It’s that time of year again. As income tax returns are filed, we keep seeing advertisements and notices telling us to top up our pensions and reduce our income tax liabilities. Yes, contributing to a pension is an effective way of reducing tax, but this is only one benefit of making a contribution.
When individuals are too focused on the tax relief obtained from their pension contributions, they lose focus on the other great benefit of pension funding; tax free investment growth. This is understandable. Tax relief is obtained in the short term and is seen as an immediate benefit, with the end goal of building a substantial retirement fund further down the road.
When it comes to investing your contributions, the level of returns on offer are historically correlated with the level of investment risk taken (provided you take a diversified approach to investing). To give an example, take the annualised, industry average investment growth of four different types of investment options over the past 15 years.
The expected level of return increases in line with each fund’s exposure to risk. In this case, the average Defensive Managed Fund would be expected to produce the lowest long term return, with the average Global Equity Fund expected to produce the highest long term return. This is indeed the case, with their respective 15-year average returns to 30 Sept 2021 detailed below.
Source: Longboat Analytics
Returns are gross figures, before management and advice fees have been taken into account.
Past performance does not guarantee future performance, the value of your investment can go down as well as up.
To take this a step further, let’s assume Client A invested €25,000 into their pension 15 years ago, on 1 October 2006, and invested their full contribution in the average Defensive Managed Fund. Let’s also assume Client B invested the same amount on the same day, but was invested in the average Aggressively Managed Fund. Finally, let’s also assume both are paying annual management charges of 1.25% p.a. to cover the cost of the investments and the advice received.
Both clients would have obtained the same amount of tax relief (€10,000 using today’s marginal rate of 40%). However, after 15 years of tax free investment growth, their respective values would be as follows:
Client A - €33,696.22
Client B - €49,505.22
Both clients saw the benefit of €10,000 tax relief, but Client B is now almost 47% better off than Client A. Of course, Client A may not have been willing to take more risk than they did, and that is perfectly fine. It is important to fully understand the risk involved in any investment.
The reason this is so important to highlight is that too many people see their October/November pension contribution as a tax saving exercise, and not an investment decision. For the likes of self-employed individuals who contribute to a personal pension plan every year, this is extremely important. If you don’t identify an appropriate investment strategy early, you are potentially losing out on significant gains in your overall retirement funding long term.
How do you know what is right for you?
When it comes to pension funding, you are essentially planning for your future retirement. However, there is a lot more to consider than just your pension by the time that day comes around.
Over the course of your working life, you will have various assets, liabilities, incomes and expenditures. Trying to figure out how they fit into the bigger picture is difficult, and without proper analysis you may make poor financial decisions.
The best way to manage this is to create a personal financial plan, and the sooner this is done the better. It allows you to see your future financial needs, quantify them, and plan for them. Without it, planning for retirement is just a guessing game.
If you plan on making a pension contribution before the income tax filing deadline, now may be the time to look at the bigger picture and ask yourself what you need your money to do for you.