PENSIONS: Budget increases in tax-free contributions promise to help taxpayers build up substantial retirement nest-eggs in a very tax-efficient manner A large number of people. . . do not appreciate the level of contribution required to provide meaningful retirement income, writes John McGovern

A number of improvements have been made to pensions legislation in recent years. The debate on the Pensions (Amendment) Bill 2001 has highlighted improvements started by the Minister for Finance, Mr McCreevy, in his 1999 budget.

The advent of Approved Retirement Funds (ARFs) for company directors and the self-employed, later extended to all Additional Voluntary Contribution (AVC) funds, was followed last year by the announcement of the legislative framework for Personal Retirement Savings Accounts (PRSAs) - a new, low-cost, easy-access product designed to simplify setting up a pension scheme for those without current pension arrangements.

Other substantial benefits for members of traditional pension schemes include the reduction of the statutory "vesting period" from five to two years, and the revaluation of the pre-1991 element of preserved pensions from defined-benefit schemes.

The introduction of the Pensions Ombudsman and minimum values for retirement benefits from contributory schemes have also contributed to making membership of an occupational pension scheme better than ever before.

When new measures proposed in the Finance Bill are in place, members of occupational pension schemes will have an opportunity to build up substantial retirement nest-eggs in a very tax-efficient manner. The limits for tax-free contributions to AVCs will be increased significantly. Until now, the maximum employee contribution to the pension scheme that was eligible for tax relief - inclusive of AVCs - was 15 per cent of salary in each year. Mr McCreevy now plans to increase this limit to an age-based scale identical to that currently enjoyed by those with personal pension arrangements - mostly the self-employed and proprietary directors.

The age-based limits are:

Up to 30 years of age: 15 per cent of net relevant earnings;

30 up to 40 years of age: 20 per cent of net relevant earnings;

40 up to 50 years of age: 25 per cent of net relevant earnings;

50 years of age and older: 30 per cent of net relevant earnings

For employees, "net relevant earnings" will, in most cases, be gross salary.

Contributions up to these limits will be deducted from income before tax is assessed and employees will also get tax relief on PRSI contributions. Each €100 a standard rate taxpayer puts into their pension scheme will reduce their take-home pay by only €74. A top-rate taxpayer will have at least €44 of the contribution effectively funded by the taxman.

These tax-efficient contribution limits will apply to members of occupational pension schemes, including where the proposed PRSAs are used as an AVC vehicle. A different table of limits - for combined employee/ employer contributions - will apply for stand-alone PRSAs:

30 to 40 years: 25 per cent of net relevant earnings;

Over 40 years: 30 per cent of net relevant earnings.

The new PRSA legislation is aimed at encouraging more people into making private provision for their retirement - a stated objective is to increase coverage from 50 per cent of the working population to 70 per cent. But it is apparent that a large number of people who are already in pension schemes do not fully appreciate the level of contribution required to provide meaningful retirement income.

The contribution level of a significant number of defined contribution pension schemes is 10 per cent of earnings - 5 per cent each from the employer and the member. This level of funding will provide a pension at age 65 of some 60 per cent of earnings, provided you start funding at age 20. This would be a very basic pension - it will stay level in payment and will die with its owner. In recent years, a number of factors have led to a need to re-assess contribution levels:

Life expectancy continues to improve, leading to larger retirement funds being required to provide the annual pension;

The lowering of interest rates means that the cost of annuities has increased;

A slow but steady trend towards earlier retirement.

Table 1 shows the pension as a percentage of earnings that would be built up by age 65 years for a 10 per cent annual contribution, based on the age funding commences and an index-linked pension where 50 per cent of the pension would continue to be paid to the surviving spouse on the death of the pensioner. It shows that, even if contributions of 10 per cent of earnings start at age 20, the employees pension at age 65 will be less than half their income. For someone starting at age 30, the pension will be only 29 per cent of pre-retirement earnings.

It shows clearly why employees need to seriously assess their pension situations.

The maximum pension that the Revenue Commissioners will permit to be funded is two-thirds of earnings. A 30-year-old hoping to achieve this level of retirement income at age 65 would need contributions of 23 per cent of earnings, every year. For someone who wanted to retire at age 60, even higher contributions would be needed. The same 30-year-old would need annual contributions of 32 per cent of earnings to retire on a two-thirds pension at age 60.

Table 2 shows the pension as a percentage of salary that will emerge at age 65, for contributions made up of 5 per cent of earnings by the employer, plus the age-based maximum by the employee. It is based on an index-linked pension where 50 per cent of the pension would continue to the surviving spouse on the death of the pensioner.

For employees commencing their pension schemes before age 40, the new maximum limits will be more than sufficient to build up a realistic pension. For older members of occupational pension schemes, there is an option for their employers to contribute at a higher rate, in order to fund a realistic pension.

This option would not apply to stand-alone PRSA holders where the combined employer/employee maximum contribution limit is capped (see above).

An important factor in achieving Minister McCreevy's expressed wish of greater pensions coverage, and, indeed, a reasonable level of retirement income for those already in pension schemes, is the incentive to save. Most company pension schemes have eligibility requirements and employer contribution levels that will provide the impetus for employees to commence saving for retirement. In a PRSA environment, these structures will not exist and the onus to save will be even more on the individual.

Mr John McGovern is a director of Becketts Employee Benefits Consultants.