Pensions still best way to beat hefty tax bill

The self-employed can make considerable savings at year-end with an AVC, writes Laura Slattery

The days are getter shorter and darker, but self-employed people can console themselves with the thought that autumn is pensions season.

It may seem like scant consolation, but any self-employed person who successfully sorts through their paperwork, itemises their receipts and calculates their tax liability the right side of the 2004 income tax deadline - or gets their accountant to do it for them - will be able to make significant tax savings.

Although all tax reliefs are under review, workers can currently get tax relief on pension contributions at the higher rate of tax that they pay, subject to certain limits.

"There is very little that people looking to save income tax for the year 2004 can do about it, but pensions are one of the few ways they can make savings," says Eilis Quinlan, an accountant with a practice in Naas, who runs seminars on pensions planning for her self-employed clients.

Typically, people work out their tax liabilities, how much tax relief is available and work backwards before deciding how big a lump sum they will invest in a personal or small self-administered pension.

"To a certain extent, there is no point throwing money at a pension if you can't get tax relief on it," says Quinlan.

Small business owners have often ignored pensions in the past, taking the attitude that their business is their pension, with assets that can be flogged off when, or if, they retire. But pensions have become more appealing and less restrictive in recent years, Quinlan notes.

The introduction of approved retirement funds (ARFs) mean it is no longer compulsory for a personal pension holder to convert their fund into an annuity (fixed, regular payment) on retirement.

Instead, they can keep their pension contributions invested in an ARF, the proceeds of which can be passed on to their dependants when they die.

Investment options have also widened to include property thanks to a provision allowing people to borrow within self-administered pension schemes.

"Even before borrowing was allowed, the fact that you could administer the fund yourself was hugely attractive," says Quinlan.

People do investigate their options and make informed decisions, she says. "There's no one smarter with how they invest than someone with their own money."

The income tax deadline - October 31st for paper returns and November 17th for people filing via the Revenue's online service (Ros) - should spur people to get their retirement provision in order.

To encourage waverers, pension providers tend to offer better deals on charges around this time, while some brokers also offer special discounts.

"Somebody who takes out a pension now could be 2 per cent better off than if they took one out six weeks ago. I can't see any reason why people would take one out at any other time," says Ian Mitchell, director of Deloitte Pensions & Investments.

The special offers usually take the form of "bonuses", or higher allocation rates. At this time of the year, it should be possible to get an allocation rate that is higher than 100 per cent.

For example, Standard Life has announced a special offer of 3 per cent on personal pension investments over €30,000 made before the end of November and 2 per cent on investments below this figure.

The offer is thus worth an additional €400 to someone investing €20,000 and €900 to someone putting in €30,000.

Regular charges on contributions are sometimes euphemistically disguised as allocation rates by the pensions industry: a 95 per cent allocation rate, for example, means 5 per cent of the contribution is not going anywhere near the pension fund but is being diverted to pay commissions and make profit for the provider.

On a common pension offering such as a standard personal retirement savings account (PRSA), there will be a charge of 5 per cent on contributions and an annual management charge of 1 per cent.

"If you're only putting in a few bob, if you're a PAYE person making an additional voluntary contribution (AVC) for example, 5 per cent and 1 per cent is as good as you're going to get," says Owen Morton, adviser at Moneywise Financial Planning.

But someone making an annual deadline-inspired pension contribution of about €20,000 or more should be able to get a much better deal, he adds. "But you would have to negotiate. If you walk in off the street, they won't just hand you a discount."

A pensions investor should always ask their broker or the sales agent about entry costs and ongoing charges, says Morton. The eroding effect of all the charges levied on the projected investment returns can be summarised in a percentage known as the "reduction in yield" factor, he adds.

If there is a 5 per cent charge on contributions and a 1 per cent fund management charge, someone making annual contributions of €60,000 will have a fund of €796,384 after 10 years, assuming investment growth of 7 per cent per annum, Morton says.

The reduction in yield factor - the effect of the charges - is 1.91 per cent.

But someone who has negotiated a better deal on charges could end up paying as low as 1.2 per cent on contributions and a fund management charge of 0.875 per cent, according to Morton.

The reduction in yield factor here would be 1.09 per cent, leaving them with a fund of €834,100. After 10 years, they will be the best part of €40,000 better off than their counterpart who has failed to bargain.

Figures sourced from brokerage Adviser Plus by Deloitte show similarly dramatic differences between the personal pension plans sold by the main life assurance companies.

The AIB personal pension plan sold by Ark Life front loads its charges in the manner of old-style personal pensions. For this reason, it will take someone investing €60,000 a year 30 months before they break even.

The projected value of the fund after 10 years is €826,692, based on an assumed growth rate of 6 per cent.

By contrast, someone investing in Hibernian's horizon plan will break even in the first month and end up with a fund of €866,994.

Someone with a lump sum to invest in a pension should get quotes from several providers and ideally discuss all of their investment options with a financial adviser, says Mitchell.

There is one reason, however, why a pensions investor might not seek out the lowest charges: if they think that a particular fund will deliver higher than average returns that will more than compensate them for the higher charges.

"On multi-manager funds, there would be an extra layer of charging. Their argument is that you get what you pay for," Mitchell explains. "But on normal managed funds, you can't guarantee that one fund is going to perform better than another."

So investors have to choose between the certainty of lower charges and the possibility of higher returns. One example of this, according to Morton, is the Fidelity Special Situations Fund, which has a management charge of 2 per cent, but boasts double the return of the FTSE index over 10 years.

"It's a very popular fund that sells itself really," says Morton. "But some people say they would be more happy in a fund with a 1 per cent charge and less pressure on it to outperform."