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Thursday, 25th April 2024 |
| Approved retirement funds, the ability to gear up for property investment in particular, and the of launch of PRSAs have all focused attention on pensions as an exciting savings option. It is important that exciting options be viewed with a cool eye. |
The annuity
In Ireland attitudes to pensions have varied hugely over the last several decades. In pre entrepreneurial Ireland, up to approximately the 1960s, the typical mother wanted a pensionable job for her son. The Civil Service, the insurance companies, and the banks were associated with such wonderful employment opportunities.
Later, as Ireland opened up to industrial development and ceased to be a giant farm with docking facilities for emigration boats, pensions came more to be viewed in the light of the “annuity trap”. Employees became conscious that the capital sums built up in pension funds on their behalf inevitably had to be invested in the purchase of an annuity which would not outlast the longer of their lifetime, or that of their spouse, typically.
This was a major discouragement to employees to paying additional voluntary contributions (AVCs) to their employer’s pension fund. The most the employee could hope would be the commutation of a part of that AVC fund on retirement, with the balance turned into income for his/her lifetime or that of their spouse typically.
The approved retirement fund has radically changed the popular perception of a pension. The approved retirement fund enables an employee to retain the capital represented by his AVCs, and to draw on that capital as well as any income and gains it generates, during his lifetime, and to pass on the capital to his dependants after his death. The employee has been freed from the “annuity trap”, and none too soon, given the very high expense of purchasing annuities currently.
Proprietary directors and self-employed persons likewise can avail of an approved retirement fund and escape the annuity trap. However employers contributions to occupational pension funds for non 5p.c. directors, continue to be subject to the purchase of an annuity and the fund cannot be inherited as a lump sum. Of course the employee may commute part of it into a tax free lump sum, but the bulk of it will usually still have to be employed in the purchase of an annuity.
Given that contributions to an approved pension fund are tax deductible (subject to Revenue limits) and that the fund itself is a gross fund exempt from Irish income tax and Irish capital gains tax, it makes sense for any person who can afford long-term savings to consider making a substantial part of such savings through a pension fund.
Property and gearing
The Finance Act 2004 signalled a relaxation of the traditional bar on approved pension funds directly gearing up for the purpose of investment. Most pension trustees considering such gearing would do so in the context of a property investment. Previously a geared investment could be made only indirectly, by investment in a fund, which itself had a degree of gearing. Now it is expected that the Revenue Commissioners will permit a similar level of gearing directly by the pension fund.
One significance of the ability of a pension fund to gear directly is that the form of property investment can change. Some pension contributors would prefer a direct investment in a single property, rather than the indirect investment in a range of properties which a fund provides. This is particularly the case with small self-administered funds where the members of the scheme can directly influence the choice of property investment, and possibly its subsequent management.
There is no relationship between the tax breaks made available for savings through pension funds, and property investment. The fact that a pension fund chooses to invest in property has no impact on the tax breaks available to those making additional voluntary contributions, or employers contributions, to the fund. It is important that pension fund trustees, and contributors to pension funds, should not be misled by the tax advantages available to contributions to a pension fund, into losing sight of the importance of getting value for money when they make investments. An over priced property investment cannot be justified on the basis that it is being purchased from tax relieved moneys, especially since the tax relief is available regardless of whether or not the investment is made in property, or any particular property.
PRSAs slow
Despite the new interest in savings for retirement through pension schemes, PRSAs (personal retirement savings accounts) seem to be slow in take-up. There can be many reasons for this. One of the basic reasons is probably that those in better paid employment are typically those already in occupational pension schemes. In contrast, those employees without pension cover are often those who are the least well paid, and therefore the least likely to have surplus income for saving in the first place. There is also considerable pressure on younger employees to devote all surplus income to funding mortgage repayments, leaving them with little opportunity to consider pension funding.
In addition to these fundamental problems, the PRSA does have one technical problem. The total limit on tax relieved funding to a PRSA, both by employer and employee where both contribute, is the same as the limit on additional voluntary contributions by an employee only to an occupational pension fund. The consequence of this is that if an employee chooses to have his pension provisions made solely through a PRSA, the total tax deductible provision that can be made by the employee and the employer is less than if it were done through an occupational pension fund.
It would be preferable if the limits of funding for an individual to a PRSA could be brought into line with those in an occupational pension fund.
However, this alone will not increase coverage which will only occur with increased education in relation to the need to provide for retirement income.
Gradual retirement
Traditionally, an employee retired on a once and for all basis. One day he was working a full day, and the next day he was completely retired. Such sudden retirement can be traumatic for the employee and his family, and can deprive an employer of the services of an employee who would have considerable experience, if perhaps reduced energy levels.
It is possible for an employee to gradually retire, by moving on to a regime of reduced hours and reduced pay, rather than retiring completely. It might be thought that the employee’s wish to commute the maximum sum possible of his pension fund (whether that be employers contribution or AVCs) into a tax free lump sum would mitigate against such gradual retirement. The normal limit on commutation is one and a half times salary at retirement. If this were the only limit, it would be obviously disadvantageous to an employee to retire at a time when his salary has reduced from its peak. There are however alternative means of measuring the maximum sum which an employee may commute on retirement.
The final remuneration figure which forms part of the calculation can be taken to be either the average of any three or more consecutive years ending in the ten years prior to retirement or the basic remuneration of any twelve month period in the five years prior to retirement together with the average of any fluctuating emoluments over three or more consecutive years ending on the date of retirement.
As can be seen these two alternate bases of computing the limit to what can be commuted tax free enable an employee to look back quite far into his employment to identify his peak earning period, scheme rules permitting. An employee or director therefore need not be disadvantaged greatly by the decision to reduce his efforts and commitment to his employment as he grows older, provided his ‘sunset period’ of employment does not last longer than ten years. If an employee lingers on in an employment into late old age, they might well find that their peak earning period was more than ten years prior to their retirement, and some difficulty could arise.
The issue of gradual retirement can arise both from the perspective of a workaholic, who wants to stay in employment long past retirement date, and the employee ‘who has a life’ and wants to begin to slack off from work activities long before his retirement date.
Pensions are a live issue at every stage of an employee or director’s career. It is not an issue solely for the grey haired. If an employee neglects planning his career in terms of his pension, as well as in terms of his salary, he will lose out in the end. |
Ray McKenna is a director in KPMG’s people strategies division.
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| Article appeared in the May 2004 issue.
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