Personal Finance

The beginners’ guide to pensions

...
Image
Image Daragh Cassidy
Head Writer

In this guide we give you the lowdown on all the basics you need to know about pensions.

Never the sexiest of topics, let’s be honest, but an important one nevertheless. 

We could spend up to a third of our lives in retirement so it’s important to plan for it accordingly, even if it always seems like something that can be put off until another day...

What is a pension?

A pension is simply a long-term savings plan, the goal of which is to build up a big lump sum of money that you can live off when you retire. 

Pension plans can go by many different names and all the jargon around them can be quite off putting for people. But the goal of every pension is the same - to help you provide for your golden years. 

Why should I save into a pension? 

So that you can live comfortably in retirement - something which the State pension alone won’t allow you to do.  

Most experts recommend that you need a pension of at least half your pre-retirement income in order to live comfortably in your golden years. But two-thirds is best. 

The average full-time wage in Ireland is now around €48,000 - this means you'd need an income of at least €24,000 in retirement, but around €32,000 or two-thirds of income is better.

The current State pension is just under €13,000 a year, which means most workers can expect to experience a significant drop in their living standards unless they make their own provisions for their retirement years. Plus there's no guarantee that the State pension will even be around in a few decades' time as it becomes increasingly unaffordable due to an ageing population.

Central Statistics Office statistician James Hegarty recently warned the government-appointed Pensions Commission about this ticking pensions time bomb when he outlined how there are currently five working age people to every one person over the age of 65. However by the year 2051 this will fall to just 2.3 people for every one person over 65.

In short, people need to start making their own plans for retirement. 

The good news is that saving into a pension is one of the most tax-efficient things you can do with your money. 

Why choose a pension over a normal savings plan? 

To encourage people to save for their retirement, the Government has made pensions a really tax-efficient way to save in three key ways.

1. Tax-free growth

Your pension savings are able to grow tax-free. This means you are able to avail of compound annual growth or “growth on top of growth”. 

With a normal savings plan, you’ll be charged DIRT (currently 33%) once a year on any gains you make. With a life insurance plan (a popular type of savings policy sold by life insurance companies that invests in things like stocks and bonds,) you’ll be charged exit tax (currently 41%) every eight years. 

But with a pension your savings can continue to grow tax-free for decades. 

Take a look at the simple example below. 

David and Seán both have €10,000 to invest. David places his money into a savings account while Séan places his into a pension. At the end of five years, assuming growth of 3% a year, Seán is up over €500 due to compound growth. 

David savings plan: taxed yearly at 33% 

€10,000

Seán pension plan: tax-free growth

Seán - €10,000

After year 1

€10,201

After year 1

€10,300

After year 2

€10,406

After year 2

€10,609

After year 3

€10,615

After year 3

€10,927

After year 4

€10,828

After year 4

€11,255

After year 5

€11,045

After year 5

€11,592

2. Tax relief on contributions  

What if I told you there was a simple way to pay less tax on your income. You’d be interested, right?

Well that’s exactly what a pension allows you to do. It allows you to earn more money free of income tax - as long as you put that same money into a pension. 

This means if your top rate of tax is 20% a €200 pension contribution each month will only cost you €160 after tax. If your top rate of tax is 40%, a €200 contribution will only cost you €120 after tax.

Take a look at the simplified example below. 

Both David and Seán earn €3,000 each month. But because of the tax relief that’s available on pension contributions, even though Séan has made a €200 contribution into his pension, he is only down €120 after tax compared to David. 

David monthly salary*  

€3,000

Seán monthly salary*

€3,000

Tax at 40%

€1,200

Pension contribution 

€200

Take home pay

€1,800

Taxable salary 

€2,800

Tax at 40%

€1,120

Take home pay

€1,680

*in reality not all of David and Séan’s salary would be taxed at 40% as some would be tax-free while some would be taxed at 20%. 

3. Tax-free lump sum

When you finally reach your retirement age and want to access your pension savings, 25% of it can be taken as a tax-free lump sum up to certain limits (the rest you can then use to buy an annuity or more simply a pension for the rest of your life). 

Pension tax-free limits

There are limits to how much of your salary that you can save into a pension tax free, based upon your age.

Age Percentage limit

Under 30

15%

30-39

20%

40-49

25%

50-54

30%

55-59

35%

60 or over

40%

For example, if you're 40 and earning €40,000, you can get tax relief on pension contributions up to €10,000 a year.

What's more, only earnings up to €115,00 are taken into account. 

Company pensions

Bigger employers, but many smaller ones too, will often have their own pension scheme (called a group pension scheme) which you will usually be invited to join upon starting your job.

If your employer doesn’t have its own group pension scheme or you’re not allowed to join it, then they must provide you with access to at least one standard Personal Retirement Savings Accounts (PRSA) into which you can save for your retirement. 

If you sign up to a pension scheme through your employer they will deduct your contributions each month directly from your salary and the tax relief explained above above will apply automatically. 

In many cases your employer will also contribute towards your pension for you too - but usually only if you contribute something as well. Most employers offer around 5%, sometimes more. This means if you earn €40,000 a year they’ll put in €2,000 a year for you, which is nothing to be sniffed at. And you won’t pay any tax on this money either.

This mix of tax-free growth, tax relief on your pension contributions, and contributions from your employer make a pension by far the best way to save for your retirement. 

What pension should I join?

Your options will depend on your work situation. If you are an employee you may be able to join a pension scheme run by your employer as outlined above.  

Employees in the public sector can join their public sector pension scheme. The self-employed can take out a personal pension. 

Meanwhile PRSAs are open to virtually anyone to save for retirement.

If you’re currently in a job and aren’t contributing towards a pension, ask your employer about saving for a pension today. 

When should I start a pension?

The earlier you can start paying into a pension the better, even if it only means you can save a small amount each month.

That’s because the longer you leave it, the more expensive it gets.

Let’s say you’re aiming to build up a pension fund of around €265,000, which would give you a pension of around €20,000 a year (which includes the State pension of about €13,000) as well as a cash-free lump sum upon retirement of €66,250 i.e. 25% - the maximum amount you’re allowed to take. 

Here’s what you would need to save each month to reach your retirement savings goal at 68.

Age 

Before tax relief

After tax relief

Approximate savings

25

€400

€240

€265,000

35

€565

€339

€265,000

45

€870

€522

€265,000

55

€1,800

€1,080

€265,000

As you can see, the later you leave it, the harder it gets to meet your goal. However these amounts don’t include any contributions that your employer might also make, which could ease the savings burden. 

Note these figures are estimates only and are based on certain assumptions such as your monthly pension contribution increasing by 2.5% each year up until your retirement age and growth of 5% per annum before charges.

Access

As a pension is for your retirement years, in most cases you cannot access the money in your pension until a certain age.

Depending on the type of pension plan you are saving into, this age can be anywhere from 50 to 66 usually. 

So don’t put money into a pension if you think you’ll need it a few years later for a rainy day. 

As it stands the qualifying age for the State pension is 66 but it was due to rise to 67 in 2021 and then 68 in 2028, however the increase has been postponed for now due to political wrangling. 

However if you are currently under the age of 50 you can be guaranteed that the qualifying age will be at least 68 by time time you reach retirement, if not higher.

Where does my money go?

When you save into a pension your money usually gets invested into a mix of stocks, bonds and property. Some pension funds will also invest in commodities such as coal, oil and gold. This is because these investments provide the potential for far higher returns than simply keeping your money on deposit.

If saving for a pension through your employer, they should be able to provide you with advice on all the funds available to you. There is often what's called a ‘default investment fund’. This is the fund that’s recommended by the pension provider and its investment mix will change every few years as you get closer to retirement. 

However you don’t have to choose this fund and will usually have flexibility about where your money is invested. You can also spread your money - so if you want 25% of your savings each month to go into the default investment fund, and the remainder to go into a fund that invests solely in property, for example, you can choose this.

As always, make sure you get good financial advice about where you invest your money. 

Pension fees and charges 

Your pension provider will charge a fee for managing your money. 

Fees and charges can have a huge impact on the value of your pension fund over a long period of time so it’s important you pay close attention to these.

The charges can vary but are usually one or a mix of the following:

  • A fund management charge or annual management charge (AMC): 0.5% to 1.5% on average, which is levied on the value of your savings each year. Different funds can have different charges.
  • Entry fees/entry charge: from 2% to 5% of contributions usually. This is a charge on the money you invest. So if you invest €100 a month into your pension and there is an entry charge of 5%, it means only €95 is invested. Sometimes this may be referred to as an 'allocation rate' of 95% instead. The higher the allocation rate the better and some of the better pension plans may even provide 100% allocation.
  • Policy fee: a fixed amount per month: usually €5 or so to cover administrative charges.

Some funds can charge higher AMCs of well above 1% with the promise or lure of higher potential returns. However research has shown that over several decades, most funds end up tracking the wider market anyway and that the biggest bearing on the value of your pension fund upon retirement will be fees and charges (and how much you’ve saved too of course). 

So in general, the lower the fees the better. 

Leaving a job

When leaving a job you’ll have various options as to what to do with the pension you have saved with your employer. 

However a key point to remember is that if you have been saving into a group scheme for less than two years, your employer will usually refund you the money you have saved minus any money they may have also contributed. In other words they’ll kick you out of the scheme and it’ll be as if you were never saving in the first place. 

This is an important thing to consider if you are thinking of leaving your job after less than two years or so.

Get in touch

Do you have a pension or are you thinking of starting one? Do you have any questions we haven't covered?

Get in touch in the comments below and we'll get back to you!