Pension or Investment?
From time to time, I see a new client with an investment but no pension or at least no private pension. A public pension is a default of a public employment. They have opened an account with an investment platform and decided to start buying and selling shares based on the news and the research they believe to be true. They seek self-validation by proving their stock market intuition right through a rise in the value of their investment. It is easier than ever to access investment markets and instruments through the power of technology. When I ask about their investment process or framework most state, they have read a few books, researched the company, and keep their eye on the news. The overwhelming focus is on large, short term investment returns. The goal is to get rich quick. Beyond this there is little further thought given to the reasons for investing. Our previous blog post on investment principles is a good place to start: https://money-mentor.ie/blog/investment-principles
There is no such thing as short-term investing, rather gambling or speculating. Gambling & speculating are closer to entertainment than investing. One can do very well or very badly relative to the level of risk. This is largely due to luck. Luck is when timing meets opportunity. Having a flutter is in Irish people’s DNA. The lotto, scratch cards, bingo, raffles, betting, the list goes on. It is fun, sociable and engaging. But what do all these pastimes have in common? A low entry price for high potential reward. The lotto for example has an entry price of €4 but a potential reward of €4,000,000. Unfortunately, the probability of winning the lotto jackpot is 1 in 10,737,573. It is low risk, high potential reward. We lose €4 with the minute chance of winning €4,000,000. In other words, a Black Swan. A Black Swan is the impact of a highly improbable event. For the lucky few that do win the lotto it is a life changing windfall. There is little harm in having a small fun fund so long as we are comfortable losing it all and it doesn't adversely impact our other life goals.
A pension can be seen as inaccessible, long-term with a limited investment universe. Get rich slowly. The fundamental difference between a pension and an investment is income tax relief. When we contribute to a pension, we receive an instant 20% or 40% return on our money depending on our income tax rate. We keep more of the money we spend time at work to earn.
If we take a twenty & forty-year time horizon and use the same future expected investment returns, charges, and inflation we are comparing apples to apples. The numbers speak for themselves. The below table outlines the fund we will receive if we receive a 4% real return (into our pockets) after charges of 1.5% and inflation of 2% is deducted over 20 and 40 years:
|
Type |
Monthly Savings |
Income Tax |
20 Years |
40 Years |
|
Pension |
€1,000 |
€0 |
€367,997 |
€1,185,901 |
|
Investment |
€600 |
€400 |
€220,798 |
€711,541 |
When we access our pension, we will receive a tax-free lump sum and will then pay income tax on the income received from our pension. The investment will be taxed at 33% (CGT) or 41% (Exit Tax). On the above calculations alone, a pension is a no brainer. Having compared a pension to an investment we now unpack the added benefits of a pension in the form of:
Time & Tax
Time is our most valuable asset & tax will be one of our biggest lifetime expenses. To keep more of the money we earn, we save into our pension. We are effectively buying back a portion of our future time each time we save into a pension. In order to save into a pension, we will have to have a sufficient savings rate to accommodate the reduction in our after-tax income.
Financial Independence
If working, we currently spend time at work to earn an income. This is referred to as active income. A passive income is generated regardless of needing to go to work or not. A pension is the best vehicle to transition from an active income to a passive income. Financial independence is the day we chose to go to work rather than having to go to work. Our motivation, health and ability to work may not be the same in the future as it is today.
Pay Ourselves First
Life is busy. By paying into our pension, we are paying our future selves first. We should be our number one priority. Automating our pension savings removes the will power required to prioritize ourselves first given the numerous other needs and wants that will inevitably eat into our income.
Charges
Occupational pension schemes can have lower charges than an after-tax investment. I’ve seen as low as 0.10% but it can vary widely. It all depends on the employer’s benefits package for employees and investment fund selection. Example, if we contribute €1,000 per month, earn a real return (after charges & inflation) of 4% per year with a 1.5% annual charge over 40 years, we will have accumulated a fund of €1,185,901 as outlined in the table above. We will have paid €563,118 due to the annual charge of 1.5%. If the annual charge were to drop from 1.5% to 0.5%, we will have accumulated a fund of €1,532,378. A 1% reduction in the annual charge affords us an additional €346,477 into our pocket.
Employer contribution
It is not uncommon for an employer to contribute to an employee’s occupational pension as part of their employment benefits package. This is essentially free money and is usually linked to a requirement for the employee to contribute a percentage of their salary to secure the employer contribution. The employer contribution does not form part of the employee’s personal pension tax relief band.
Pay Increases
Pay increase, what pay increase? A pay increase can quickly be absorbed into lifestyle spending. If we have a pension setup it should be reviewed and adjusted in line with our income as it rises. If part of an occupational pension scheme this should be done automatically.
Future Uncertainty (Risk Management)
Controlling what we can control is the key to managing life’s risks. From a financial perspective, the financial goals outlined below, in order of priority, should be our first port of call prior to saving into our pension:
1. Know how much our current lifestyle costs us.
2. Spend less than we earn.
3. Save a €1,000 starter emergency fund.
4. Pay off all non-mortgage debt.
5. Save 3-6 months of expenses in an emergency fund.
6. Insure ourselves against injury/accident, serious illness or death prior to financial independence.
Completing the above steps will ensure our financial fundamentals are sound. One of a pension’s biggest strengths and weaknesses is its inaccessibility. A pension’s purpose is to provide us with an income in retirement or when financially independent. Its long-term nature is a positive when investing but a negative for engagement and buy in (long term gratification). There are rare occasions when access to our pension can be granted:
· Ill Health Early Retirement
· Terminally Ill
· Death
We are typically motivated in two ways, intrinsically &/or extrinsically. That is, we do things for ourselves based on our own values and goals &/or for someone or something else. Intrinsic or extrinsic, protecting & securing our families financial future can be a powerful motivator. A pension helps us protect & secure our own financial future and that of our family in the event of ill health, serious illness, or death.
Link to Spotify podcast episode: https://open.spotify.com/episode/5a6cwTJkmNHGBvlJJPSbOI?si=7ce4b856cb434aa6
Link to Apple podcast episode: https://podcasts.apple.com/ie/podcast/s2-e7-save-into-your-pension-or-an-investment/id1539630506?i=1...
For personal financial planning advice email team@vantagefp.ie or call (01) 539 2670.