Many Directors of family owned companies are presently questioning the merit of continuing pension funding.
Small self administered schemes which were set up in the past ten years, and received large cash contributions out of their company profits over the past decade, have been decimated by poor investment performance.
Senator Shane Ross writes regularly in the Sunday Independent regarding the pension industry generally. In our opinion, many of the Senator’s views on the industry have substance in reality. He writes that the investment advisors and pension brokers are motivated too much by high fees and commission based business models, and the pension scheme holder ultimately suffers from this.
Tax relief drives many to keep investing in pension schemes – it is a legitimate tax saving opportunity. The effective tax saved by making pension contributions for owner directors is just 12.5% – not the full Income Tax rate, and any analysis should be based on this lower level of tax savings. In our experience this fact often gets lost in the discussion.
Answer
In order to answer the question posed – Should I keep going? – what is needed is a clear long term financial analysis of pension returns net of expected fees and all future taxes. Even where a generous rate of investment growth of 4% per annum year on year is assumed (much more than most have experienced in reality in the past 10 years) this analysis can provide a surprising result.
Take the case of a 40 year old Director, with 20 years to a planned retirement at age 60, who has a fund value to begin with of €200,000. If he were to invest €50,000 plus the company tax savings from making the contributions per year for the next 20 years and 4% growth per annum was achieved:
- The total fund including the value of all tax relief and investment growth, before fees/levies would be €2m.
- The fees, commissions, and levies charged during the period would be €500K.
- On and during retirement the Revenue would collect over €650K in future tax.
- The cash available to the Director on and during retirement would be €850K.
Thus, the net benefit of the pension pot is split 42.5% to the Director and 57.5% to all others. This is a high effective tax/cost rate and the analysis thus undermines the perceived tax and investment efficiency of pension schemes.
Assumptions
The set of assumptions used in arriving at these figures are based on our experience of the realistic likely outcomes. For example, annual charges for service providers when taken together are assumed to be just over 2% of the Gross value of the pension at the end of each year. Further, we assume the recently introduced Government pension levy will not be lifted in 2014 as promised. The political capital in introducing the levy having now been spent, this soft target will be used to deliver more funds to Government for much longer. One might even expect the levy to be raised from 0.6% to 1% per annum as opposed to seeing its abolition.
The threshold for taking a tax free lump sum is now as low as €200,000 at age 60 for such directors. A more limited tax applies up to a lump sum of €575,000. After that all other sums taken out by way of retirement benefits suffer full marginal rate tax – i.e 55%. Therefore, the Revenue will give tax relief now at 12.5% (the Corporate Rate) but future tax ‘clawbacks’ will heavily outweigh the benefits of this for most.
Finally, the above analysis assumes growth of 4% per annum – each year, every year. If achieved that would be a wonderful performance. If not, then the ‘benefits’ of the pension fund as shown above look even worse.
Alternatives
There is an alternative. Ignore the 12.5% tax relief in the decision making process. Consider keeping the money in the company, or in a separate subsidiary investment company. Don’t pay the high fees and commissions of the highly regulated pension industry for the next 20 years. Self direct your own hard earned profits into safe and secure investments for your retirement.
What about the tax? With proper planning, an efficient overall tax result can be obtained by carefully structuring your personal and company financial affairs and planning a tax strategy for the Director and his family when retirement time comes. In fact by not having the funds tied up in a regulated pension structure, and instead having the funds in your own investment company greater flexibility exists and it is likely that a lower overall tax burden ultimately will be the result.
Conclusion
In conclusion, a totally new analysis needs to be applied by owner Directors in determining their pension and retirement strategy. Part of this strategy may involve having a pension scheme, but one which probably will never exceed a value of €1m at the planned retirement date. The second and most important part of the strategy is to retain control of the surplus profits which have been hard earned and use these prudently, within a structure you fully understand and actually control – without the regulatory constraints of the pensions industry.
Speak to Brian about his ideas and methodology for long term tax planning for Company Directors and build your own financial model for retirement.