Recent years have seen a range of changes to the pension taxation regime; including limits on the maximum amount that can be accumulated tax effectively, a lowering of tax reliefs on personal contributions and a reduction in the amounts that can be drawn tax free at the point of retirement. 2012 seems likely to see more change. There is evidence of a reduction in the level of pension savings generally – so against this background it is useful to re-evaluate the tax benefits of pension funding in this changed environment, with a view to identifying “optimal” pension saving strategies.

The Attractions of Pension Saving:

The benefits of pension saving are based on the ability to invest gross earned income and achieve tax-free investment growth. At the point of retirement a tax free lump sum is permitted up to certain limits, with income tax then payable as the pension is drawn down.

For pension savers whose employer makes contributions to an Occupational Pension Scheme on their behalf, the exemption of such payments from income tax, PRSI and the Universal Social Charge continue to make them an attractive and tax-effective way to remunerate staff. A Pension Levy of 0.6% of the fund value has been introduced for the 4 year period up to 2014, but investment growth remains tax free other than this.

For personal pension contributions made by individuals (for example, such as AVCs) the exemption from PRSI and the Universal Social Charge was withdrawn in January 2011. At this point employer contributions became more tax effective than individual contributions.

A point of detail on this – the method of taxation of Personal Retirement Saving Accounts (PRSAs) is such that even where employer contributions are made, no relief is received from the Universal Social Charge. 2011 has seen a shift away from PRSAs to more tax efficient pension structures in cases where the Employer is making relatively significant levels of contributions.

The introduction of reduced limits on the tax free lump sum which can be taken at retirement, and on the overall pension which could be built up without incurring penal tax rates, has meant that the accumulation of significant pension funds risks becoming tax inefficient – that is, that tax payable on drawdown may exceed tax relief received on contributions. A better strategy for individuals whose pension would exceed the lifetime limits will be to make savings outside of the pension environment. For higher earners and individuals with significant accumulated pension funds, there is a need for pause, to ensure that their pension saving plans are delivering the expected tax efficiency.

In What Circumstances is Pension Saving Clearly Attractive?

Where income in retirement is expected to be lower than (broadly) €40,000 pa for a married couple and €20,000 pa for an individual, pension funding is significantly tax effective. For pension funding up to these levels, income in retirement is taxed at a lower rate than the rate at which tax relief is received and the ability to take a Tax Free Lump Sum of up to €200,000 (with a further €375,000 allowed subject to the standard rate of tax) is a further significant tax incentive.

In What Circumstances Might Alternative Savings Vehicles be Considered?

The position is less clear for individuals with more significant pension funds built up. Tax on fund values in excess of the Standard Fund Threshold is a much greater risk, the advantages of drawing a tax free / tax efficient lump sum at retirement may have been fully utilised, and income in retirement will be taxed at marginal tax rates.

Such individuals will have been in the fortunate position of being able to accumulate significant pension funds, but they will benefit from considering the dynamics behind the future growth of their pension savings, and what actions might be taken:

1. Consider estimated pension benefits at retirement – where your fund is projected to exceed limits at which penal tax charges would apply, the option of ceasing pension contributions should be considered. As an alternative, contributions might be taken as taxable salary and the net income used to make investments through a savings policy such as a life policy for example.
2. Consider plans to access pension benefits – how and when are pension benefits likely to be accessed, and what flexibility can be developed in this regard. Given that ‘excessive’ pension funds are penalised, the accessing of pension benefits in an optimal manner can significantly increase the tax efficiency of pension savings.
3. Consider the investment strategy being followed within your pension scheme – where pension benefits are likely to exceed limits at which penal tax charges would apply, it may be appropriate to consider a lower risk investment strategy. Where higher investment returns cause the cap to be breached, the application of an ‘excess tax’ reduces gains-yet the impact of any investment loss would be borne in full. As such, a high risk investment strategy as an individual approaches the pension cap has an asymmetric risk/reward profile.
4. A preferred approach would be where personal circumstances allow the possibility of taking additional risk with non-pension assets so that an individual's overall investment strategy remains intact. The benefit of this approach is that where the pension cap is exceeded, both the capital amount and the income are taxed-whereas within a non-pension structure only the investment growth will be taxed.

How Might the Landscape Change Further?

Of the changes to the pension taxation regime expected in 2012, one of the potential changes is a reduction in the size of pension fund that an individual can accumulate tax effectively. The Minister for Finance's Budget Day speech noted that “the incentive regime for supplementary pension provision will have to be reformed to make the system sustainable and more equitable over the long term. My Department and the Revenue Commissioners will work with the various stakeholders in the next year to develop workable solutions”.

As to what this might mean in practice, we would highlight two views, those of the pension industry (as captured by comments from the Irish Association of Pension Funds):

• “The IAPF contends that this measure has the potential to provide an equitable platform for retirement planning. Anyone who wants and can afford a pension income in excess of €60,000 can then provide for it themselves.”

and those of the Minister for Social Protection:

• “What you also have to take into the account is.... the commitment in the Programme for Government to move to a situation where in the private or the public sector the Government would not give tax breaks of more than is required to fund an annual pension of €60,000. That... if you like is the framework, so that means that capping which has been used in the UK and restrictions on total amounts... ensure that as much as possible of your reliefs are geared toward lower and middle income earners. I've said before that I prefer that approach.”

Implementation may not be completely straightforward, but where implementation considerations can be overcome, a consensus may quickly emerge that capping pension benefits that can be accumulated tax efficiently is the most appropriate way forward.

What Next Steps Should be Considered?

The changing pension taxation environment has created the need for a more careful approach in making future pension saving decisions.

• Does the employer make contributions to the pension scheme? Employer pension contributions remain exempt from PAYE, PRSI and USC – whereas if salary was paid in lieu, it would be subject to all three deductions (As noted, Employer contributions to PRSAs are effectively taxed as Employee contributions).
• Is there any scope remaining to take advantage of pension tax efficiencies? (eg to fund a higher lump sum that may be possible to draw tax free / at lower rates of tax? to fund an income in retirement that will be subject to tax at less that marginal rates?)
• Is the existing €2.3 million pension cap likely to be breached? Would a lower cap be breached if it was to be reduced in the future?
• Is future investment growth on existing investments likely to cause a breach in any pension cap?

Conclusion

As the pensions taxation environment continues to evolve, the traditional wisdom that making pension contributions is a tax efficient method of saving for the long term may not always apply.

Individuals should carefully consider their individual circumstances before making any decision about pension funding. Based on their taxation profile, the extent of their current pension savings, the source of contributions to their pension savings and the likely impact of future investment strategy and contributions, different individuals are likely to find varying levels of attraction in saving through a pension fund.

Employers will also have to adapt to meet the challenges of the evolving pension's environment. To enable them to remunerate, retain and recruit staff tax efficiently companies will have to become more flexible when dealing with pension arrangements in 2012 and beyond.

Munro O'Dwyer is a Director with the Pensions Group at PricewaterhouseCoopers.

Email: munro.odwyer@ie.pwc.com

Direct: +353 (0) 792 8708

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