Should I invest in a pension or save money in a bank account!?
Last week I shared some ideas about the value (or potential lack thereof) in having a pension of 'average' size. The reaction to that piece was really quite interesting; it seemed to have surprised some people! There is no question that €100,000 is a lot of money, no matter what way you slice it however having that in a pension fund at the point of retirement leaves one with, to be fair, quite limited options to access a meaningful withdrawal income. In last weeks' piece I referred to a previous blog we shared about the value of amassing a pension pot of €1m, and the considerable options that offers one at retirement. That got me thinking and so this week I take a hearty stab at comparing the merits of saving into a regular deposit savings account, or into a pension if one was aiming for a lump sum of €1m! We will explore which of these in this 2-horse race, in Net terms stands to offer you the best possible chance of success. This is not something that I have never seen done before, maybe there's a reason for that.....let's see!
Any analysis/projection such as this will carry a whole host of assumptions and defaults. It really is not an exact science, as much as we might like it to be! All the major factors which will impact on the bottom-line results will be variable, fluctuating and uncertain. For the purpose of the initial comparison the below are the assumptions we are working with;
Deposit Interest Rates - 1.5% Gross Return per year average
Deposit Growth Tax Rate - 35% DIRT tax
Inflation - 2% per year average
Pension Contribution Tax Relief- 40% (No relief for USC or PRSI)
Pension Fund Growth Rate - 6% Gross
Pension Charges - 3% 'Contribution Charge' & 1.8% Total Fund Charge per annum (we're being conservative here!)
Pension Draw-Down Rules & Tax Rate - See Example!
You may be far from it but for the purposes of this example I am going to assume that you are 45 years of age, and your name is Sam! You are earning a decent income of north of €100,000 per year, and things are pretty good. Up to this point you have done only a reasonable amount of saving or deliberate provision for your retirement years, preferring to live in the moment and spend your income on stuff and things!
But you have now reached a point where you are wondering what you should be doing to make the most of your current situation, and prepare for when you do decide to stop working full-time. Everywhere you look you see pension adverts from the big providers, your mates talk about it when you socialise, and you are feeling the pressure to start a pension of some sort and begin preparing, but you just aren't sure....so let's try help! You are determined to have €1m saved, put aside by the time you reach 68........and are unsure of how best to do it, deposit account or pension.
Deposit Savings Account
When we are saving personal funds into a deposit account we are obviously using 'after tax' funds, as in we have paid income tax, USC and PRSI on the money we save, and hence, in this scenario half of what the funds were when they were Gross Income. If we are working on the assumption that you want €1m in your deposit account by the age of 68 we can work out how much you need to save per month between now and then in order to reach that goal.
If you are achieving 1.5% Gross return on a regular savings account, on average over that period and the rate of DIRT is 35% on average, the net return achieved on your savings is 0.975%. Based on those assumptions you will need to start saving €39,000 per year starting right now, or €3,250 per month. Those of you with an eagle-eye will observe that this €1m that you are accumulating in 23 years from now is not quite the same as €1m today, particularly given we are assuming 1.5% inflation over those years, but we will get to that soon! Pick this route and you will invest €897,000 of your own after tax income to build a pot of €1m, interest (after DIRT tax) adding €103,000 to bring the funds to the magic €1m figure.
Accumulate €1m in Pension Fund:
If we apply the same logic to a pension fund saving of €1m we need to factor in the variables of a pension; the charges, the growth rate and the tax relief available. We are assuming a 97% allocation rate (meaning 3% of each contribution is taken by the pension provider - which can be avoided if you pick your provider well, but we're leaving it in here for realistic figures-sake). We are also assuming you are paying 1.8% per year on the value of your fund which has the impact of reducing the 6% quoted growth to 4.2% annual growth. Based on all of this we can factor that €28052 is the annual sum that you need to save into that pension, or €2,337 per month. After the 3% fee is taken on each monthly payment, and the 6% growth, less the 1.8% fund management fee, will deliver a pension pot of €1m in 23 years from now.
If you pick this route you will invest €645,012 of your own, with the interest (net of charges) adding the other €355,000-odd to bring your pot to the €1m mark. This route suggests that you will need to invest €252,000 less that if you were saving in a deposit account, in order to reach the desired pot size; that's just shy of 30% of an advantage you would have in reaching the target pot size. Worth noting that the driver of this positive difference for pensions is the ability of it to achieve a return of 6% or so, which a 'high risk' fund traditionally has done (at least). Opting for 'lower volatility' funds have not usually gained these levels of returns but still carry the same level of fees! Go figure!
What Tax Relief Could I Get On A Pension?
And now for the real 'kicker' in this debate! Under current revenue rules you can, at 40-odd years of age, contribute up to 25% of your gross income, and claim full income tax relief on what you put into it. The max income on which you can claim that 25% relief on is €115,000. In your case we are saying that you earn the €115,000, and so you contribute €28,052 per year, entitling you to the max relief possible.
If you contribute €28,052 per year to your pension you will get 40% tax relief on that payment. Revenue will give you relief of €11,501, meaning you will have €11,501 less tax to pay each year, and in essence a rebate of that amount each year. The net effect of that is that when you pay €28,052 into the pension it is costing you, in real terms only €16,551.
When we factor in the tax relief, you will have actually paid a grand total of €380,673, when combined with the tax relief, and combined with the fund returns would, in this scenario, deliver the €1m pot! When you look at it this way is essentially true to say that you are almost tripling your money over a 23 year period even by achieving 4% Net Returns (6% less 2% fund fees). Interestingly it will definitely and fully triple if you can get the fund fees to 1%, and remove the absurd 'allocation charge' which is all-too common in today's market. Do that and you would have near €1.2m of saving the same amount, thanks very much!
Back on track, based on where we are at now you can say that in saving €1m Sam is going to be over €500,000 better-off if saving it via a pension, given the assumptions we are working off
Drawing-Down From A Pension Versus a Deposit Account:
Up to now the pension route has been by-far the most favourable option at this stage, but we now need to navigate the small matter of drawing the pots down.
With a deposit account it will be very straight-forward, you can walk into your bank, credit-union or online and transfer the money to you current account as and when you need it essentially, and spend it as you wish. Not so simple when the funds are in a pension, and this one can cause a lot of confusion!
If things remain as they are when you get to 68 years of age with a €2m pension pot you can take 25% tax free (subject to a max of €200,000), with another €300,000 and pay only 20% tax on that lump sum. That accounts for €560,000 of the pot, of which you get €500,000 of into your bank account to do as you wish!
In this case we have €1m of a pot, and so take a different tack. Here he can take 25% (up to max €200,000) and then an additional €50k at 20% tax, meaning €250,000 in the hand and paying €10,000 tax. So what about the remaining €740,000 in the pension pot? Well, as you will have read last week, unless you have a minimum of €12,700 guaranteed income from State or other pensions (we'll assume you don't) you will need to park €63,500 until you reach 75 years of age in an AMRF. So now there is €676,500 remaining in your pot which needs to be allocated somewhere. With this you can either hand it over to an insurance company in exchange for an annuity (very few are opting for this route based on current annuity rates!). So we'll assume you take 'Option B' here, and invest the €676k in an Approved Retirement Fund and draw 5% per year, or €33,825 per year ( you could take a lot more obviously but that's all you need to live the lifestyle you seek in this example, plus you also have €250,000 cash you just took out to keep you going!).
If you are over 65 (which you are in this scenario!) and are married or in a civil partnership (which you are in this scenario!) you can earn €36,000 per year Gross before paying income tax. As you are entitled to the State Pension (€243) and your partner is classed as a 'Qualified Dependant' (€162), you have a joint income of €21,080 per year from State Pension.
When you also start taking the 5% from your ARF (€33,825) you now have a total income of €54,905 pushing you over the tax limit of €36,000. You would therefore essentially pay 20% tax on the amount over the €36k, which is 20% of €18,905, meaning you will lose €3,780 approximately per year to tax. If we assume that such a fund as we have in the ARF stands a 78.4% chance of outliving you if we assume one of you will live to 90 (25 years), we are working on the basis that you WILL live 25 years and therefore draw these funds for 25 years. I have also allowed for another hefty fee of 2% on the ARF during retirement. The result of this calculation is that over the course of the 25 years you will lose €94,525 in tax over these years.
Phew, so what does all this mean in euro terms I hear you ask!? Well, out of the €1m pot you got €250,000 lump sum and then an annual amount of €33,825, for 25 years (not forgetting that during your retirement the funds were still invested in the same growth oriented fund it was in when you were accumulating, it's the only logical way!). You did pay some tax, €10,000 on the initial lump sum, and then another bit each year for 25 years of retirement as a result of your income being pushed over the €36,000. Total tax payable therefore totals at €104,525, which on a €1m pot is an effective rate of 10.4%, which isn't terrible by any means!
So Is It Better To Save In A Pension Than A Deposit Account?
Last week I was slating the average pension pot, and this week it looks like, in this scenario at least, a pension is a far better mechanism in which to save a large pot of money.
In figures terms, based on the assumptions we have used here, it stands at:
Amount of savings required to build €1m in a deposit account: €897,000, and you will have total unobstructed and un-taxed access to the €1m.
Amount of savings required to build €1m in a pension pot: €380,673, and you will have to pay tax, and a little bit of jiggery to get your money, paying tax of €104,000 approximately; equating to a total cost of €484,000 to accumulate the €1m. Pension wins, in a straight-financial-shoot-out at least, by over €400,000!!
Pensions are far from perfect, access can be messy and confusing, fees can be ridiculously higher than they ought to be or can be, you might not get the growth you need or hope, you might not stick to the plan or your plan might change on the back of changes made outside your control........Likewise deposits are great in lots of ways, they typically do what they say on the tin, granted the rate of return isn't a world-beater typically but it stacks up on several fronts. I guess nothing is perfect, there are no guarantees with anything, but if you are wondering if a pension or a deposit account might be most worthwhile route in building a sizeable pot of money for your future self then, on these assumptions at least, there is only one winner in this particular race!
As always send me an email with any ideas, suggestions or questions that you have, love to hear from you.
Paddy Delaney QFA | RPA | APA | Coach