MAKING CENTS: How to make a great pension an even greater

An individual reached out to me last week with a question about his Defined Benefit (DB) pension. He admitted that he didn’t know much if anything about pensions but he knew what he had was a very good one.

He doesn’t pay anything into it because he was told he didn’t have to, but then someone mentioned AVC’s and how he should be paying into them. He was confused because he didn’t know what the benefit was.

That was the reason he made contact, and I’m glad he did and glad someone told him about AVC’s.

Which is why in this article I’m going to tell you what I told him and why paying into AVC’s was going to make his already great pension even better.

When it comes to a DB pension, the annual pension you receive is typically calculated based on 1/60th of your final earnings for each year of completed service. The maximum is 2/3rds of your final salary, meaning you’d need 40 years’ service.

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Some schemes will also allow you to take a tax-free lump sum, calculated at 3/80ths of your final pensionable salary. When it comes to your salary, they could base their calculations on an average of your best three consecutive years in the ten years before retirement or the average of your last three. It can vary from company to company.

Anyway, AVC’s, which stand for Additional Voluntary Contributions, are made by pension scheme members to increase their benefits at retirement. AVC contributions can be used for both Defined Contribution (DC) and Defined Benefit (DB) schemes.

And they really are a great tax-efficient way of boosting your retirement savings.

When it comes to DB pensions in particular, their big value-add is preserving the full amount the company is promising to pay you each year.

At retirement, you will typically be given two choices:

-An annual pension paid at normal retirement age, or

-A tax-free lump sum plus a reduced annual pension paid at normal retirement age.

So, if you decide to take a tax-free lump sum, your annual pension will take a hit.

The cost of taking tax-free cash can range from €9 to €14 for every €1 of pension you give up.

Let me show you what this looks like.

Let’s assume a person ends up with a DB annual pension of €33,000 at retirement and, based on their years’ service, is allowed to take a tax-free lump sum of €75,000.

They’d have two choices:

-An annual pension of €33,000 and no tax-free cash, or

-A tax-free lump sum of €75,000 and a reduced pension of €27,643.

(I’m using a commutation factor of €14 for every €1 of pension, i.e. €75,000/€14 = €5,357.

So, in exchange for an annual payment reduced by €5,357 every year, you get a lump sum of €75,000 instead.

But how do you (a) get access to that €75,000 tax-free money whilst (b) preserving your €33,000 per year?

The answer is by making AVC contributions.

You can build up a side AVC fund that runs in tandem with your DB pension so, at retirement, you use that AVC fund to take as much tax-free cash as you can without impacting your core annual pension.

So, if you save into an AVC fund, you can create a third option at retirement:

-n annual pension of €33,000 AND a tax-free lump sum of €75,000.

This is how you can enhance your DB pension.

Unfortunately, far too many people don’t understand that they can create this third option. They think a DB pension is a great one, and it absolutely is, but they can make it even better.

You (or the pension administrator of your company’s pension scheme) can easily work out how much of a tax-free lump sum you can take at retirement. This influences the amount you should target in your AVC fund and, therefore, how much you should set aside each year.

You can make assumptions yourself like I just did, but you can always verify the numbers with your pension administrator. They’ll be able to tell you, based on your current income, its trajectory and your years to retirement, what future tax-free lump sum you may be allowed to take. This will help you determine the contributions you should be making rather than blindly contributing an amount and finding out later that you under- or over-funded them.

It’s also important to check with the scheme provider that they will not force commutation of the pension, i.e. the only way you can get a tax-free lump sum is by reducing the annual pension they’re promising to give you. It’s not that common, but we have seen this before.

When it comes to a Defined Contribution (DC) fund, you are allowed to take 25% of the fund tax-free up to a limit of €200,000.

For example, if you built up a fund of €550,000, you can take €137,500 tax-free. The remaining €412,500 should be placed in an Approved Retirement Fund (ARF), which will be used to pay you an annual income.

If your fund is greater than €800,000 and the 25% amount you’re entitled to is greater than €200,000, the excess amount, i.e. the next €300,000, is taxed at 20%.

So, if your fund was €1,000,000, 25% is €250,000.

The first €200,000 is tax-free and the next €50,000 is taxed at 20%, meaning you’ll end up with total cash of €240,000.

Remember, no matter what type of pension plan you are a member of, whatever contribution you make towards a pension fund, including AVC’s, if you pay tax at the marginal rate, you are getting tax relief at 40% on the amount you invest.

So, for every €100 you invest, it’s only costing you €60.

If you made an annual contribution of €10,000, it would only end up costing you €6,000.

And think of it this way: if someone offered you €10,000 in exchange for €6,000 every year, would you take it?

Of course you would, and you should. You’d be mad not to.

Even if you never needed the additional monies in the future, you should still choose to make additional contributions, however big or small, because if you don’t, think of it as leaving money behind each year in unclaimed tax relief.

The majority of people I encounter, once they become aware of this, make those additional contributions. They typically come from part of an annual bonus, existing savings, vested stock, increases in salary, monthly cash-flow surplus or redirecting spending from other areas.

And sometimes people make the mistake of thinking that making pension contributions and saving into a regular savings account are one and the same. They really couldn’t be further from the truth.

Let me run the maths between both because it explains why they’re so different.

If you choose a savings plan route, any contribution comes from after-tax income, so you have to pay PRSI, USC, income tax etc. first.

If you save, for example, €10,000 each year, this is effectively costing you about €19,607 each year. You end up paying tax at a rate of 51%, i.e. income tax 40%, PRSI 4% and USC 7%.

Whereas the same contribution to a pension fund is costing €6,000.

So, it’s the same €10,000. It’s just that the non-pension route is costing you €19,607 and the pension route €6,000.

Clearly, the pension route is the better option regardless of whether you are a member of a Defined Contribution scheme or a Defined Benefit one, for all the reasons I’ve just outlined.

Liam Croke is MD of Harmonics Financial Ltd, based in Plassey