Pension timebomb: will proposal to standardise tax relief defuse crisis?
As the pension timebomb ticks on, a proposal to standardise tax relief on contributions has emerged. While this might help lower-paid workers, it punishes those in a higher bracket, says Justin O'Gorman
THE fact that Ireland faces a pensions crisis is no longer denied. Successive ministers with responsibility for this area have made tackling this crisis a priority. And, after years of waiting, the National Pensions Framework was published earlier this year.
This document is supposed to provide the blueprint for this crisis to be averted.
And in the last couple of weeks, the Pensions Board published its annual report, which included strong warnings that workers will have to radically re-adjust their expectations when it comes to retirement as a result of losses that pension funds have sustained over the past couple of years.
Indeed, the boss of the Pensions Board, Brendan Kennedy, stated: "Pensions Board data shows the level of investment risk being taken is still too high."
Mr Kennedy went on to question whether the trustees of pensions schemes, those who advise the trustees and individual workers, themselves were aware of the consequences of the risks associated with the pension schemes.
It would appear that the Pensions Board is advocating a reduction in the risk that pension schemes take with the funds invested.
However, a reduction in the investment risk also reduces the potential returns that the funds receive.
And while cutting risk may be desirable, it also reduces the long-term valuations of the pension scheme.
Therefore, the worker still ends up in the same situation -- a lower pension at retirement age than initially expected.
In order to counteract this reduction, workers will have to increase the contributions they make to their pensions.
One of the main points in the Pensions Framework document was a proposal to standardise the tax relief on pension contributions at 33pc. This recommendation goes against the idea of encouraging middle-income earners to make contributions to their pensions or to increase contributions they already make.
Why is this?
Well let's look at a couple of examples.
Let's take a male and female worker, both single, earning €40,000 per annum aged 35 retiring at age 65.
Both individuals have no existing pensions and are looking to fund for a pension of 50pc of final salary.
As both individuals are in their 30s, they can contribute a maximum of 20pc of their salary to a pension for tax-relief purposes.
The male worker needs to contribute €861.65 per month to fund for a 50pc of final salary pension, and the female worker needs to contribute €876.02 per month.
However, the maximum contribution per month they can make for tax-relief purposes is €666.66.
If they both make the maximum contribution for tax-relief purposes of €666.66 per month, their pensions will fall to 38.5pc of final salary for the male and 37.8pc for the female.
After tax relief at 41pc, the net cost of the monthly contribution falls to €393.33 per month (PRSI and health levy reliefs have been ignored for the purpose of this exercise).
But if the recommendation to reduce the tax relief to 33pc is enacted, the net cost of the contribution will increase to €446.66 per month -- a rise of €53.33 per month net or 13.5pc. Now individuals making contributions to their pensions look at how much the net cost is and not the gross cost.
If our male and female worker cannot afford to pay the new net amount, they may end up reducing the gross contribution to a level that matches the old net figure they were paying, for example, reducing the gross contribution to €587.06 per month which after tax relief of 33pc is €393.33 per month net.
What has this done to our workers' pensions?
Our two workers are retiring on pensions of 33.8pc and 33.26pc of final salary respectively -- a significant reduction from the aspiration of retiring on 50pc of final salary.
A lot has been written over the past few years about how it is unfair that individuals on the lower tax rate only receive relief at 20pc on pension contributions and that those on big incomes get relief at 41pc.
Social Protection Minister Eamon O Cuiv reiterated this at the launch of the Pensions Board report.
This misses the point completely. By all means increase the tax relief that lower-paid workers get on their pension contributions to encourage them to contribute to a pension, but don't do it at the expense of those workers on the higher tax bracket.
A single person starts paying 41pc on any income over €36,400. This is hardly a "fat- cat" salary. We need to do all we can to encourage people to deal with their pensions, not penalise them because they happen to be 41pc taxpayers.
n Justin O'Gorman is a senior financial adviser at MyAdviser.ie