Here’s an interesting proposition. Imagine if someone said to you that for an investment of €25,200 they could give you €215,400 back. Yes, that’s a more than nine-fold return on the initial investment. That sounds too good to be true, and in most cases it would be. But not when it comes to pensions.
That €215,400 figure is the amount Bank of Ireland calculates an individual would accumulate if they contribute €200 a month over 35 years to their pension fund. That assumes standard PRSA fees and an average annual investment return of 6 per cent.
But that €200 contribution will only cost €60 a month after tax relief if your employer puts in a matching contribution of €100 per month. The employer’s contribution, the State contribution in the form of tax relief on money on the way in and growth in the fund, and the compound growth of the fund combine to deliver this extraordinary rate of return.
“Benjamin Franklin said those who don’t understand compound interest are destined to pay it while those that do are destined to benefit from it,” says Bank of Ireland head of pensions and investments Bernard Walsh. “I describe the employer and State contributions as free money. In a lot of schemes, the employer will match contributions up to a certain level. People should put in as much as they can to maximise that and benefit from the tax-free compound rate of return.”
And while past performance is no indication of future returns, Walsh points out just how well people have done over the past decade. “The typical managed fund delivered a return of 130 to 140 per cent over the past 10 years,” he says. “Even if you take someone very unfortunate who invested a lump sum just before the crash in 2008, they would still be 50 per cent up now. The other thing people tend to forget is that they are buying in every month and you average out the cost of entry. If the fund has produced a negative return at the end of a year, that is not a big problem because you have been buying in at the lower prices in the months running up that and are still buying in at the lower price.”
“Making a contribution to a pension scheme is always a good idea,”says Davy financial planning specialist Paula Finlay. “With the State retirement age being pushed out to 68 and the pension worth only €13,000 a year, most people won’t be able to rely on it to replace their income when they retire. Also, there will be a lot less people in the workforce in 20 to 30 years’ time. There will be a ratio of 1:2.3 between retired people and those at work by 2045. It is 1:5 at the moment. That means there will probably be a move to means test the State pension at some stage.”
‘Power of compounding’
The earlier you start contributing the better, she adds. “That maximises the power of compounding,” she points out. “If you are changing job, join the scheme immediately so you don’t miss out on growth and employer contributions. If your employer wants to match your contributions and give you free money, take it.”
She advises people to maximise their contributions regardless of the employer role. “Your tax relief on your own contributions is limited but it increases with age and you can make contributions as high as 40 per cent of salary as you get closer to retirement. Everyone is entitled to make additional voluntary contributions. You can use these to boost your fund and increase the amount available through the tax-free lump sum.”
That is another aspect of pensions of which people are often unaware. Everyone is entitled to take up to 25 per cent of their fund value, subject to a limit of €200,000, as a tax-free lump sum on retirement. That means the individual with a €215,000 fund can take almost €60,000 tax-free straightaway to pay off debts and maybe even take that world cruise they’ve been promising themselves.
"You can't get that type of tax-free return anywhere else," says Rob Meaney, head of responsible investments with Mercer Ireland. "Scheme members near retirement who have the ability and knowledge to do it can put in additional contributions both to increase their pension and maximise their tax-free lump sum. Every €100 they put only costs €60 if they are paying tax at the top rate."
Finlay also advises people to continue to avail of the tax-free growth as long as they can. “If you can delay your retirement there is no need to invest in an approved retirement fund straight away at 65,” she explains. “You can delay that right up until you are 70 so that you can benefit from tax-free growth up until then.”
AIB head of retirement planning Tony Doyle says it is critically important to retain that level of tax relief to provide an incentive for people to invest in pensions. "The debate on tax relief should be put to bed. The sort of people we have coming in to see us are in the middle of their careers. They might be entrepreneurs with a few businesses that didn't work behind them and now have 10 to 15 years to make a pension work for them. Also, a lot of professionals don't reach high earnings until later on in their careers. It is very important to have a system that incentivises them to try to catch up."
