Financial independence means having enough passive income to live the lifestyle we want to live. Passive income is income we receive regardless of working the day job. Financial independence is one of life’s most cherished and expensive financial goals. Imagine for a moment we had enough money to live our current lifestyle without the need to go to work. How would we feel? What would we do with all our free time? Whether we love or loathe our job and everything in between, to be financially free of our job and be able to choose how we spend our time, is in my opinion a life goal worth saving for. For most of us the best way to start building a passive income is by building wealth tax efficiently, by contributing to a pension. A pension is a long-term savings account linked to our employment income. It is one of the best wealth building tools at our disposal. A pension is to prepare us financially for the time we no longer need to work. When we contribute to a pension, we automatically pay ourselves first, therefore removing the will power required to save consistently after everyone and everything else is paid. Many of us pay the government, taxes, the bank or landlord, mortgage or rent, before we pay ourselves. Much of our income during our working lives is allocated to paying bills, raising a family, events, occasions, hobbies, interests and travel. Saving what is left over at the end of the month means we are prioritizing our future selves last. This is likely to lead to little or no savings over time. By paying ourselves first we prioritize ourselves first, transitioning from an active income to a passive income.
Income tax is likely to be one of our biggest expenses during our careers if not the biggest. The better we do financially, the more tax we will pay. An example, Lucy is 35, earns €80,000 per year and is married to Frank. Frank is 38 and earns €70,000 per year for a total household income of €150,000. Lucy and Frank will collectively pay €40,000 in income tax in 2020. If Lucy and Frank both worked a 50-hour work week on average they will have spent over 6 weeks or a month and a half each per year at work to pay the €40,000 income tax bill. Put another way Lucy and Frank will pay a collective €3,333 per month in income tax. I can’t think of many other expenses that large on a monthly basis. For simplicity, say these details remained the same for their entire career. Lucy and Frank will pay a total of €1,200,000 in income tax to retirement on a straight-line basis. That is a sizeable sum being paid to the government. The government of Ireland recognizes the expensive life goal of being financially independent and has incentivized us to save for it accordingly. They do this through applying income tax relief on pension contributions. There are currently two rates of income tax in Ireland, 20% standard rate & 40% higher rate. By contributing to our pension we instantly receive a 20% or 40% return on our money by avoiding income tax. I do not know of any other investment with those types of consistent returns each time we get paid. To put this into perspective, say Lucy and Frank contributed €500 a month each into a pension for a total of €1,000. Instead of receiving €600 into their bank account after tax, €1,000 will go straight into their pension. This is an instant return of 40% that Lucy and Frank save for their financial independence. It does mean we have to forego receiving €600 into our bank account. By contributing to a pension it is assumed we know how much our current lifestyle costs us, spend less than we earn, have a fully funded emergency fund, are debt free besides the mortgage and are protected against life’s worst outcomes outlined in previous episodes.
If Lucy and Franks pension contributions were to remain at €500 each per month for the next thirty years, they will save €360,000 on a straight-line basis. €144,000 of this is the 40% uplift of not paying income tax. We would only have €216,000 or 60% if we saved our after tax income. Not only this but when our pension is invested it can grow tax free. Investments outside of a pension attract capital gains or exit tax at 33% or 41% respectively on any gains. To give you an idea of how advantageous a pension is over investing our after-tax income we take Lucy and Frank’s previous example. Lucy and Frank will receive a €360,000 pension fund if they each save €500 per month for 30 years. If Lucy and Frank receive a 4% annualized investment return after charges and ignoring inflation, their pension pot would be €699,940. They then compare investing €300 each per month in after tax income, 40% less because there is no income tax relief. If they receive the same 4% annualized investment return after charges and ignoring inflation their pension pot would be €419,964 after 30 years. The pension is the clear winner with 67% more than the after-tax savings. This is before we apply capital gains tax of 33% to the after-tax investment which leaves us with just over half our accumulated pension fund. Our pension fund will be taxed as income once we begin to draw it down. That is after we receive our tax-free lump sum of 25% of the fund or salary and service calculation.
The more money we save into our pension the more of our income we keep for ourselves, especially having spent our time earning that income at work. There are limits to the amount of income we can contribute to a pension. These are percentages linked to our age. We can contribute 15% of our income up to 30, 20% up to 40, 25% up to 50, 30% up to 55, 35% up to 60 and 40% from 60 onwards. Certain professional sportspeople can contribute a larger percentage in their younger years, 30% up to 50. The annual income limit for these percentages cannot exceed €115,000. Lucy and Frank being in their thirties can contribute up to 20% each as neither of their salaries exceeds €115,000. The standard fund threshold or pension fund limit for tax relief purposes is €2,000,000 per person.
So where do we start when it comes to pension? We start at the end and work back. When estimating our financial independence goal, we start with what we would need to live our ideal lifestyle in retirement. In Lucy and Franks example, they are currently on a combined household income of €150,000. They estimate their desired lifestyle in retirement will cost them €100,000 per year before tax. It is important to remember that many of the expenses we currently have such as the mortgage, other debts, kids, commuting, professional clothing, work events and so on will no longer be part of our cashflow in retirement. Of course, there will be added expenses such as healthcare, travel, leisure activities, shopping and so on with all the extra time. It all depends on our lifestyle in retirement. Big lifestyle, big target, small lifestyle, small target. Ignoring inflation, we determine the fund required for this level of passive income by multiplying €100,000 by 25, which gives us €2,500,000. This is the fund required today to provide Lucy and Frank with a €100,000 income per year based on the 4% rule. The 4% rule is a theory that relates to a term called the safe withdrawal rate. The safe withdrawal rate is the percentage one can withdraw each year without depleting the funds invested over the long term. This is of course all based on assumed variables. It will come as an unpleasant surprise to many the funds required to become financially independent. It can be a herculean figure and may have us giving up before we even get started. There are a number of factors that can assist us reaching our financial independence goal. These are:
The state pension;
Our public &/or private pensions;
The state pension. When pensions were first introduced in Ireland in 1908, average life expectancy was fifty-five years of age for men and women. The pension age was 70. Therefore, just under 6% of the population at the time were eligible for a pension. Since then, average life expectancy have increased from 55 to 80 for men and 83 for women. There are currently two types of state pensions, contributory or noncontributory. The contributory state pension is paid based on our PRSI contributions or stamps paid during our working lives. It is not means tested. A full state pension is currently €12,912 per year, not to be sniffed at. To purchase an equivalent level of income today would cost us around €400,000. To determine what level of state pension we may be entitled to, we can request a copy of our PRSI record. This can be requested through MyGovID under MyWelfare. Over the next 30 years Irish demographics will change considerably, from 4 people working for every one retired to 2 people working for every one retired by 2050. This coupled with the short-term nature of politics makes the possibility of receiving a state pension less and less likely the younger you are. It is quite likely the state pension age will continue to rise given we are living longer; the state pension may be reduced or means tested &/or taxes will rise to foot the burgeoning state pension bill. Avoiding the doom and gloom for a moment, if we were to include two full state pensions for Lucy and Frank and that’s a big if, being in their mid to late thirties, they would be receiving €25,824 of their €100,000 target retirement income from two full state pension’s. This leaves Lucy and Frank with €74,176 of income left to replace to reach financial independence or a fund of €1,854,400 to accumulate.
Neither Lucy or Frank work in the public service but if they did, they would be entitled to a public pension depending on when they commenced employment, their level of service, seniority, pay and which government department they work in. It is important to know what public pension we will be entitled to in retirement and how our public pension interacts with our state pension and PRSI record. There are some pension estimator calculators on government department websites but the best port of call is to enquire internally with our employer. A public pension is similar to the state pension in that it pays a defined benefit in the future, that is a specified amount based on the criteria mentioned previously. With the state and public pension there is no specific personal pension fund being built. These pensions are wholly reliant on government finances and therefore taxes for funding. If we are working in the public sector we need to determine the anticipated amount of our public pension. Once we know this figure and reconcile it against our desired income in retirement, we may need to setup a pension privately to shore up any shortfall. A public/private pension hybrid is perfectly normal.
Private pension. A private pension is for anyone who works in the private sector. Employers are obligated to offer all employees access to a pension in the form of a Personal Retirement Savings Account (PRSA). Employers are not obliged to contribute. If an employer does contribute to our PRSA pension it is treated as a benefit in kind and forms part of our percentage pension contribution threshold. If an employer has setup an occupational pension scheme, employer contributions attract corporation tax relief to certain limits and do not form part of our percentage pension contribution threshold. Example, Lucy and Frank both have private pensions. Lucy is part of an occupational pension scheme and her employer contributes 10% of Lucy’s salary or €8,000 per year. This is contingent on Lucy making a minimum contribution of 5% or €4,000 a year. Lucy is contributing €500 per month or €6,000 per year and therefore meets this requirement. Lucy’s employer receives corporation tax relief on the employer contribution, and it does not form part of Lucy’s personal 20% pension contribution limit. Lucy receives income tax relief on the €500 and an additional €667 per month employer contribution for a total of €1,167 per month. By contributing €500 per month to a pension which only costs Lucy €300 in after tax income, she receives €1,167 per month into her pension with the help of her employer. In other words, Lucy foregoes €300 in after tax income and receives €1,167 per month into her pension. Frank on the other hand isn’t as fortunate as Lucy. Frank’s employer does not offer an occupational pension but a Personal Retirement Savings Account. Frank does not receive an employer contribution but maintains his €500 per month, the same as Lucy. Franks foregoes €300 in after tax income to save €500 into his pension. If Frank’s employer did contribute to his PRSA it would reduce his 20% pension contribution limit accordingly.
We will separate Lucy and Frank’s pension situation for a moment. With Lucy and her employer’s contribution, a 4% return after charges and ignoring inflation, Lucy will accumulate a pension pot of €816,597 in thirty years’ time. Based on Franks pension contribution, no employer contribution, with a 4% return after charges and ignoring inflation, Frank will receive a pension pot of €349,970, in thirty years’ time. Frank accumulates less than half of what Lucy does as a result of Lucy’s generous employer contributions. The employer contribution super charges Lucy’s pension. When we combine the two estimated pension pots at retirement it equals €1,166,567. This is still shy of their desired pension pot of €1,854,400 with a shortfall of €687,833 for a €100,000 income in retirement. Knowing this Lucy & Frank can save more into their pension, work longer, increase income, increase risk pursuing a better return or reduce their desired lifestyle in retirement. Of course, there are all sorts of different permutations, when we add in rental property income, part time work, relocating, sale of a business or farm, downsizing the home, selling investment properties, inheritances, or a windfall and so on.
The above example is a very simplified one and everyone’s financial circumstances are different. If you find it all overwhelming, all I can say is just make a start. Start contributing to a pension, it makes so much sense from a wealth building perspective. Find out the minimum pension contribution specific to your employment and start with that. Starting is half the battle. No sooner have a couple of months past we will have adjusted financially and pension contributions will have become an automatic part of our savings. We can start to nudge it up as we get more comfortable and confident with our money. Don’t be discouraged if we don’t see massive investment returns immediately, they take time. In all likelihood we won’t see sizeable performance gains until we reach €100,000 plus. Reaching this goal allows positive performance and compounding to really take hold. It’s similar to rolling a snowball. It starts off small and is small for a while but then the speed of its increasing size grows rapidly due to its mass. Warren Buffett, one of the worlds greatest investors made his first million at 32, his first billion at 56 and his current net worth of 85 billion at age 90. This is an exaggerated example, but time and compounding are the critical ingredients. The best way to think about pensions is that each time we contribute to one, we are buying back part of our future time. We are subsidizing our future passive income.
In many ways a pension resembles a mortgage, only in reverse. We are all mad for the mortgages. I know, you are probably thinking I’m mad but let me explain. A mortgage is a loan from the bank in which we receive a sizable sum of money up front to buy a home. We repay the loan with interest regularly over thirty years. A pension starts at zero with a target income in retirement, thirty years from now. We contribute to our pension regularly, earning an investment return over thirty years. We will then have accumulated a sizeable sum of money to fund our retirement income. The repayments or pension contributions are regular. We pay interest on a mortgage or earn an investment return on a pension and receive sizeable amounts either at the beginning, mortgage or at the end, pension. At the end of a mortgage, we are debt free but at the end of saving into a pension we are financially independent. From a behavioral perspective home ownership is instant and so is the anchor of debt it comes with. We are also charged interest and so it will cost us more time at work. However, when it comes to a pension and delayed gratification many of us are less than enthusiastic in accumulating significant savings that we can access decades into the future. We tend to put things that are far in the future on the long finger and deal with them tomorrow. Many of us don’t start a pension because we don’t think that far ahead. Can we do our future selves a favor?
When deciding whether to contribute to a pension we need to ask ourselves, are we ok having to work our entire lives rather than choosing to work. When posing this question it is important to remember all the time, energy and skill required to do our jobs everyday, not to mention the stresses and strains many jobs come with. Even if we want to work our entire lives, will we be able? Will our priorities, goals and behavior change over time? As always, it’s important to focus on what we can control. It helps if we are optimistic about the future. Yes, many terrible things are happening and will continue to happen but believe it or not there has never been a better time to be alive. By contributing to our pension we are buying back some of our future time that doesn’t need to be spent working. We are effectively subsidizing our financial independence with each pension contribution.
In summary, financial independence is a life and financial goal worth saving for. Tax will likely be our biggest lifetime expense. We can reduce this expense by saving into a pension and paying our future selves first. Saving for financial independence or part financial independence should start in a pension due to its tax deferred benefits. Before taking aim at a financial independence goal, find out what pension we can anticipate receiving from the state, from previous public &/or private jobs in our career, from our current public &/or private job and reconcile this with our desired lifestyle in retirement. If there is a shortfall seek to maximize the additional pension opportunities at work or privately. If we are new to pensions do our future selves a favor and just start. It is never to early or to late to start a pension. The longer we put a pension on the long finger the more costly and risky it becomes. Contribute to a pension even if it’s the minimum amount or secure our employers matching contribution if able and available. Through a pension we can access and own assets that appreciate in value long term, businesses and bonds. We will discuss investing in episode 8. As always, seek good advice.
This week’s book recommendations are Atomic Habits: An Easy & Proven Way to Build Good Habits & Break Bad Ones by James Clear. James provides a logical framework from which to affect lasting change in our lives for the better. It is a very practical book full of useful ways to frame our daily decision making. And The Millionaire Next Door: The Surprising Secrets of America’s Wealthy. This book identifies the traits of those who are wealthy and examines the commonalities between them. Many of those who are wealthy don’t wear luxury clothes, drive luxury cars or reside in luxury homes. This book may surprise you. This week’s movie recommendations are Forrest Gump. The movie tracks Forrest Gump, a slow witted yet endearing character, through his life and coincidentally many historical events of the mid to late 20th century. Who doesn’t like Tom Hanks? And staying in 1994, The Shawshank Redemption. Andy Dufresne is sentenced to life in prison but maintains his innocence. The movie follows the ups and downs of prison life at Shawshank. Andy, a very smart individual never gives up on his innocence and his quest to be free once again. Fear can hold you prisoner; hope can set you free.
Link to Spotify podcast episode: https://open.spotify.com/episode/4FgcRzeJD3n4asZc7K26lX?si=a58fb3376f4b4879
Link to Apple podcast episode: https://podcasts.apple.com/ie/podcast/s1-e7-pensions-financial-independence/id1539630506?i=1000503190564
For personal financial planning advice email email@example.com or call (01) 539 2670.