This week we are hoping to answer several questions we have had from listeners in the past 6 weeks or so. It has been put to me that it would be valuable to share our thoughts and to explore whether it would be more beneficial to invest in a low-cost investment plan, achieve a decent level of return and pay whatever tax is due on withdrawal, or to invest into a pension, achieve the same level of return, pay what tax is due on withdrawal.......on the face of it, to me at least, it seems there will be no competition, but you know what they say about assumptions (My favourite quote about assumptions is...... 'Don't Make Assumptions'!)
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Invest or Pension......?
To be frank when I sat to do this analysis I wasn't sure where to start, I may have resembled the confused looking dog on the cover for a while initially! It is not a question that I have ever really been asked before in detail, so it took quite a lot of thought! The essence of the questions that I have received from listeners is, factoring-in the potential returns, fees and taxation of the 2 options, which one will yield greatest net return, an investment in a low-cost fund (if such a thing actually really exists!) or a pension in a regular managed fund!? We are making one BIG assumption here, and that is that in the investment you are paying low fees and in the pension you are paying high fees. I say this is an assumption because this is not always the case of course.....but it was the question posed so let's take it head-on!
For the purpose of the analysis here we will assume you are going to pay €500 per month (not increasing with inflation) into either a Personal Retirement Savings Account, or an online Regular Savings ETF over a 20 year period. We will assume 6% Gross return per annum for the duraton. At the end of that period we will see how fund values compare in Net terms....
Fees on the PRSA in this illustration are the onerous and murky sort, an allocation rate of 97% (even-though we still see a lot of 95% allocation rate stuff out there, which is hard to swallow), and a quoted annual management charge of 1% (but which is in reality much more likely to be at least 2%) so we're going with 2% for this illustration!
On the other hand the fee on the regular saver is 0.5% per year, all-in/Total Expense Ratio/Ongoing Charges Figure, or whatever you wish to call it!
The low cost fund that was referred to was an Exchange Traded Fund. We have covered ETF's a few times previously (here & here), and there are aspects of them that I like. One aspect that is regretful is the fact that people automatically perceive the fees on ETF's to be 0.00001% or something, and that you pay little or no tax on the gains, this may be the case if you live in the USA!.......The simple fact is that we do not live in America (yet!) and we do not have access to the same options that they do over there.....indeed we can't (in the strictest sense) now access US ETFs as a direct result of PRIIPS Regulation as of Jan this year. As a result if you do invest in an ETF, either via a financial advisor or directly through a broker you'll most likely be investing in an Irish or EU based ETF, meaning you will pay 41% Exit Tax on any gains you realise, and you will pay somewhere in the region of 0.5% annual fee for the fund depending on what you opt for.
In addition if investing directly into ETFs on a regular basis, you will need to track which units you buy each time you invest, and track those and then pay the exit tax (from the fund or from your own cash) on the 8th anniversary of those units being purchased. How anyone would hope to do that in a way that is less than a total nightmare is beyond me, and I have digested A LOT of the online material on the subject! There is so much confusion on the topic, and it is no wonder when Revenue typically only issue 'guidance' on aspects of the subject!
At Year 8:
Contributed = €48,000
Fund Value (@5.5% Net Growth Per Year) = €59,785
Tax Payable @ 41% = €4,797
At Year 16:
Contributed = €96,000
Fund Value (@5.5% Net) = €151,537
Tax Payable (having already paid exit tax at year 8) = €17,900
At Year 20:
Contributed = €120,000
Fund Value (@5.5% Net) = €214,400
Tax Payable (having already paid in year 8 and 16) = €22,600
The end result therefore (in this simplified and linear growth example) is a total fund value of €214,400, which is a sizeable pot based on €500 with no indexation over a 2 decade period. When we deduct the tax paid over the period of €45,297 = €169,103 Net
This example does not take into account the impact of time on an investment, nor indeed the impact of diminishing the real value of the tax that was paid 12 and 4 years prior to the maturity of the account...
The Pension Route:
Major advantage that is often referred to is the fact that a pension pot can grow totally tax free while it remains in the pot, it is only on draw-down that you will be faced with your options and potential taxation of any income you draw from it.
Again, we are assuming that you are being 'charged' an allocation rate of 97%, meaning only 97% of what you invest is being invested, the 3% being taken as a charge. We are also factoring in 2% annual management fee, which has the impact of reducing your annual net growth to 4%. We are not allowing for a Bid/Offer spread on the fund price (I saw another recently at 5%, which also had 95% allocation rate, plus an additional 1.8% management fee, border-line theft).
At Year 20:
Contributed = €120,000 (same as above)
Fund Value (@4% Net)= €176,000
What strikes one instantly here is the fact that the higher annual fee and the 97% allocation rate has a dramatic impact on the final value, and on the face of it would make a pension route seem nonsensical, but there is more! We have failed to note that in this illustration the investor is a higher rate earner, and so is paying 40% income tax. She therefore can claim relief on her contributions, meaning the €500 per month is only actually costing her €300 after relief. The overall impact of that relief means the effective cost of that €120,000 total contribution (assuming 40% Income Tax Rate Payer) is €72,000.
Another way of looking at it is that the same investor could have invested €200,000 over that period (€830 per month) and it only cost them €120,000, or €500 per month which would give a final pot value of €286,000!
We could draw the line here and say that charges (as we already know and have analysed previously) have a large impact over the long term. However we want to go one step further and look at the practicalities of this investor actually taking cash out of the pension from here!
In this illustration we will say that she can take 25% of her lump sum value totally tax free, meaning €44,000 on the spot. We are then also going to assume that she has the required €12,700 of 'guaranteed income' from other sources which allows her to invest the remaining €132,000 in an Approved Retirement Fund. From there (she is now 66) she will withdraw (and pay tax and USC) 5% per year for the next 30 years. And because she is a very shrewd and wise investor she continues to leave the pot in a fund which historically has delivered well in excess of the 5% income she intends to draw from it!
Over the next 30 years she take €6,600 (5%) from the pot, thanks to her credits, allowance and minimal other income she pays an average of 10% income on this pension income, and so over the remaining 30 years of her life she draws a further €180,000 or so net income from her fund.
And to cap it all off when she passes away at 97 the ARF (thanks to the constant upward curve of equity markets which she has remained invested in) is then valued at €315,000. This passes to her 3 children, who yes pay 30% income tax on the benefit (being over 21 years of age), meaning the ARF which sustained her throughout her 30 years of retirement now gets passed to the next generation relatively unscathed at €220,000, whereby they can then reinvest it and the magic begins all over again!
The Net income taken from the pension pot in this instance, when we factor all of the above into account (and not including the growth it will provide for the next generation) is now totalling something like €460,000!!
We have made lots of assumption here! No 1 option is going to lead to a perfect predictable outcome. Indeed while pensions may appear to have been the winner in this instance we all know that pensions are not perfect, the fees are not perfect, the structures are not perfect. However, when approached with fact-based assumptions based on what has gone before, and by utilising the rules and opportunities that exist there is no denying their superiority as a tool to give one the possibility to live a dignified life in retirement, avail of income tax efficiently, and ultimately to pass a meaningful legacy to the next generation.
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