Despite the fact Ireland offers generous tax benefits for saving into a private pension, about a third of Irish workers fail to take advantage. This is according to the latest CSO data. But a far bigger number have a poor understanding of how pensions work, the final amount they will need in retirement, or the impact inflation will have on their final pot.
The State contributory pension pays about €15,000 a year. How much a person will receive of that will depend on their total PRSI contributions.
How much you will need in retirement to have a comfortable life will depend on who you are. If you are a big spender, you’ll need more. If you are frugal today, chances are you’ll be able to survive on less.
But for most people, there is hesitancy to examine the subject in any detail. Some of this comes down to fear of the unknown – the language and financials of pensions can be intimidating. For others, it’s a form of resignation, they know they spend too much today and have little capacity to save for the future.
But for this article, let’s examine some of the day-to-day habits people have that result in little capacity to save in the first place. And how they can take action to improve their financial situation for retirement.
1. Match Growth with Growth
Often when I meet with someone in their early twenties, someone that is starting out in their career, income can be tight. It’s a stage of life where every Euro matters. So, putting them into a financial straight-jacket for the sake of starting a pension is not the best move. This is not the purpose of money, its role is to serve as a tool to deliver needs and wants, to live life, enjoy it and, save a little for the future.
Instead, what I do is demonstrate how easy it can be using the pension system to their benefit.
I recommend that as their career advances, they should look to establish and grow their pension savings accordingly, and in line with inflation.
All too often, as incomes rise, bonuses come along or careers advance, the natural tendency is to spend it.
Set a fixed increase of 1 or 2 percent annually in anticipation of receiving a raise. Remember that for someone in their twenties, they can put 15% of their annual salary into a pension. This rises to 20% in their 30’s, 25% in their 40’s, 30% in early 50’s, 35% in late 50’s and 40% in their 60’s and beyond. An employer’s contribution does not impact that limit. In Ireland, the pensions system is very generous.
2. Use the 3 + 1 Approach for Spending Detail
Last week, I met with someone that was financially distraught. Although they were earning a very good income, they were unable to save.
When it comes to setting financial goals, there is a very simple approach.
It’s called the 3 + 1. First, to get to grips with what is going on financially within the household, I ask that they track their finances for 3 months in-a-row. Then, once a year after that.
Using this approach, the 3-month tracking revels a lot about the individual. But more importantly, it provides important clues about their spending habits.
If there is a spending habit they are unaware of or in denial about, the 3-month tracking approach will highlight it.
In that recent case, during our 1:1 consultation, some issues were coming to light. One was where in social company, they pay the tab most of the time. And there were some personal spending habits that gave rise for concern.
Smaller day-to-day expenses can add up quickly. A €20 bet can seem trivial but 3-times a week over the course of a year will cost more than €3,000 (it’s €3,120 because of €60 per week over 52 weeks).
Using the MoneyWhizz pension calculator reveals the true cost, and opportunity.
10-year gambling cost – €31,200
10-year AVC contribution + €47,974
In other words, the person can gamble €31,200 or have an extra €47,974 in their own personal pension pot after investment growth is factored in. The differential between the two is €79,174.
For this example, I assumed for a 5% rate of fund growth with 10 years left to retire.
The trick with the 3 + 1 approach is it can identify relatively simple ways to highlight costs that can be shaved and redirected to grow your personal pension pot.
3. Robbing Peter to Pay Paul
On a separate 1:1 consultation 2 weeks ago, I met with a client that was in love with their credit card. It was their “best friend and always there for them in times of joy, crisis and helped them through some challenging times”. I have to say, it was the first time I heard a credit card described this way. But to their point, a credit card offers tremendous flexibility and is almost universally accepted as a means of payment.
Credit cards also offer a convenient means of repayment by way of the minimum payment. This results in unpaid balances being carried forward each month. The interest charge is compounding. At 18% APR (or more), those costs compound very quickly.
I am not against credit cards on their own. They serve a purpose. What I highlight to users is the total cost of credit. When users realise it, for some, they are motivated to repay as quickly as possible. For others, it may be resignation that their financial situation is costing them more than they prefer to pay but have no means of early repayment.
Carrying expensive debt while not paying into a pension is a massive opportunity lost.
The more expensive the debt, the greater the priority the user should place on repaying it as quickly as possible.
When it comes to mortgages, while the term of the loan does matter, because the APR is low, paying into a pension, even where the investment growth is 5% makes more sense than paying down the mortgage early. MoneyWhizz offers additional analysis on how the figures work.
Remember, compound interest works in extraordinary ways. When it comes to debt, it makes that debt extremely expensive. But when it comes to a pension in Ireland, it offers a springboard to grow financial security in retirement at an extraordinary rate.
4. Failing to Create a Rainy-Day Fund
A rainy-day fund is a line of defense when your finances take a hit. Having one means that life can go on. Those hits can include a loss of employment, income or a sudden rise in expenses.
The problem that surfaces in many situations is pension contributions can be the first to take a hit when times are tough. Someone may reduce AVC contributions or pull out of a company-sponsored scheme altogether when they don’t have that rainy-day fund to carry them.
5. Maximising Bonuses and Other Windfalls
It’s not uncommon for employers to offer their staff financial incentives such as bonuses.
Or a career promotion can lead to a big pay raise.
But putting that money to good use will be vital.
There can be three approaches.
First, a lot of people will be tempted to ‘treat’ themselves and their families. And there is nothing wrong with that. Life is about experiences and enjoyment.
Second, the cohort that rushes to pay down debt. And as I have highlighted earlier, that really should depend on the type of debt, and particularly the interest charge on that debt. Credit cards should always be paid off quickly. Mortgages are a different matter.
But the third option of putting extra cash into retirement is still the only place in Ireland where it can really do some good.
This is due to the tax-relief pensions attract. First off, the contribution is done by way of the income relief itself. Someone in their thirties earning €50,000 is taxed on €40,000 if they put €10,000 (20%) into a pension. Otherwise, a lot of that income will be taxed at 40%.
One question I often get asked is whether someone should signup for an AVC where regular pension contributions are taken from their gross income or save and backdate their pension contribution. This can be a very personal choice. If you are concerned about stock market performance, then the latter might be more appealing. But if you believe in the long-term power of the stock market to generate growth, then the AVC route is the simplest and most convenient and avoids the refund filing with Revenue.
There is no one-size-fits-all approach to saving for a pension. But there are extraordinary benefits where Ireland excels. It really is a powerful way of building up a lot of funds that can be accessed for a better life.
Frank Conway is a qualified financial adviser and Founder of MoneyWhizz. He can be contacted on info@moneywhizz.org
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