19th November 2018
It was in conversation with a friend recently, who has just started working for a new company, that I was asked if I believed it makes any sense to join a pension scheme offered by an employer. He was told that if he put 4% of gross salary into his pension that the employer would put 6% in, totaling 10% of his gross salary. This seems like a reasonable offer from the employer in this Defined Contribution scheme however he had concerns which he shared with me!
Having done a little of his own research he had concerns about the fees that he had read of, concerns about the fact that ‘you could get back less than you invest’, and the mystery about how one goes about taking the money out at the end. These 3 very real and very common questions and concerns lead to, I guess, many people not engaging with pension, and without answers to those questions I wouldn’t blame them for a second!
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In trying to answer the question ‘should I join my company’s pension scheme or not’ it might be worth taking each of the 3 questions, not with a view to finding an answer in the affirmative but a considered and credible answer!
Concerns About Fees:
First things first, you get nothing for nothing, and pensions are the same. I won’t go as far as to say that you get what you pay for because we frequently come across cases where investors are paying waaaay above what they should be and are getting no value for that extra fee they pay. We’ve discussed the impact of fees on your pensions and investments in a past blog, worth a read perhaps.
If you are going to go and set up your own pension, be that a Personal Retirement Savings Account (PRSA) or a Personal Pension, into which both you and your employer will contribute then you could be facing some saucy fees! Depending on where you source your pension and what type of funds you invest in you could be faced with a double-whammy. One is what is known as an ‘allocation rate’, which essentially means that only a certain percentage of your savings each month are allocated to your pension pot. The minimum allocation rate that you should see on these contracts is 95%, as in, they keep 5% of each and every monthly payment you make. Some providers, depending on where you buy your plan, will offer 97%, 98%, 99% or even 100%…….if I have explained this clearly then you’ll know you really do want to be on 100% allocation rate, meaning every cent you invest into your plan is invested.
In euro and cents terms, if there was €1000 going into your pension scheme each month, between you and your employer, 100% allocation, the amount invested wasn’t increasing each year, and if that fund grew at 6% each year, after 20 years the fund would be worth €453k or so. If the allocation rate was 95% and all else was the same the end figure would be €430. The allocation rate here reducing your final pot by €23k,
The 2nd and more believe-it-or-not more impactful of the 2 main fees is the management charge applicable. Again this is one that we have covered in the past and has such a significant influence on your final pot-size is so often over-looked by investors. Interestingly there was a piece of legislation introduced in EU this year that means an insurance company is obliged to tell you exactly what fees you are paying on a yearly basis. This legislation however only applies to investments in retail investment products and not pension funds, meaning it can be hard to determine exactly what annual management fees are relating to your pension fund.
For instance your pension provider may be telling you that you are paying 1% per year annual management charge on your pension, however that may or may not be the full picture of fees. For the sake of argument let’s assume it is 1%. Using the same example as above, getting 6% return, investing €1000 per month, 20 year duration, you’ll end up with a pot of €453k if there was no annual fee, €405k if the fee was 1% per year, and €363k if it was 2%. A massive difference and worth doing some homework to try determine how much you are actually paying, and whether you are getting some ongoing planning/coaching/guidance for what you are paying, or not!
If you are getting your PRSA or Personal Pension through an existing employer scheme then there is a strong chance that you will benefit from a very high allocation rate and a low management fee, often below 1%. The impact that these fees can have is significant so do your homework before committing!
Will I Get Back Less Than I Invest?
Eh, possibly. In reality it is only due to Consumer Protection Codes that this warning is put on financial products, however there is always a danger that you could get back less than what you put in. It is statistically almost impossible, based on historical returns (which are not guarantee of future returns of course!) that over any 15 year period or more in a well diversify equity portfolio the value would be less than invested, however when it comes to pensions there are lots of variables to consider. Many pensions now have ‘default’ strategies which will move a large portion of your pension pot into ‘safe’ funds as you near retirement to try protect you from falls as you approach retirement. We covered this ‘lifestyling‘ in the past, and it has its pros and cons. It may benefit you or it may hinder you depending on the timing of your retirement.
Fees and inflation can have a large impact on whether you get back less than you invest, particularly if you pick funds which do not deliver a meaningful return over time. We did not factor inflation in the above calculations however lets assume that inflation runs at 2% average over the 20 years that you are saving into a pension pot. Lets now assume that you are also paying the equivalent of 1.6% in fees (annual mgt charge and allocation rate combined). In total your fund is essentially being eroded by 3.6% every year on average. If you are invested in a fund option within the pension that is a ‘low volatility’ fund, based on your results of a Risk Questionnaire or because you didn’t want to invest in ‘risky’ funds then you may well find that you do not achieve 3.6% or more growth per year average. The impact of this of course is that your pot is losing purchasing power over time.
Another concern that many have is that if they do invest in ‘risky’ funds that the markets will fall just as they retire. This is possible for sure, however over the past 100 years the average period that markets remain ‘fallen’ is just over 2 years, after which time they have always recovered and gone above and beyond where they were before the temporary decline. The reason this has been significant is that when one retires they did not have to take, indeed quite often couldn’t take, the full value of their pot right then and there. If they were retiring and due to take their tax free lump sum they typically had the option to wait until the markets recovered before taking their lump sum from the pot, if they wished. That is a strategy that was rarely used but was available to all! Indeed if one really had to take the tax free lump sum at retirement date but at the same time wanted to keep the bulk of their pot in ‘risky’ funds (funds which delivered almost double-digit average annual returns the past century!) they could keep 25% of their pot in conservative funds and the balance in the funds which delivered the goods. The impact of this was that irrespective of what the more volatile funds were doing at point of retirement their 25% lump sum would have been steady and worth (hopefully) what they paid for it.
Ultimately there is always the risk that you could get back less than you invest, even if you pick the lower volatility funds (or perhaps especially if you pick the lower volatility funds!). There are ways that you can mange the risk of getting back less but you can never fully guarantee against it, it is part and parcel of life, just like you can’t guarantee that YOU will be here when the time comes to take the money!
How Do I Take My Money Out?
This, in my mind, is the single-most important and probably least understood aspect in the whole ‘should I do a pension’ question. It is quite often misunderstood and misrepresented…..lets put the record straight! We have referred to this in the past too in a another Blog, episode 16 back on January 4th 2017, nearly 2 years ago now!
With interest rates where they are using your pot to buy an annuity/pension for life from a Insurance Company is representing very poor value for most retirees and so they aren’t touching it. Interest rates will change in future and annuities may become a more attractive offer however for now they simply aint! That means that the following option is the most practical for people at present.
You are earning €50,000 gross salary from your job, not including bonuses or car allowance. You have signed-up to the company pension and are saving 4% of your salary into it. This is €167 per month but after tax relief is only costing you €90 approx if higher rate tax payer or €130 if lower rate payer. Your employer is contributing 6% (€250 per month), so there is €417 going into your pot every month, and it is costing you €90! You are getting an allocation rate of 97% (meaning the insurance company are keeping 3% (€12.51) of each monthly amount. You are paying 1.3% of an annual management fee.
Do that for 20 years, achieving 6% gross average return on your pension fund and you will have in the region of €210,000 in 20 years time. Taking into account inflation at 2.5% average, that would have the purchasing power of €128,000 today. May or may not sound like a lot of money to you, either way those are the sums!
From the €210k, based on current rules, they could take 25% of that tax free, or €54k. Providing you have a minimum ‘specified income’ (or guaranteed income from another source) of €12,700 you can then put the balance into an Approved Retirement Fund. If you don’t have the €12,700 guaranteed (from State pension or other) then you are obliged to put €63,500 into an Approved Minimum Retirement Fund and leave it there till you are 75, which would put a fair dent in your accessible pot.
So lets assume you can put the remaining 75% into an ARF, you do that, and you are then obliged to pay tax as if you are drawing 4% per year, so you draw 4% per year. Your 75% equates to €156k, so 4% of that is €6,240 per year of income draw-down per year, or €520 per month. Depending on your circumstances you will pay 20% or 40% income tax on that plus PRSI and USC, so one would be netting in the region of €350 or €250. In today’s terms that is equivalent purchasing power of €213, or €152, again assuming 2.5% average inflation over the 20 years.
One of the ideas with an ARF is that your fund will remain invested and continue to grow so that your withdrawals are being covered by the returns, leaving your pot intact and then becomes a legacy which you can pass to your loved-ones on your death. Sequence of returns has a huge influence on this, and that’s something we looked at last week, if of interest!
It is important to note that the above calculations are all assuming that you DO NOT increase your savings into the pension each year in line with inflation, which you really ought to do as it can and will make the figures look a little better!
The figures may sound pretty crappy to you, or they may sound OK. Either way it is worth noting that for the price of €90 per month for 20 years a higher rate tax payer is building a pot of €210k, assuming the above returns and fees. And really interestingly, of that €210,000 they have contributed a grand total of €21,600 themselves! The rest, the other €200,000-odd has been delivered by growth and employer contributions……..so if you were going to slate pensions and claim that they are a farce and a scam then perhaps this might give you some food for thought!
Pensions aren’t perfect, there is a lot of confusion and concern, there are a lot of questions that people should seek answers to before committing, however there is no denying that there are some very positive upsides too that can go a long way towards supporting someone as they transition out of full time employment and go off to live the dream!
QFA |RPA | APA | Exec Coach
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