Planning for your retirement in spite of Government policy
The reason why retirement planning is much more important now than it might have been for earlier generations is down to longevity. People are living a lot longer in retirement than was the case in times past. Some 40 years ago, a male retiring at age 65 had an average life expectancy of some 13 years. Today, that has increased to over 20 years. That’s a 60% increase. And for females you can generally add an extra 3 or 4 years.
With people living much longer in retirement, pensions also have to last much longer. Consequently, making provision for one’s retirement years is now more important than ever.
Government Policy
Against this background, why are Governments doing their best to discourage or even penalise individuals who try to make prudent financial provision for their retirement years?
Government planning in relation to pension provision (whether that be Social Welfare pensions, public sector pensions or private sector pensions) has been as well thought out as its management of the financial crisis. We have had numerous white and green papers, statements from Ministers, a National Recovery Plan, Budget changes, etc., and the net result is that most people, in the private sector at least, are totally confused as to how they should go about trying to finance their retirement or indeed whether it is now worthwhile at all putting aside funds for retirement. Continuous policy changes in relation to pensions have only served to confuse.
Just take a look at the proposals and changes adopted in recent times:
• If you are self-employed, you cannot contribute to a personal pension plan in respect of any income above €115,000 p.a. (circa 50% of the salary on which senior Civil Servants are provided with pension benefits).
• The FF/Green Government proposed in the National Recovery Plan document to cut tax relief on personal contributions (paid by self-employed or employees) to standard rate of 20% by 2014.
• The Fine Gael policy during the election campaign was to retain tax relief at the marginal rate, but instead introduce a 0.5% Levy on all pension funds.
• More recently, the current Government have suggested that the rate of tax relief would be set at a common rate of 33% irrespective of one’s marginal tax rate (which would be in addition to the Levy above?). This is supposedly designed to encourage lower paid individuals to fund pension benefits.
• In the December Budget, the Government reduced the capital value of pensions which individuals could accumulate to €2.3m, with any excess taxed at 41% in addition to the normal income tax on the subsequent drawdown of the remaining 59% (equivalent to a composite rate of 69%).
• The current Government have also suggested that they will reduce the fund cap further, as part of their Policy for Government.
• The maximum tax-free lump sum which one can take on retirement has been capped at €200,000.
• Those individuals who invest their post retirement fund (out of a Defined Contribution plan) into an Approved Retirement Fund must now draw down a minimum of 5% of the fund each year and pay tax on same.
• Finally, in the last Budget, the PRSI/Health Levy relief has also been removed on employee contributions to occupational pension schemes, thus reducing the tax relief by circa 8%.
Against this background, is it any wonder that some individuals are taking the view that conventional pension funding is on a slippery slope to oblivion?
New 0.6% Levy
And now we have a new Pension Tax, designed ostensibly to fund the Jobs Initiative:
• The current Government have now proposed to tax all pension funds – oops my mistake – to tax all private sector pension funds (including, perhaps, some pensions in payment and Approved Retirement Funds, though this is not clear at present) at a rate of 0.6% of the total fund value. So members of private pension funds who have been reasonably prudent in attempting to fund for their retirement will have 0.6% of their fund value sequestered (despite the challenging investment results of recent years) whilst members of occupational pension schemes which are unfunded (largely or entirely in the Civil/Public Service) escape. Can this be simply because 0.6% of nothing is …nothing?
• Whilst it is relatively simple to apply the Levy in Defined Contribution cases (because there is an actual fund for each individual), it is much more complicated in a DB scheme where there is simply one overall fund. If the Fund pays out 0.6% of its total value each year for say 4 years, how is that translated back to individual members in terms of reducing benefits or increasing contributions? Does it simply increase the current funding deficit? Or does the Employer effectively have to meet the cost?
• In relation to pensions in payment, the Irish Association of Pension Funds estimates that the 0.6% Levy on fund values would reduce pension payments by circa 9%, but it could be more. However, it seems that this would only apply to annuities paid out of the pension fund as opposed to where the pension fund offloaded its liability by buying an annuity from a Life Assurance company. Again, will this reduction of 9% or more apply only to private sector schemes where the annuity is paid out of the fund, but not to public sector pensions where the pension is paid out of general taxation?
Implications
I would pose the following questions:
• Why are self-employed restricted to funding a pension in retirement based on an income of half a senior civil servant’s salary?
• Why would any individual contribute to a pension plan if tax relief on the way in was limited to 20% (as proposed under the FF/Greens National Recovery Plan) but the income in retirement was potentially going to be taxed at circa 50% (top rate tax plus Universal Social Charge)?
• In addition to the Levy, the new Government seems determined to reduce the maximum tax relief as well, admittedly not to 20%, but to 33%. That might be fair if the subsequent income was only taxed at a maximum of 33%, but I cannot see that happening. So do we face both a fund Levy and a reduction in the tax relief?
The reduction in the pension fund cap to €2.3m may not seem that penal. If you are a member of a Civil Service pension plan (or indeed a member of a private sector Defined Benefit occupational pension scheme) the cap equates to a gross pension income of €115,000 (because Defined Benefit pensions are valued at a notional 20:1). Many might say that such a cap is not unreasonable in the current difficult times. Perhaps. But it is not that simple, as I have outlined below.
Dire Straits (not Mark Knopfler et al)
I fully appreciate that we live in straightened times and that the Government stands in dire need of new revenue, to be achieved either by increasing tax income or by limiting reliefs. Obviously, looking at the estimated €75bn set aside in private pension funds, it is tempting to take just a little of that (0.6%) to finance the much-needed jobs initiative. In defending the move, various Ministers have referred to the “very generous tax breaks which the Pensions industry has enjoyed over many years”. In point of fact, the “pensions industry” has not enjoyed any tax breaks — it is pension scheme members who “enjoy” these tax breaks (or, more correctly, tax deferral). But even if that were true, then it applies equally to public and private sector employees. So why do only private sector employees get the opportunity to finance the jobs initiative?
Minister Joan Burton, in justifying the Levy, stated that the “pensions industry” had focused unduly on high net worth individuals. Whilst clearly a small number of such individuals did accumulate very large pension pots (presumably with the approval of their Boards of Directors and within Revenue regulations at the time), it’s hardly a justification for penalising the “ordinary decent” pensioner with far more modest pension pots. Equally, Minister Noonan’s comment that this Levy will see funds “brought home to invest in jobs” is astounding. The Levy may be brought home, but this move hardly encourages Pension Trustees (who have a legal responsibility to manage the funds prudently on behalf of members) to invest more domestically, particularly since such Funds have suffered very significant losses on Irish equities and Irish Government Bonds over the last few years.
If the value of private pension funds is circa €75bn (covering an estimated 500,000 people), that equates to an average fund of some €150,000. So on average (and averages can be deceptive) the Levy will cost each member circa €900 p.a. for 4 years. But the Comptroller and Auditor-General recently estimated that the unfunded liability for public service pensions is some €108bn. Since this covers some 330,000 employees, it equates to an average “fund” of €327,000 (more than twice the figure in the private sector).
Let me stress that this is not a rant about public service pensions. I am simply pointing out that one sector of the pension population are being asked to fund the jobs initiative whilst another sector (most public and civil servants and politicians) are not been required to contribute. My underlying concern is that all these changes and proposed changes seem to be designed to deter individuals making any further pension provision at the very time when they should be prudently planning for a longer period in retirement.
Breach of Trust
By its very nature, pension planning is a long term exercise. Pension funds are often accumulated over 30 or 40 years. Implicitly, individuals enter into a contract with Government when they start out to set aside funds for their retirement. The Irish model for decades has been based on deferred taxation – tax relief on contributions on the way in and tax on income on the way out. However the recent changes, some might argue, are a breach of that contract.
If an individual had been prudent in building up a pension fund of say €2.2m under the previous rules and was still say 4 or 5 years from retirement, the sudden introduction of a €2.3m fund cap will mean that individual cannot avoid the penalty of double taxation. Even if they cease all future contributions, even meagre investment growth will bring them above the €2.3m cap by the time they retire. Perhaps the only benefit of the new 0.6% Levy will be to help reduce the excess by which such individuals would otherwise have exceeded the cap.
The 20:1 valuation basis adopted for Defined Benefit schemes (including private sector schemes and schemes for Civil Servants, Judges etc.) is particularly favourable in comparison to how members of Defined Contribution schemes are treated.
Take the following example:
- Senior Civil Servant earning €200,000 at retirement
- Retirement pension of €100,000 (50% of salary) plus a lump sum of €300,000 (150% of salary)
- Notional values is – 20 x €100,000 + €300,000 = €2.3m
- Result, no double taxation at retirement
Compare that to an individual in the private sector trying to fund a comparable benefit at say age 65 out of a Defined Contribution plan:
- Cost of buying a joint-life annuity of €100,000 with indexation in payment is circa €2,700,000
- Add cash lump sum of €300,000
- Total fund required = €3,000,000
- Tax liability at 41% of €700,000 = €287,000
So in effect, if the private sector (Defined Contribution) individual tried to replicate the senior Civil Servant retirement benefit package, requiring a fund of circa €3m, he would have to surrender all his lump sum as a tax penalty. Is this equitable?
Conclusion
I fully understand that the Government want to reduce the tax relief given to pension funding (even if it is only tax deferral). However I believe that if they proceed with all their proposals, they will save far more than planned, simply because many people will cease funding entirely and thus forego any tax relief. (The Law of Unintended Consequences comes to mind.) Whilst this may be the real plan (though not stated publicly), this is surely yet another short term decision, not unlike the decision of the previous Government to rely on transient property taxes in framing long term Government expenditure plans. The net effect could be to condemn future generations to longer years of poverty in retirement.
If we have to tax pension funds (individuals saving for retirement) to fund the jobs initiative, so be it. It is perhaps a price worth paying if it helps to regenerate the economy and there is no other alternative. But equity requires that all pension savers should contribute. Those making the decisions to tax private sector pensions should show an equivalent level of commitment to the venture.
The Minister has stated the Levy will only apply for four years and will neither be extended nor increased. It is to be hoped that this promise is one that will be kept.
For the past number of decades, Ireland’s longer term social policy goals have included the encouragement of pension savings. Despite a few headline cases, the vast majority of pension tax reliefs have been availed of by middle income earners (not rich fat cats) attempting to make prudent financial planning decisions for their old age. These are mostly individuals who, whilst getting tax relief at marginal rates, will also pay tax on the eventual retirement income at marginal rates (probably even a higher marginal rate).
Because pension planning is such a long term commitment, it therefore requires a sustainable and reliable long term tax regime so that individuals can make rational long term decisions. Basing pension policy on a handful of high profile cases where individuals have accumulated pension pots of €27m, etc. is not a sensible strategy. The “ordinary decent” pensioner deserves a better thought out and more equitable policy from our political masters, particularly when those political masters are themselves exempt from some of the more draconian elements of such policy.
The reason why retirement planning is much more important now than it might have been for earlier generations is down to longevity. People are living a lot longer in retirement than was the case in times past. Some 40 years ago, a male retiring at age 65 had an average life expectancy of some 13 years. Today, that has increased to over 20 years. That’s a 60% increase. And for females you can generally add an extra 3 or 4 years.
With people living much longer in retirement, pensions also have to last much longer. Consequently, making provision for one’s retirement years is now more important than ever.
Government Policy
Against this background, why are Governments doing their best to discourage or even penalise individuals who try to make prudent financial provision for their retirement years?
Government planning in relation to pension provision (whether that be Social Welfare pensions, public sector pensions or private sector pensions) has been as well thought out as its management of the financial crisis. We have had numerous white and green papers, statements from Ministers, a National Recovery Plan, Budget changes, etc., and the net result is that most people, in the private sector at least, are totally confused as to how they should go about trying to finance their retirement or indeed whether it is now worthwhile at all putting aside funds for retirement. Continuous policy changes in relation to pensions have only served to confuse.
Just take a look at the proposals and changes adopted in recent times:
• If you are self-employed, you cannot contribute to a personal pension plan in respect of any income above €115,000 p.a. (circa 50% of the salary on which senior Civil Servants are provided with pension benefits).
• The FF/Green Government proposed in the National Recovery Plan document to cut tax relief on personal contributions (paid by self-employed or employees) to standard rate of 20% by 2014.
• The Fine Gael policy during the election campaign was to retain tax relief at the marginal rate, but instead introduce a 0.5% Levy on all pension funds.
• More recently, the current Government have suggested that the rate of tax relief would be set at a common rate of 33% irrespective of one’s marginal tax rate (which would be in addition to the Levy above?). This is supposedly designed to encourage lower paid individuals to fund pension benefits.
• In the December Budget, the Government reduced the capital value of pensions which individuals could accumulate to €2.3m, with any excess taxed at 41% in addition to the normal income tax on the subsequent drawdown of the remaining 59% (equivalent to a composite rate of 69%).
• The current Government have also suggested that they will reduce the fund cap further, as part of their Policy for Government.
• The maximum tax-free lump sum which one can take on retirement has been capped at €200,000.
• Those individuals who invest their post retirement fund (out of a Defined Contribution plan) into an Approved Retirement Fund must now draw down a minimum of 5% of the fund each year and pay tax on same.
• Finally, in the last Budget, the PRSI/Health Levy relief has also been removed on employee contributions to occupational pension schemes, thus reducing the tax relief by circa 8%.
Against this background, is it any wonder that some individuals are taking the view that conventional pension funding is on a slippery slope to oblivion?
New 0.6% Levy
And now we have a new Pension Tax, designed ostensibly to fund the Jobs Initiative:
• The current Government have now proposed to tax all pension funds – oops my mistake – to tax all private sector pension funds (including, perhaps, some pensions in payment and Approved Retirement Funds, though this is not clear at present) at a rate of 0.6% of the total fund value. So members of private pension funds who have been reasonably prudent in attempting to fund for their retirement will have 0.6% of their fund value sequestered (despite the challenging investment results of recent years) whilst members of occupational pension schemes which are unfunded (largely or entirely in the Civil/Public Service) escape. Can this be simply because 0.6% of nothing is …nothing?
• Whilst it is relatively simple to apply the Levy in Defined Contribution cases (because there is an actual fund for each individual), it is much more complicated in a DB scheme where there is simply one overall fund. If the Fund pays out 0.6% of its total value each year for say 4 years, how is that translated back to individual members in terms of reducing benefits or increasing contributions? Does it simply increase the current funding deficit? Or does the Employer effectively have to meet the cost?
• In relation to pensions in payment, the Irish Association of Pension Funds estimates that the 0.6% Levy on fund values would reduce pension payments by circa 9%, but it could be more. However, it seems that this would only apply to annuities paid out of the pension fund as opposed to where the pension fund offloaded its liability by buying an annuity from a Life Assurance company. Again, will this reduction of 9% or more apply only to private sector schemes where the annuity is paid out of the fund, but not to public sector pensions where the pension is paid out of general taxation?
Implications
I would pose the following questions:
• Why are self-employed restricted to funding a pension in retirement based on an income of half a senior civil servant’s salary?
• Why would any individual contribute to a pension plan if tax relief on the way in was limited to 20% (as proposed under the FF/Greens National Recovery Plan) but the income in retirement was potentially going to be taxed at circa 50% (top rate tax plus Universal Social Charge)?
• In addition to the Levy, the new Government seems determined to reduce the maximum tax relief as well, admittedly not to 20%, but to 33%. That might be fair if the subsequent income was only taxed at a maximum of 33%, but I cannot see that happening. So do we face both a fund Levy and a reduction in the tax relief?
The reduction in the pension fund cap to €2.3m may not seem that penal. If you are a member of a Civil Service pension plan (or indeed a member of a private sector Defined Benefit occupational pension scheme) the cap equates to a gross pension income of €115,000 (because Defined Benefit pensions are valued at a notional 20:1). Many might say that such a cap is not unreasonable in the current difficult times. Perhaps. But it is not that simple, as I have outlined below.
Dire Straits (not Mark Knopfler et al)
I fully appreciate that we live in straightened times and that the Government stands in dire need of new revenue, to be achieved either by increasing tax income or by limiting reliefs. Obviously, looking at the estimated €75bn set aside in private pension funds, it is tempting to take just a little of that (0.6%) to finance the much-needed jobs initiative. In defending the move, various Ministers have referred to the “very generous tax breaks which the Pensions industry has enjoyed over many years”. In point of fact, the “pensions industry” has not enjoyed any tax breaks — it is pension scheme members who “enjoy” these tax breaks (or, more correctly, tax deferral). But even if that were true, then it applies equally to public and private sector employees. So why do only private sector employees get the opportunity to finance the jobs initiative?
Minister Joan Burton, in justifying the Levy, stated that the “pensions industry” had focused unduly on high net worth individuals. Whilst clearly a small number of such individuals did accumulate very large pension pots (presumably with the approval of their Boards of Directors and within Revenue regulations at the time), it’s hardly a justification for penalising the “ordinary decent” pensioner with far more modest pension pots. Equally, Minister Noonan’s comment that this Levy will see funds “brought home to invest in jobs” is astounding. The Levy may be brought home, but this move hardly encourages Pension Trustees (who have a legal responsibility to manage the funds prudently on behalf of members) to invest more domestically, particularly since such Funds have suffered very significant losses on Irish equities and Irish Government Bonds over the last few years.
If the value of private pension funds is circa €75bn (covering an estimated 500,000 people), that equates to an average fund of some €150,000. So on average (and averages can be deceptive) the Levy will cost each member circa €900 p.a. for 4 years. But the Comptroller and Auditor-General recently estimated that the unfunded liability for public service pensions is some €108bn. Since this covers some 330,000 employees, it equates to an average “fund” of €327,000 (more than twice the figure in the private sector).
Let me stress that this is not a rant about public service pensions. I am simply pointing out that one sector of the pension population are being asked to fund the jobs initiative whilst another sector (most public and civil servants and politicians) are not been required to contribute. My underlying concern is that all these changes and proposed changes seem to be designed to deter individuals making any further pension provision at the very time when they should be prudently planning for a longer period in retirement.
Breach of Trust
By its very nature, pension planning is a long term exercise. Pension funds are often accumulated over 30 or 40 years. Implicitly, individuals enter into a contract with Government when they start out to set aside funds for their retirement. The Irish model for decades has been based on deferred taxation – tax relief on contributions on the way in and tax on income on the way out. However the recent changes, some might argue, are a breach of that contract.
If an individual had been prudent in building up a pension fund of say €2.2m under the previous rules and was still say 4 or 5 years from retirement, the sudden introduction of a €2.3m fund cap will mean that individual cannot avoid the penalty of double taxation. Even if they cease all future contributions, even meagre investment growth will bring them above the €2.3m cap by the time they retire. Perhaps the only benefit of the new 0.6% Levy will be to help reduce the excess by which such individuals would otherwise have exceeded the cap.
The 20:1 valuation basis adopted for Defined Benefit schemes (including private sector schemes and schemes for Civil Servants, Judges etc.) is particularly favourable in comparison to how members of Defined Contribution schemes are treated.
Take the following example:
- Senior Civil Servant earning €200,000 at retirement
- Retirement pension of €100,000 (50% of salary) plus a lump sum of €300,000 (150% of salary)
- Notional values is – 20 x €100,000 + €300,000 = €2.3m
- Result, no double taxation at retirement
Compare that to an individual in the private sector trying to fund a comparable benefit at say age 65 out of a Defined Contribution plan:
- Cost of buying a joint-life annuity of €100,000 with indexation in payment is circa €2,700,000
- Add cash lump sum of €300,000
- Total fund required = €3,000,000
- Tax liability at 41% of €700,000 = €287,000
So in effect, if the private sector (Defined Contribution) individual tried to replicate the senior Civil Servant retirement benefit package, requiring a fund of circa €3m, he would have to surrender all his lump sum as a tax penalty. Is this equitable?
Conclusion
I fully understand that the Government want to reduce the tax relief given to pension funding (even if it is only tax deferral). However I believe that if they proceed with all their proposals, they will save far more than planned, simply because many people will cease funding entirely and thus forego any tax relief. (The Law of Unintended Consequences comes to mind.) Whilst this may be the real plan (though not stated publicly), this is surely yet another short term decision, not unlike the decision of the previous Government to rely on transient property taxes in framing long term Government expenditure plans. The net effect could be to condemn future generations to longer years of poverty in retirement.
If we have to tax pension funds (individuals saving for retirement) to fund the jobs initiative, so be it. It is perhaps a price worth paying if it helps to regenerate the economy and there is no other alternative. But equity requires that all pension savers should contribute. Those making the decisions to tax private sector pensions should show an equivalent level of commitment to the venture.
The Minister has stated the Levy will only apply for four years and will neither be extended nor increased. It is to be hoped that this promise is one that will be kept.
For the past number of decades, Ireland’s longer term social policy goals have included the encouragement of pension savings. Despite a few headline cases, the vast majority of pension tax reliefs have been availed of by middle income earners (not rich fat cats) attempting to make prudent financial planning decisions for their old age. These are mostly individuals who, whilst getting tax relief at marginal rates, will also pay tax on the eventual retirement income at marginal rates (probably even a higher marginal rate).
Because pension planning is such a long term commitment, it therefore requires a sustainable and reliable long term tax regime so that individuals can make rational long term decisions. Basing pension policy on a handful of high profile cases where individuals have accumulated pension pots of €27m, etc. is not a sensible strategy. The “ordinary decent” pensioner deserves a better thought out and more equitable policy from our political masters, particularly when those political masters are themselves exempt from some of the more draconian elements of such policy.
