Everlake Retirement Planning for Gen X, Y & Z
Introduction
The words ‘pensions’ and ‘retirement planning’ spark all sorts of thoughts and feelings in people –fear, boring, can’t afford it, not relevant to me, I’ll think about it later, already have it sorted.
It’s rarely a subject that people relish discussing, especially when they are young or just entering the job market. It can also spark uncomfortable feelings in those who feel they should have started earlier.
Much of the language used in Financial Services is full of jargon and three letter acronyms like ‘AVCs’. Information is often presented in an unclear manner and can hardly be described as accessible or designed to inform.
So, we’ve written this guide for everyone aged between 20 and 55, aka generations X, Y (millennials) and Z.
Regardless of your age and your feelings towards pensions and retirement planning, we implore you to at least give this guide a quick once over. You may not action anything here for a few years, but hopefully you will come away better informed about some of the decisions you will need to make along the way.
You may feel that you are on top of your pension planning, but this guide may give you some new food for thought or will at least reassure you that you’re on the right track. Think of it as an NCT for your retirement plans.
Those thinking about starting a pension will get a good steer on where to start and the right approach to take.
Anyone planning to retire within the next 10 years, with a retirement fund already being built, will require a different approach. You should refer to our Guide to Approaching Retirement to ensure you get the most from the pension fund that you’ve worked hard to build.
Knowing that you have sufficient income to do all the things you both need and want to do in life, without fear of ever running out of money, is one of the key results of the Financial Planning process.
Why Do I Need a Pension?
The State Pension in Ireland is a little over €13,000 per annum. For many people this amount is barely enough to live on and definitely not enough to fully enjoy your retirement years.
More people are continuing to pay rent or mortgages after they finish working and many, if not most, people generally underestimate their life expectancy.
There are considerable tax benefits from establishing an additional source of income in retirement (or indeed saving to retire early) through a private or company pension and in this guide, we will seek to dispel some of the myths.
It’s this simple. Saving regularly in a pension plan should allow you to have additional income in later life. This could allow you to change career, reduce your hours, retire early or simply do more than you would be able to afford to do if you just had the bare minimum State Pension
For those high earners, it is a fantastic tax break and is sometimes used as a wealth management tool to pass on wealth to the next generation in a tax efficient manner.
For younger people (20s and early 30s), the primary financial priorities should be:
• Protecting the sources of future wealth – your earned income and possibly future inheritances
• Buying a house
• Ensuring you have sufficient life insurance
Financial Protection needs (life insurance and income protection) rank ahead of retirement planning for younger people because death, long-term illness or disability at a young age can have devastating financial impact.
Instead of thinking that very rare events are impossible, you should instead think that they are improbable but might still happen anyway. The key to a good retirement plan is to be able to cope and adapt to the unexpected, and this means making sure that both your income and your life is adequately insured.
By the time you reach your 50s and 60s you will have built an expectation of a certain lifestyle (holidays, hobbies etc). For many people it will prove impossible to maintain their standard of living into retirement if they keep their savings on deposit with a bank. The reason for this is savings come from post-tax income and the average rate of return on deposits, after allowing for tax and inflation, has always tended to be close to zero.
Pension plans simply allow you to save from pre-tax income and allow the money to grow tax efficiently at a higher expected return than a bank deposit account.
State Pension While Working Abroad
You may be entitled to collect a State Pension based on your foreign social security record, if you have worked abroad, in addition to your entitlement to an Irish State pension.
For example, if you have worked in the UK for at least 3 years you are entitled to a UK State Pension but with less than 10 years National Insurance contributions, you will receive nothing. You are entitled to pay voluntary National Insurance Contributions to top up your UK State Pension record.
Currently, you can go back as far as 2006 and buy back missing years but this is changing in April 2023, when you will only be able to go back for a maximum of 6 years. The UK State Pension is worth around £10,000 pa, can be inherited by a Spouse or Civil Partner and is currently payable in addition to the Irish State Pension. For more information on topping up a UK State Pension visit here.
Inheritances
We mentioned earlier that one priority should be to protect a possible future inheritance.
The reason this is included in our retirement planning guide is that for many young people in Ireland today, saving money into a pension or even buying a house is not a realistic proposition without the assistance of our parents.
Much of the wealth in Ireland has been created relatively recently and certainly in the last 50 years. Therefore, many families don’t have experience of wealth and estate planning.
Equally, the younger generation of today face challenges that simply were not a consideration for our parents’ generation. They benefited from gold-plated final salary pensions, free education, roaring stock and housing markets, falling interest rates and negligible inflation for decades.
Contrast that with the challenges of today - unaffordable housing, roaring inflation, and rising interest rates, not to mention the potential havoc of climate change and increasing political instability relative to the last 50 years.
For some young people today, without parental assistance, the choices are to either buy a house or have a family or save for the future. For many people it’s not possible to do more than one of these well.
Inter-generational financial planning can help both generations. Should your parents or grandparents be in a position to help you financially it can be prudent to discuss receiving your inheritance before they pass away. Receiving a cash lump sum by way of a gift or a loan, when you’re younger, to purchase a house, start a business or upskill, can arguably be more beneficial than receiving it later in life.
Having these conversations with family can be difficult and awkward out of context. We can facilitate these conversations as part of your financial planning, and we specialise in inter-generational wealth planning. For more information on inheritance tax exemptions and rates see Revenue here
It’s also worth noting the small gift exemption that’s available to everyone. Should your parents, grandparents or other relatives wish to help you with pension payments or other expenses, they can use the small gift exemption to give you €3,000 each per calendar year.
Please see our guide to Estate Planning for further details.
When Should I Start a Pension?
Some people delay starting a pension as they think they are too young or can’t afford the contributions yet. Let’s face it, putting things off until tomorrow is part of the human condition. Others have received advice from a parent or trusted relative to start ASAP and have contributed to a pension since they started in full time employment.
Many people fall into pension planning somewhere throughout their career when it’s offered by an employer or because they’ve read or heard something that’s given them the motivation to start.
In our opinion, when is the best time to start a pension? Almost everything you read about pensions the world over will talk about starting your pension early and the benefits of compound interest.
Low to Mid Earners
The number one priority for everyone should be to buy a house. Those on lower salaries should always prioritise buying a house over saving into a pension, since the alternative is having to pay rent or live at home with the parents.
The reasons behind this are tax efficiencies. Your rent is paid from post-tax income, so not having to pay rent is ‘earning a return’ at your top rate of income tax. If you sell your home, it is free from capital gains tax, and you can rent a room tax free up to €14,000 pa.
Logically therefore, people should borrow or be gifted the house deposit from their parents and buy a house as soon as possible.
Buying a two-bed+ property and renting out the extra room(s) will generate income to help pay off the mortgage or pay back the parents for the loan of the deposit.
The primary financial goal should be to build up equity in the property by overpaying the mortgage to reduce the loan to value. As soon as it is affordable and practical the property can be sold (any profit is tax free) and a larger property can be purchased.
Mid to High Earners
Mid to high earning individuals, who are homeowners, should pay into a pension. Beyond keeping a small emergency fund available, any extra cash or bonuses should be used to make additional voluntary contributions (AVCs) to their company pensions, rather than accumulating excess cash in the bank. See below for more on AVCs.
Very High Earners
Individuals with very high salaries should also pay into a pension but will likely hit the €2m pension cap, especially if bonuses are also paid to the pension.
Once this cap has been reached, creating inter-generational wealth should be considered. Establishing a family partnership or, if a director of their own company, restructuring their shareholding with growth shares are some options available to these individuals.
The Cost of Delay
The impact of making relatively modest contributions early in life cannot be understated.
For example, if someone saves €3,000 pa, growing net of costs at 5% pa, for the first 20 years of their life, by age 20 they would have a pension fund valued at €99,197. Making no further payments for the rest of their life, and just leaving this to compound, the resulting retirement fund is €698,351 at age 60.
A 20-year-old with no prior contributions would need to save €5,791 pa from age 20 to age 60 to get the same result. That’s €481 pm!
Note that under age 30, only 15% of net relevant earnings receives tax relief for pension contributions, so our 20-year-old would need to be earning nearly €40,000 pa.
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 a child saving since birth. Keeping everything else the same, a 30-year-old would need to save €10,511 pa to have the same pension fund at age 60. That’s a whopping €875 pm.
Hopefully, this illustrates the point that those early contributions really are the most valuable. The amount you need to save roughly doubles every 5 years just to stand still.
Now, whilst that’s all mathematically true, it’s still not the right answer for everyone.
Traditional retirement planning isn’t the correct fit for everyone. There are broadly three types of people we meet, each requiring a different approach to planning for their future.
Company Pension Schemes
Ideally, retirement planning should be in the form of an executive or company pension with matched employer contributions.
This is important to consider when looking for a new role and could be the deal breaker if you’re choosing between two different job offers.
Check your employment contract before you sign. We frequently review employment contracts that do not permit bonuses to be paid directly into your pension, as this would be deemed to be ‘salary sacrifice’ by Revenue.
An Additional Voluntary Contribution paid by an employee receives income tax at a rate of 40% for a higher rate taxpayer.
However, a contribution paid by the employer receives up to 52% tax relief (including PRSI and USC) AND the employer also receives tax relief of employer PRSI at up to 11.05%.
It is therefore very good practice for an employment contract to include the provision for a discretionary bonus, which can be either paid as cash through payroll or directed in full or in part directly to the pension.
If an employer is offering to match your pension contributions (usually up to a certain % of salary) and it’s affordable, you should definitely start paying contributions into the pension. Otherwise, you’re taking a pay cut.
In other words when looking for a job two things are really important:
1. Employer sponsored benefits like income protection, life assurance and matched pension contributions.
2. The option to pay some or all of a discretionary bonus directly to the pension.
How Much Should I Contribute?
One of the main benefits of contributing to a pension is the income tax saving at your marginal rate.
There are two limits to the tax relief for employees; an age related % of salary limit and the total earning limit, or maximum amount of earnings considered for calculating tax relief, is €115,000 per annum.
Age-related percentage limit for tax relief on pension contributions
The most straightforward way to pay into a pension is through payroll. Your employer can deduct your contributions monthly and you will receive the tax relief at source. Employers are obliged to facilitate this for you, even if they do not offer a company pension.
However, some employers are reluctant to volunteer this information to avoid the administrative chore. The alternative requires you to claim the tax back each year and, in most cases, can be done with Revenue online.
Property rental income, investment income and dividends are not considered relevant earnings for pension contributions in Ireland.
Basic Rate Taxpayers
We frequently find people who mistakenly think that it isn’t worth paying into a pension if you are only a basic rate taxpayer. This is a very common mistake.
In fact, it still makes perfect sense to do this (and in some circumstances we recommend funding a pension with no immediate tax relief at all).
If you pay 20% tax and invest your money personally, you only have €80 out of every €100 to invest and typically any profits on this will be taxed at 41% every 8 years.
Whereas if you invest in a pension, €100 out of every €100 is invested. No tax is payable on profits while the money is growing in a pension fund. Therefore, all things being equal, you will have more money in the future if you save via a pension.
Those who are jointly assessed, with a spouse or civil partner who is a higher rate taxpayer, will effectively receive 40% tax relief on their pension contributions even if they don’t personally pay tax at the higher rate.
Exceeding Pension Contribution Limits
Does it ever make sense to exceed the pension contribution limits? Another common misconception is that the maximum possible pension contribution is somehow capped by the above percentages.
Although, this is de facto true in many public sector pensions due to the risk of overfunding, it isn’t in the private sector.
The maximum tax relieved contribution in any one tax year is limited by the age at the start of the tax year and the overall earnings cap. However, there is no limit on the amount that one may contribute to a PRSA, and unused tax relief can be carried forward indefinitely.
For example, Mary is 18 and studying at college fulltime. She has no earned income so “cannot contribute to a pension”. Wrong. She can.
He parents give her €300,000 tax free (no gift or inheritance tax) which she pays into a PRSA, where it will grow free from personal tax until age 50 when she may be able to begin drawing down on the fund. As a rule of thumb, the value of the pension can be expected to double every 10 years in nominal terms (not allowing for inflation) so by age 48 her pension fund could be worth around €2.4M.
Mary starts work at age 22 and expects to be self-employed for her whole career. Her earnings in the first year are €40,000.
The maximum tax relieved pension contribution she could make that year would be 15% of €40,000 = €6,000.
Mary paid in €300,000 when she was 18 but hasn’t yet claimed any tax relief yet, so she claims the relief for the €6,000 that she is eligible to make this year and Revenue will adjust her income tax by €1,200. The remaining €294,000 is carried forward to next year and the year after until it is all used up.
Additional Voluntary Contributions (AVCs)
Additional voluntary contributions (AVCs) are any contributions over the regular set monthly amounts paid into an occupational pension by an employee.
AVCs make sense for those accumulating post tax savings in cash, as they can save you tax and increase your retirement benefits. Beyond holding a small emergency fund, cash should generally be used to overpay debt or fund AVCs.
AVCs can be made for the previous year up until 31st October of the current year. You can submit a claim to receive tax back straight away. If you’re self-employed you can make a pension contribution to reduce your tax bill. This is why the month of October is often referred to as ‘Pension Season’.
We frequently find people who mistakenly think that the maximum possible pension contribution is the percentage shown for their age less what the employer is paying in.
This is a very common mistake. In fact, the employer contribution is disregarded when calculating the AVC.
So, if you are 42 years of age and you and your employer are both paying in 5% of your salary to an occupational pension scheme, the maximum AVC you can make is 25% less 5% = 20%.
Pay Down Debt or Invest
Once you have maximised pension contributions, should you pay down debt or invest?
As William Shakespeare said, “neither a borrower nor a lender be”. There is a lot to be said in terms of emotional peace of mind from clearing debts, and in particular expensive consumer debts like credit cards and car loans.
When it comes to mortgage payments, the financial arguments can be more nuanced, especially if you have a cheap tracker mortgage. However, with interest rates heading higher, if you have a large mortgage payment relative to your disposable income then paying down debt can make a lot of sense. We simply don’t know what mortgage interest rates will average in the future. Obviously, we don’t have a crystal ball, but if we look back into the past, we can see that mortgage rates have tended to be much higher than they are now with the average since 1975 being 8.18%.
Source: CSO.ieSo, if money is tight now with historically low interest rates you are probably going to struggle if mortgage rates were to increase. Therefore, all things being equal, paying down debt will save you interest at the average prevailing interest rate over the remaining term of your mortgage (rather than just at the rate today).
This is an important distinction to make since an online mortgage repayment calculator will work out how much interest you will save based on your current mortgage rate.
Generally, we advise against investing overpaying off a mortgage. We discuss this further here
Statement of Reasonable Projection (SORP)
A statement of reasonable projection is a statement predicting the likely future value of a pension from a defined contribution scheme or a PRSA. It is based on assumptions relating to future contributions and investment returns, and the cost of buying an annuity when a member retires.
In projecting the future value of your fund at retirement, your pension plan administrator or PRSA provider will have to make a number of economic assumptions regarding future investment returns, interest rates etc. It is important to note that any figures provided regarding your future benefit levels are only projections and you will only know the level of your retirement benefits shortly before you actually retire.
We face constant frustrations as Financial Planning practitioners when the pension regulations, intended to seek to inform investors, are clearly at odds with a different set of regulations governing our disclosure obligations. In practice this results in confusion and damaged trust in the investing process.
We have therefore developed a retirement projector tool to illustrate the key issues when planning for retirement
• How much you save
• For how long
• How much investment risk
Should I Stop Contributing?
My pension has reached €800,000 should I stop contributing? Another common misconception about pension planning that “I’ll just pay 40% tax in retirement so there is no point in saving more”.
There are no zero cost and zero tax options so you need to make a comparison between some different scenarios, all of which could leave a financial benefit.
1. Pay in and obtain the 40% tax relief, defer the pension to age 75. If you die before you reach age 75 your spouse or civil partner receives the whole value of the fund tax free - no income tax, no capital gains tax, no CAT and no penalty tax if you exceed the lifetime €2m allowance. Conclusion: you need life insurance with tax relief on the premium.
2. Gross roll up. Let’s say you invest in equities and the return is 7.2% pa net of charges to keep the maths easy. Now let’s say a fund held directly also pays 7.2% net of charges but is subject to personal tax. Your pre-tax €10,000 will be worth €20,000 in 10 years’ time. Whereas if you invest the net income that’s going to be about €5,000 which if you invest today, you will have €10 in the fund (rule of 72). You will then lose a further 41% in exit tax so €2,050 in tax. Net position €7,950 vs €20,000. So let’s assume that you always have a marginal rate of tax of 50% and that you’ve used up all your lump sum entitlement. Taking that €20,000 as a lump sum fully taxable at your highest marginal rate is still going to leave you with a net €10,000 compared to €7,950. In effect you received an interest free loan from Revenue and the difference is the gain on the income tax deferred. If you invest in something that’s subject to CGT you will be taxed at 33%. If you pay income tax, you will lose your marginal rate of tax (up to 55%). So a pension gives you gross roll up relative to any other option you will have a larger gross fund in the future and the longer you leave it the more this will compound in your favour.
3. Taxable lump sum. Even if you have a pension fund of €800,000 and can use up the tax-free lump sum, the next €300,000 of a lump sum is only taxable at 20%.
4. Not all of your pension is taxable. Imagine you have an ARF with €1m and you are forced to take an income of 5%, which is subject to income tax at your marginal rate of 40% plus USC. In this example, 95% of your ARF is not subject to tax. See earlier argument about gross roll up. Assume your ARF grows every year, so the value rises back to €1m. Effectively your ARF hasn’t paid any tax it’s constantly deferred. You are only paying income tax on the income distribution not the original tax deferred capital. When you die your spouse or civil partner inherits the ARF then adult children inherit at a rate of 30% which doesn’t count towards the CAT thresholds, so these are also available. Had you held those assets personally and the CAT thresholds had been used up then the kids would pay an additional 3% tax €30,000 tax saved
5. Match withdrawals with medical expenses. Imagine you have an ARF with a million and in your 70s you incur €100,000 of medical expenses. That year you should take a larger withdrawal from the ARF, partially to meet those expenses but partly because you can claim 20% tax back on medical expenses. That’s a €20,000 tax rebate.
6. Few people pay high rates of income tax in retirement because of allowances and reliefs. Note that when you are over age 66 you do not pay PRSI, reducing the deductions by 4% pa in retirement. A single person would need to have a pension income of over €120,000 pa before they have an effective rate of tax of more than the flat rate of Exit Tax (41% tax year 2022) that applies to most investments in Ireland.
Investing Your Pension
Don’t be too cautious! If you are under age 40, in our view, there is no real benefit in pursuing a low risk or balanced investment approach with your pension. Younger people should pursue a higher risk investment approach, ideally with 100% invested in global equities including emerging markets They have a time horizon of several decades and short-term moves in the stock market now will have no impact by the time of your retirement. This should be reviewed at around age 50, or earlier if you plan to draw some benefits from your pension at age 50 (see below)
It's often said that “diversification is the only free lunch for investors” and your equity portfolio should still be well diversified.
Although we all know that we should not ‘put all our eggs in one basket’, in practice many investors fail to diversify their investments sufficiently. Often the ways to accumulate significant wealth, such as leveraged positions in property, are often the riskiest and not the way to preserve your wealth.
As we reach retirement it is prudent to review the assets you have and seek to spread your investment risk.
