The risks of an over-funded pension

If you’re used to hearing that we all need to do more to fund our retirement, it might come as a surprise to find that an under-funded pension isn’t the only thing to worry about – an over-funded one brings concerns too.

Not as serious, obviously, but if you want to get the best bang for your pension buck, it’s important to be aware of the Standard Fund Threshold. It currently stands at €2 million. Breach it and there are tax consequences.

It's something some may have overlooked. "Historically, there was no cap, then it was €5 million, then with indexation it became €5.5 million, then it was cut to €2.3 million, and it currently stands at €2 million with no indexation," explains Andrew Fahy of Investec.

If, for example, your fund accumulates €3 million, you’ll be hit with a chargeable excess tax (CET) penalty of 40 per cent .

Knowing this might inform your investment strategy as, once you pass the €2 million mark, what’s the point of taking the risk if you are 100 per cent on the hook for the downside but you only have limited participation in the upside, he asks.

Some people in those circumstances might switch to cash, while for others the best option is to take their retirement benefit and move to an approved retirement fund (ARF), which is free to grow to any level without CET.

If you’re a couple, you will have two lots of €2 million, because both spouses have that threshold, “so if there is an ability to do it you might not focus entirely on one spouse”, suggests Fahy.

Non-pension investment

There are very many non-pension investment vehicles which should do better for you than cash. "The only difference is that you won't get all the tax benefits you get from pension contribution," points out Bernard Walsh of Bank of Ireland.

Though past performance is no indicator of what’s in store, a managed fund will typically have shown a growth rate of more than 50 per cent in the past five years. Investment returns like that could easily have tipped your accumulated fund over the threshold.

The value of your pension pot is estimated on the day you retire, and any portion over the threshold taxed at the higher rate. “The most common way of controlling it is to limit the contributions you make to the fund as you approach it,” says Trevor Booth of Mercer.

The reason the cap was put on – and without much fuss – was because it was seen as a tax on higher earners. “It still only affects the lucky few, so the message is still to put as much as possible into your pension,” he says.

If you look likely to exceed the cap, you could start putting your excess contributions into a non-pension retirement savings plan, an insurance-wrapped savings plan which is subject to 41 per cent tax on investment growth. You could buy an investment property or invest in shares.

Gift it

Alternatively, a very tax-efficient way to manage excess cash – even if the only benefit you’ll get from it in retirement is the hope that they’ll pick a nice nursing home for you – is to gift it to your kids.

“You can give €3,000 per annum, per child, per parent – so that’s €6,000 a year with no tax implications and which doesn’t impact on inheritance thresholds,” says Niamh Prendergast of Davy.

Incidentally, nursing home fees are themselves eligible for income tax at the higher relief. There are also EII [Employment and Investment Incentive] schemes, the successor to BES [Business Expansion Scheme], she says, all of which might be worth a look for someone with cash to invest.

But nothing beats pension contributions for tax efficiency. “Where else will you get tax relief, potentially for 40 years, as well as tax-free growth? There’s no other option that offers as much in terms of tax,” says Prendergast. All the more reason to do your level best to hit that threshold.