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I don't believe in Pensions


I don't believe in pensions 

 

I've heard this statement or something similar from many people over the years and very often it is because of an experience that they have witnessed of a friend or relative who "lost their savings in a pension."

In Ireland, we can point to examples of fraud like Custom House Capital or poor investment decisions like owning Irish bank shares in 2008 to explain how this view might come about. But these are not the fault of the pension tax wrapper itself.

So, in this post I will set out the reasons why we should continue to believe in pensions and I’m going to start this story with my own experience from when I worked as an adviser in the UK and the advent of Stakeholder Pensions in 2001.

Stakeholders were introduced to expand the take up of pension provision in the UK by introducing a highly-regulated contract with fixed pricing rules. People weren't saving for their retirement because pensions were too expensive concluded the regulator.

If you think this sounds like an Irish Personal Retirement Savings Account (PRSA), you'd be right and the two structures share many similar characteristics especially around the pricing rules.

However, and more interestingly, the contribution rules were simplified so that anyone could claim tax relief at source on pension contributions up to an amount of £3,600pa so in effect a payment at the time of £2,808 would immediately grow to £3,600 due to the pension company claiming the tax relief at source. That’s a guaranteed increase of 28%.

You didn't need to provide proof of earnings or even have paid any tax to qualify. The idea being that, for example, women taking a career break to have a family have gaps in the pension history and this was a way to allow some contributions to continue to be made.

Naturally, if you have taken a career break to start a family, unless the household has a very high income the chances are one of the first outgoings to be hit when going from a two-income household is probably going to be pension contributions.

So, this was a well-intentioned idea that was probably only ever going to benefit the better off. If you think about it, this should be obvious for any structure which gives tax relief at the marginal rate of tax. Those who pay more tax, receive more benefit. 


What I did in the UK

 

This was one of the simplest yet most effective strategies I ever conceived and it worked like this.

Everyone in the UK could claim tax relief on pension contributions irrespective of earned income on contributions of just under £3000pa.[1] 

So, I asked myself the question rather counter-intuitively; who doesn't pay the most tax? In other words, which are the largest groups of non-taxpayers? The answers I came up with were children and the wives of my existing retired clients.

Children don't pay tax (typically) because they don't work. They also have another common characteristic which is that they are young.

If we remember from our basic financial planning principles do it now, the best time to do something is now. There is even a concept in retirement planning called the “cost of delay” 

The rule change meant that everyone under the age of 75 could claim tax relief on pension contributions. The parent or guardian could sign the pension application form on behalf of the minor and literally a new born child could start a pension and have an investment that would run for potentially 65 years.

Remember our second principle of financial planning which is that it works best for people with money and if you don't have any, find someone who does.

Obviously, the children themselves weren't going to save their pocket money in a pension that would be ridiculous.

Equally, unless the parents had very good incomes, my guess was that for most people this wasn't the best place to start looking for contributions.

Then I remembered that the annual exemption for inheritance tax gifts is £3000 and the perfect estate plan was born.

By making an annual gift of £3000 a grandparent would immediately save inheritance tax on their estate of £1,200 (40% of £3000)

If most of that payment was made into a pension for the grandchild[2] it would increase by 28% (£792 tax relief) giving total tax relief of £1,972 on a £3000 gift or an immediate return of 65.7% guaranteed.[3]

Given that the money is now probably lying in an account earning around 0.5%pa it would take about 102 years to earn that much.

The money in the pension would grow free from personal tax (no income tax or capital gains tax) until retirement potentially 65 years in the future. 

Arguably, there is a school of thought that says, this is all well and good, but don’t they need the money now? Well, that’s my point. If a third party doesn't make this provision, then it's highly unlikely that any individual will be in the fortunate enough position of being able to afford to do so themselves. Besides, as we shall see there is also a more immediate payment benefit available to the grandchild which makes this planning even more clever.

 

The cost of delay 


The impact of making relatively modest contributions so early in life cannot be understated.

If I save €3000pa growing net of costs at 5% p.a. for the first 20 years of my life, by age 20 I have a pension fund valued at €99,197. If I then make no further payments for the rest of my life my retirement fund at age 60 is €698,351.

A 20-year-old with no prior contributions would need to save €5791pa from age 20 to age 60 to get the same result. That's 481pm! Note that under 30 only 15% of net relevant earnings are tax relieved so our 20-year-old would need to be earning nearly €40,000pa to even be able to make these contributions.

If they were working on the adult rate national minimum wage of €9.15 an hour, then they would need to work an average of 81 hours a week over a 52-week year. No time available for any holidays. 

It should be clear that for most people in their 20s or even 30s just starting out in the world of work that this just isn't practical.

So, what if we wait until we are 30? Let's see how much we now need to save to obtain the same result as our child who was given a silver spoon at birth by their grandparents.

Keeping everything else the same, a 30-year-old would need to save €10,511pa to have the same pension fund at age 60. That's a whopping €875pm.

Hopefully, this illustrates the point that those early contributions really are the most valuable.

Let's see how we might achieve something similar here in Ireland.

 

CAT small gifts exemption 


In Ireland one may give €3000pa to as many people as I wish completely free from CAT. So, the first part works the same. A grandparent can make use of this small gift exemption as part of a multi-generational estate plan.

CAT is currently at a rate of 33% so that's an immediate tax saving of €990pa on a €3000 gift.

That's almost equivalent to the annual gross interest on a €10,000,000 demand deposit at current interest rates. You did read that correctly. see here 


Can we establish a pension for a grandchild?

This is a question I posed back in 2008 when I first arrived in Ireland and I received a lot of bemused looks from Irish Pension lawyers and we are still attempting to establish if a pension contract can be established for a minor by the parent or guardian signing the application form.


Who can take out a PRSA?


"Employees, the self-employed, homemakers, carers and the unemployed – in fact every adult under age 75 may take out a PRSA. The relevant legislation does not state a minimum age, however, in practice, this may be imposed by contract law. Importantly, unlike RACs, there is no requirement to have taxable earnings in order to pay contributions."[4]





Contracts with minors 


Regarding contract law, the general rule at common law is that a minor does not have the capacity to enter a legally binding contract. There are two exceptions to this rule, contracts for necessaries and beneficial contracts of service will be held to be valid if they are in the best interests of the minor. Contracts for necessaries usually include contracts for food, clothing and lodging; however, the courts have held that contracts for items regarding education and further training such as school books and training uniforms and vehicles for work are also enforceable. 

Such items were held to be necessaries in the following cases 

First Charter Financial Bank v Musclow (1974)

Soon v Wilson (1962) 

Roberts v Gray

Beneficial contracts for services usually involve contracts for apprenticeships or contracts with agents or managers, and are only enforceable if they are to the advantage of and in the best interests of the minor. 

The Age of Majority Act 1984 reduced from 21 years to 18 years the commencement of legal Adulthood in the Republic of Ireland.

So, if it could be argued that a pension contract is a "necessary" for a minor then the contract might be enforceable.

I am currently working through these legal precedents with pensions lawyers with a view to establishing a suitable contractual solution.


What about young adults?


But you don't need to be employed to contribute to a PRSA so what is the effect of funding a pension for, say an 18-year-old student?

Chapter 24 Revenue Pensions manual states: 

"An individual who is not in pensionable employment is entitled to relief on contributions up to €1,525 even if the contribution exceeds the relevant age percentage limit. This does not apply in the case of contributions to a PRSA for AVC purposes.

Where full relief cannot be given for a year of assessment in respect of contributions paid in that year, the unrelieved amount may be carried forward to the next or succeeding years and treated as a qualifying contribution paid in subsequent years. "

The key to this planning is that there is no cap on how many years into the future tax relief may be carried forward.

Relevant earnings are:


 • non-pensionable earnings taxed under Schedule E, or

• income from a trade or profession taxed under schedule D case I or II

The effect of this is that immediate income tax relief is available to everyone on €1525pa even if they have little or no relevant earnings and the balance of any unused tax relief can be carried forward and offset against future years.

Note that there is no relief from PRSI or the Universal Social Charge in respect of contributions made to PRSAs.

You can claim tax relief directly from the Tax Office. Tax relief will be allowed through the PAYE system, as an additional tax credit at your marginal rate of tax.

If you are self-employed, tax relief for contributions may be claimed in your annual tax return.

Except in the case of an employee who is a member of an occupational pension scheme or of a statutory pension scheme, a taxpayer is entitled to tax relief on a contribution of €1,525 paid even if this exceeds the normal income-based limit.

For example, if an individual aged 23 earns €9,525, the normal limit on the tax-deductible contribution is 15% of €9,525 being €1,430. If this individual pays €1,600, relief of €1,525 will be allowed, rather than the earnings based limit of €1,430.

Contributions paid in any year more than the maximum tax deductible contribution may be carried forward and claimed in future years’ subject to the annual limit for those years. Similarly, contributions paid while out of the workforce may be carried forward and claimed against future earnings on return to paid employment subject to the annual limits.

The tax relief is non-transferable between spouses in line with existing rules for RAC and occupational pension scheme contributions.

Basic rate tax relief on €1525 is worth at least €305 per year. The balance of the contribution will be carried forward to future years.

Therefore, from an Irish perspective the sum of the potential tax reliefs available is as follows:

CAT saving €990

income tax saving (at least) €305pa

Total relief €1,295 on a €3000 payment or 43.16%

How about an initial lump sum to kick things off?

If we can’t fund from birth, we need to think about how we might catch up.

Grandchildren are a group C beneficiary with an exemption of €16,250 (tax year 2020) so an initial payment could be made up to this amount for a potential immediate CAT saving of €5,362.

Annual contributions of €3,000 could be added to this initial lump sum with no tax charge in the hands of the beneficiary. 

Example

Granny makes a payment of €16,250 to her Grandchild’s PRSA on their 18th Birthday plus €3000 a year for the 3 years they are at college, a total of €25,250 in contributions.  Total CAT saving potentially €8,332.50.

The grandchild now has made pension contributions of €25,250 which they can set against their future income tax liability in the years ahead, effectively increasing their take home pay in their early years at work by at least €5,050 for a basic rate tax-payer.

€25,250 growing at an average annual rate of 5%pa for the 40 years to age 60 would have increased the eventual pension fund by €177,759. 

This planning therefore represents a good mix of medium term benefits that show up in the grandchild’s pay-packet when they start work and much longer term financial security.

It is theoretically possible to make an even larger contribution than this but there could be an immediate charge to CAT on the gift depending on the circumstances. 

Also, from a pragmatic perspective, there have been so many changes to pension rules in recent years that it could be considered unwise to assume that the current rules won’t change in the future possibly to the detriment of the investor.

If you would like to discuss further please get in touch

Or you may be interest in our guide, Personal Savings accounts which expands the analysis to include everyone up to age 75.




[1] As an aside you can also continue to claim tax relief for the 5 consecutive tax years after leaving the UK

[2] The payment could equally be made into an account in their children’s name, or indeed any other individual for that matter

[3] Assuming an estate liable to inheritance tax.