Know your AVCs

For many people, understanding their pension is complicated enough without having to get to grips with additional voluntary contributions (AVCs) as well.

But recent changes to the Finance Bill have added to their attraction and made them worth considering for many in occupational pension schemes, particularly those approaching retirement.

AVCs are basically a method of supplementing payments to an occupational pension scheme to ensure the maximum benefit during retirement.

They are voluntary in nature and can be paid into the main occupational pension scheme of which the person is a member or into a separate fund. They are subject to few restrictions although they form part of the 15 per cent of taxable earnings which are eligible for tax relief on pension contributions.

In addition, the employee must ensure that at least one-sixth of eventual pension benefits are paid for by the employer and that the benefits do not exceed the Revenue Commissioners' limits.

These allow for a pension of two-thirds of final earnings, in addition to the state pension, including a tax-free lump sum of a maximum of one-and-a-half times final salary.

It should be noted that the Revenue limits take account not just of salary when calculating final earnings, but also factor in other taxable benefits such as bonuses and benefits in kind such as company cars or health insurance. They also allow for pension provision for dependants and take account of inflation in retirement, leaving plenty of room for most people to top up their pension with AVCs without breaching the limits.

Up to now those with AVCs could really only use them toward the purchase of an annuity along with the rest of their pension fund.

But the new Finance Bill extends the freedoms provided to proprietary directors and the self-employed regarding their pension funds last year to those in occupational schemes who have made AVCs.

Effectively, this means that those with AVCs now have a number of options open to them. They can draw down their AVC assets at retirement in taxable cash form without affecting taxfree cash entitlements from the employee's main pension scheme.

The AVC funds can be invested in Approved Retirement Funds (ARF), the various alternative investment options that have come on the market since the compulsory purchase of annuities was abolished for the self-employed.

Depending on the type of investment, the money can be left to sit and grow or it can be drawn down to provide a regular income during retirement. Unlike an annuity, it does not die with the holder but can be passed on as part of his estate.

According to Neil Herlihy of KPMG Pension & Actuarial Consulting, the new legislation allows people to use AVCs as a tax-efficient savings method rather than for pension purchase.

"We believe that employees who may previously have seen AVCs as unattractive on the grounds that they augmented an already adequate company pension scheme might now consider redirecting other long-term savings toward their pension scheme," KPMG says.

"The key advantage of such a move will be that investment roll-up within pension schemes is tax-free which greatly enhances the overall investment outcome compared to taxable savings vehicles."

KPMG points out that the net cost to an employee investing £5,000 (€6,348) in a pension scheme through AVCs is just £2,800. Assuming a return of 7 per cent gross on the pension scheme investment, and a personal tax rate of 44 per cent, the value of this investment after all taxes after 30 years would be £21,500, the firm of accountants say.

By contrast, someone investing £2,800 in an ordinary taxable investment would have just £13,000 at the end of the same period, assuming a corresponding rate of return.

Employees should note, however, that they can only invest their AVCs in an ARF provided they already have a guaranteed income of at least £10,000 per annum from other sources, such as their pension, for life.

Mr John McGovern of financial advisers Becketts also cautions that the AVCs must be clearly and separately identified within the pension fund to take advantage of the new rules. In addition, workers should be aware that like other pension investments, they cannot get their hands on the money until they retire.

ARFs are now being offered by a number of leading pension providers, including Norwich Union and Canada Life.

Mr Beckett says the situation regarding ARF provision at present is "very fluid" and changing from day to day as new providers join the fray.

The Finance Bill also amended the list of those authorised to offer ARFs to include firms authorised by the Central Bank under the Investment Intermediaries Act and EU-based fund managers so new products are likely to come on stream as more and more companies turn their attention to the area in the months ahead.