,” says Connolly.

‘Four pillars’

Redmond talks of the “four pillars” of retirement savings: the social welfare pension, personal savings, private pension provisioning and, for some, continuing to work in retirement.

“If you do solely focus on pension, you are going to tie up money that’s not accessible to you.”

These four pillars can certainly help ensure a broader base of retirement income while the Government tries to find that space between the rock and the hard place of possibly allowing people more access to their pension funds before retirement but without undermining the wider base of pension provision.

Redmond points to how in the US people can access their pension for specific life events, such as third-level education for their children, weddings, etc, but adds that while something similar here might encourage more folks to save into a pension, “you have to counterbalance it against the prospect that people may just try to access it too frequently”.

One strong trend that is emerging in the pensions sector, thanks to persistently low interest rates, is the fast declining popularity of annuities.

“Many people do not want to lock themselves into a fixed income for life that they believe is at a 70-year low,” says Connolly. “For example, a typical level annuity rate for a 65 year-old might be around 4.5 per cent. If you have to pay income tax on this the return is closer to 3 per cent. Some investors, he says, will choose to try and get an indexed rather than a level annuity to help buffer them against inflation.

Annuities

“In addition, annuities have declined in popularity vis a vis DIY pensions such as Approved Retirement funds because annuities die with their owner. If you own an ARF and die, the fund value goes to your estate which is a key factor for many investors with children.”

Brendan McGinn, Goodbody’s director of pensions, says there has been little product development in Irish annuities for years.

“The latest trend is underwritten annuities, in other words if you’re in bad health at the point of retirement you may be able to get a much better annuity rate because potentially you are not going to live as long as somebody who is well.

“That’s really the only development we’ve had in this market.

“But on the other hand, it does have one advantage that isn’t available in any other product, and that is, it will pay you an income for as long as you live, irrespective of how long that is. So there’s nothing else that has that longevity insurance in it.”