So what exactly is a pension and how does it work, and more importantly do you need one?
So a pension comes in two forms – the before retirement (savings part) and after retirement (spending part).
Before retirement is basically just a glorified current account that you pay money into each month for the long term. You generally can’t touch this account until you hit 60. The good news in that each time you put money into this account the taxman gives you back either 20% or 40% (depending on the rate you pay income tax).
You also have the OPTION to invest this money. This is the part people don’t like or feel comfortable with. But remember you don’t have to invest, you can just take your tax relief and leave your saving in a cash account – in my opinion, this isn’t the best financial decision as returns from stocks, shares and property will outperform cash returns over the long term.
Investments come in different forms - for example, you can use your money to invest in stocks and shares, property funds, commodities and bonds… If you are worried about the “risk” of investing there is no need; there is a risk bar from one to seven in which a good financial advisor will take you through, one is low risk and seven…well, that’s the highest risk! I’ve only ever come across two clients that are a seven! The point is there is a risk class for everyone, even low-risk folk.
The good news on the investment side is that any growth you make in the pension is tax-free. So, your fund grows tax free until you get to retirement. Let just recap on this as it’s the most important factor in a pension – you get 20% or 40% tax back on each contribution you make and tax-free growth…the only catch is you have to leave the money there until 60 years of age!
After you get to retirement age a pension is also the income you get from the account you’ve saved in. This comes in the form of a tax-free lump sum and then you take the remainder as you need it. Obviously the more you have in the fund at retirement age the more you take out as income. There is always the worry that your pension will run out… so be careful with how much you spend in the early years! Any income from your pension is taxable! At normal rates.
The state pension is only €243.30 per week which equates to €12,651.60 per year. If you are earning anything over €25k per annum you are looking at a 50% + drop in income if you don’t have anything in place to add on top of the state pension.
The other problem with the state pension is that it’s now pushed out to 68 years of age before you get it. And I believe that if you are under 45 years of age it will be 70 -72 before you get it.
So when it comes to pension plan the Central Bank and Life Companies have made this extremely difficult for people. Which is why the coverage in Ireland is so bad I feel. There are a number of different pension plans to choose from….Personal Retirement Saving Account (PRSA), Personal Pension Plan (PPP), Executive Pensions (Company pensions), Personal Retirement Bonds (PRB), Approved Retirement Accounts (ARF), Approved Minimum Retirement Accounts (AMRFs) and lastly Annuity. No wonder people are confused eh.
Purely for the purpose of keeping your attention as we get into page two of this blog I’m going to make it easy to understand these, I hope:
PRSA – Perfect if you are self-employed or in a job as a PAYE worker without a pension scheme in work. If you are the latter your employer is obliged to let you contribute to your PRSA via payroll deduction – this means you get the tax relief straight away as a source, which is great. If you don’t want this option you can pay your PRSA via your personal bank account and claim the tax back via tax credits or at the year-end. If you leave your employment you simply move your PRSA from one employer to the next… a very simple and straight forward account.
Personal Pension Plan – very similar to the above however you cannot run them through your employer's payroll, it can only be used with your own bank account. This is the most common type of pension for self-employed people. If you are self-employed and make a pension contribution you can use this to reduce your tax bill each October, so a no brainer really!
Company pension – does exactly what it says on the tin. This is a pension that would only be used if you work for someone or if you work for yourself in an incorporated company (LTD). The condition here is that your employer has to be prepared to pay into it for you which isn’t always the case.
Personal Retirement Bond – This is an account that is used to transfer a pension from a company pension to your own name after you leave a company. It’s a very popular option for people at the moment as it allows you to access your tax-free lump sum from your pension at 50 years of age, which can be extremely beneficial to people. It is also the pension contract that is used to move a pension from the UK back to Ireland.
Approved Retirement Fund – when you retire (usually after 60 years of age) you take a percentage of your fund tax-free and then have two options with the remainder - ARF or Annuity (discussed below). An ARF is again basically just an account that keeps your money, hopefully, a lot of money . Revenue have a rule that you must take out at least 4% of your fund each year from 60-70 and 5% from 70+. People still have the option to invest their ARF which is a good idea especially if you are taking out 4% of it each year. Withdrawals from your ARF are subject to income tax and levies. You can take amounts more than 4% or 5% making the ARF very flexible for people, especially should something go wrong and you need access to fund. It’s very important to note that your ARF can go to zero! Obviously, the management of the ARF is extremely important.
Approved Minimum Retirement Fund – It's only at a time like this (writing a blog on pensions) that I realise how ridiculously complicated pensions must be to the general public). Anyway… An AMRF is a kicker to those that don’t have a decent sized pot when they get to retirement. When you take your tax-free cash from your pension at retirement I mentioned above that you have two options – ARF or Annuity. In order to take the ARF option revenue state that you must have either a guaranteed income of €12,700 per year or an AMRF with €63,500 set aside. The problem here is that the €63,500 in your AMRF cannot be accessed until age 75, you can, however, take a maximum of 4% per annum but only once. Not a problem for someone with a big fund as they would hope to have €63,500 left at 75 in their ARF anyway so no biggie for it being in an AMRF, however, if you only have, say, €100,000 at retirement age it becomes a problem as the majority of your fund is locked away until age 75 ☹.
Annuity - So the marketing department told me to keep this blog to 2 pages… that’s that one out the window.
An annuity is basically the holy grail of pensions in that it offers a GUARANTEED income for LIFE! When you get to retirement you take your tax-free cash and give the remainder of the fund (or part of it) to a Life Assurance company and they basically give you a promise to pay you €x per month for the rest of your life. The rate or amount of income you get depends on your age, health, and amount of money you have in the pot. You can also add on features to an annuity-like spouse pension (your other half will get % of your pension if you die until they die) and indexation – so your pension increases with inflation each year. The more you add on the lower the rate you will get. It’s important to note that if you die (without having a spouse’s pension added on) the life company keeps the money – nothing goes to your estate, which is a big deterrent for people.
The other problem with an annuity is that annuity rates are linked to interest rates, and interest rates are the moment are extremely low.
Ok, if you’ve made it this far in the blog you will know a few things by now – the main thing is that the more you have in the fund at retirement age the better. So like all saving the earlier you start the better. However most people are straddled with high rent/mortgage, creche fee’s to name a few so setting aside a few quid for an event 25-35 years away doesn’t seem practical. The thing to remember is that if you are under 48 you have 20 years to sort your pension problem. No need to rush. Kids, family and the now are very important, but if you have a spare few quid at the end of the month a pension is a great option to take the pressure off in a decade or so. And remember, there is no other saving account that offers tax relief that high on the way in with tax-free growth so it's your chance to get one up on the tax-man!
Take control of your finances, make your money work smarter, harder and go further. Put the right steps in place to meet your financial objectives no matter what stage of your life you are in.