The Pensions Board – Understanding Pensions
How pensions work
Introduction
Pensions are a way of providing people with an income in their retirement. People are now living longer and leading more active lives in retirement. The State provides a pension for people from the age of 66 who have enough Irish social insurance contributions. However, for many people the State Pension would not provide adequate funds to meet all their needs in retirement. Instead they look at contributing to a company or personal plan so that they can top-up this income when they retire.
Once you start working, it’s time to start thinking about a pension. The earlier you start saving for your pension the better the return on the investment should be i.e. the longer you are paying into your pension, the more you should have in your pension when you retire. If you start later, say at age 40, you will have to contribute more each month to have the same amount in
your pension on retirement as someone who started investing at age 25.
| The Pensions Board The Pensions Board is a statutory body set up under the Pensions Act, 1990. The Board regulates and monitors private pension schemes, encourages pension provision and advises the Minister for Social and Family Affairs on pension matters. |
The reasons for this are cumulative. The longer you are paying into the pension the more money you will pay in, and money paid in earlier will be invested for a longer period of time and should have a better return.
The sample table below illustrates the amount a 25 year old earning €30,000 should contribute per month to receive 55% of their current salary (€16,500) in retirement. If you wait to start contributing to a pension until you are 30 years old it will cost you an extra €20 per month and if you wait 10 years it will cost an additional €40. Therefore it is better to start contributing earlier in your career.
| The age you start your contributions | 25 | 30 | 35 | 40 |
|---|---|---|---|---|
| Yearly as % of Salary | 5% | 6% | 8% | 10% |
| Yearly Contributions | €1,500 | €1,800 | €2,400 | €3,000 |
| Gross per Month | €125 | €150 | €200 | €250 |
| Less Tax Reliefs | (€25) | (€30) | (€40) | (€50) |
| Net Contributions Per Month | €100 | €120 | €160 | €200 |
Budgeting and managing finances
The Charles Dicken’s character David Copperfield famously said “Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.” How we manage our money can make a big difference to the quality of our lives.
A budget is a simple plan to help you manage your money. It is based on the idea that you have some money coming in – your income – and some money going out – your expenses. Your goal is to make your expenses equal to or less than your income.
What you spend your money on may change at different periods of your life but a budget could include:
Income:
- Your salary
Expenditure
- Mortgage/ rent
- Food shopping
- Utility bills e.g. light and heat, phone and broadband, cable
- Insurances e.g. life, health, home
- Medical bills
- Entertainment
- Savings e.g. short-term savings and pensions
- Holidays
- Clothing
It’s important to think about what your income and outgoings will be upon retirement. At that stage you will not be receiving a salary. Your salary will be replaced with your pension. It is likely that your mortgage will be paid off and that you can benefit from reductions in your utility bills as a retired person. However, you will still have expenditures like food shopping, medical bills, insurances, entertainment, holidays, clothing etc.
The full, single person’s State Pension is currently €11,976 per year or €230.30 per week (as of Jan. 2009.) For most people, this will not be a sufficient income to meet all their needs in retirement and so they look to increasing it by contributing into another form of pension. In some cases employers contribute to employee pension schemes. The government also supports investment in pensions by offering tax relief on payments.
Who has a private pension in Ireland today?
- 61% of the Irish workforce over 30 years of age
- 56% of men in the Irish workforce
- 50% of women in the Irish workforce
These statistics show that pension take up is still quite low. In certain sectors especially the agricultural industries, catering, tourism, seasonal and part-time work, pensions coverage is lower again with less than 45% of employees in these sectors contributing to a private pension. Added to this is the fact that Ireland’s demographics will change considerably over the next 50 years. The over 65 population will be three times what it is today in 2056.With fewer people earning and more people retired, there will be greater pressure on the State pension, making it even more important for people to have private pensions.
| 2006 | 2026 | 2056 | |
|---|---|---|---|
| Numbers at work | 2,000,100 | 2,268,000 | 2,125,000 |
| Numbers aged over 65 | 464,000 | 844,000 | 1,532,000 |
| Numbers at work per person over 65 | 4.3 | 2.7 | 1.4 |
How pensions work
Most people’s pensions come from the State Pension, a company pension plan, a personal pension plan or a combination of one or more of the above.
State pensions
The State provides three types of pension:
- State Pension (Transition): payable at age 65 to people who have retired and who have satisfied certain PRSI conditions
- State Pension (Contributory) which is payable at age 66 to people who have satisfied certain PRSI conditions, and
- State Pension (Non-Contributory) which is a means tested pension for people aged 66 or over who do not qualify for the Contributory Pension based on their social insurance record.
Company pension plan
Also known as an Occupational Pension Plan, this is set up by an employer for its employees. It allows participants in the Plan to benefit from tax relief on their payments and to receive a tax-free lump sum and/or regular pension income on retirement.
There are two types of Company Pension Plan:
- Defined Benefit: With this type of plan, the pension income and/or lump sum on retirement is related to the employee’s final salary and years of service. For example, the employee might get a maximum two-thirds of their salary after 40 years' service, including the State Pension. This means that the employee can estimate their pension income, based on the salary and years of service.
- Defined Contribution: With this type of plan, the pension on retirement depends on the value in the pension fund when the person retires.
The value of the pension fund depends on:
- the value of the contributions paid in by the employee and the employer (if they make any);
- the investment performance, gains or losses, of the pension fund; and
- the amount of fees and charges the pension investment company applies.
Hierarchy of Needs
Maslow developed the Hierarchy of Needs model in the 1940-50s. His theory remains valid today for understanding human motivation. It is important that companies understand and refer to this when seeking to motivate and support employees.
The concept of pension provision comes under the safety needs which include financial stability and security.
Pension provision and facilitation motivates employees and benefits the company:
- Employees feel valued and important and have increased loyalty and commitment.
- Research shows that there is a stronger commitment from employees to participate in pension schemes where the employer makes a contribution.
- Companies with pension schemes gain a reputation for being a good employer.
Additional Voluntary Contributions
Under the rules of a company plan it will sometimes be possible to make Additional Voluntary Contributions (AVCs). These are contributions that a member makes to increase retirement benefits. Some plans do not permit AVCs, in this case a Standard PRSA can be offered by the employer or taken out by the individual for the purpose of making AVCs.
Personal pensions
Personal Pensions are not linked directly to a company but rather to an individual. There are two types of personal pensions:
PRSA: Personal Retirement Savings Accounts are a relatively new form of personal pension plan and were designed toreflect the fact that people move jobs more often now than before and so need a flexible type of pension that they can bring with them. A PRSA is owned by individuals (regardless of employment status), transferable from job to job, and available from a variety of authorised providers. They are ideal for employees, self-employed, homemakers, carers, contract or casual employees. PRSAs are monitored through the Pensions Act. They work in a similar way as the defined contribution plans detailed above.
Contributions may be paid to a PRSA by both an individual and by their employer, but the employer is not obliged to contribute. Contributions paid to a PRSA will benefit from income tax relief at an individual’s highest rate of tax and relief will also be given from PRSI and the health levies, if applicable.
RAC: A Retirement Annuity Contract is a defined contribution plan that allows people in non-pensionable employment or the self-employed to have a pension plan. It's a contract between an individual and an insurance company. There is income tax relief on contributions paid to an RAC and it is normally claimed back from the revenue in the person’s annual tax return.
How pensions work
Regardless of the type of pension the basic formula for a pension is illustrated below.
Tax relief on pensions
Tax is not paid on money invested in pensions, so if you make pension contributions you effectively pay less tax, making the cost to the investor lower than the amount invested. For every €100 of income that is invested in a pension plan, the real cost after tax relief is dependent on the rate of tax. It costs:
- €80 if the person pays tax at 20%
- €59 if the person pays tax at the top rate of 41%.
For employees, the real cost will be even lower as they will benefit from relief on PRSI and health levy payments. Members of an employer pension plan don't have to pay tax on any contributions that their employer makes.
Annuities and Approved Retirement Funds
Annuities: An annuity is a contract with a life insurance company that will pay a guaranteed, regular pension income for life in return for a capital sum. In this case, the capital sum comes from the person’s retirement fund. Income tax and government levies are paid on the received income.
Approved Retirement Funds: An ARF is a retirement fund where a person can keep their money invested as a lump sum after retirement. Withdrawals can be taken from it on a regular basis to provide an income and income tax and any other government levies are paid on this. Money left in the fund after death can be left to a next of kin.
Starting employment
You should ask about Pension arrangements when you start your first job.
- By law your employer must provide you with access to a pension, whether you are in full-time, part-time, temporary, contract or casual employment.
- You are legally entitled to information about your employer’s pension scheme or PRSA.
- Even if you are not at work you can save for retirement through a PRSA.
It's important to remember that pensions can seem complex and difficult to understand but there is plenty of detailed information available from the Pensions Board and independent financial advisors that will help you make the decisions when the time comes.
How do I choose which pension is best for me?
The pensions calculator
The Pensions Board website has an excellent calculator where you can enter information on your age, salary, and what percentage of your salary you would like to have on retirement. Log on to www.pensionsboard.ie to look at scenarios for people in different situations.
Conclusion
Starting a pension early makes a huge amount of sense. It means that you will have provision for your retirement that will allowyou to enjoy this time to the full. The earlier you start a pension, the less it will cost you in the long run. Make sure you’re informed about the best choice for you and start your pension with your first job.
Glossary
Statutory body: A government-appointed body set up to develop, give advice and be consulted for comment on a certain area of speciality.
Means tested: This means that an investigation will be done to determine whether or not an individual or family is eligible to qualify for assistance from the government.
PRSI: Pay Related Social Insurance, under which individuals who earn an income pay related contributions to the Social Insurance Fund and in return are covered for certain scheme insurance benefits, e.g. State Pension (Contributory).
Student Activity
- Go to www.pensionsboard.ie and work out the following examples on the Pensions Calculator:
- David is 28 and earns €25,000. He has €2,000 is his current fund and would like to have 60% of his salary (i.e. €15,000) a year on retirement.
- Jennifer is 35 and earns €45,000. She has €10,000 in her current fund and would like to have 50% of her salary (i.e. €22,500) a year on retirement.
- When starting a job what questions should you ask your new employer about pensions?
- If your employer does not have a pension scheme what other options are available?
- Create a budget for a retired person. Talk to a grandparent or other retired person to inform your answer.
