Easy maths to ensure you put enough into your pension
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If you are a 40% taxpayer and put €10,000 into a pension, the tax saving is like the State putting €4,000 into your pension, writes , managing director, MCG Financial Services.
I know, I know, we would say that wouldn’t we? But probably the single biggest challenge we face every day as financial planners is convincing people in their 20’s, 30’s and even early 40’s of the importance of planning for retirement from an early age.
Not doing so, often turns out to be the single biggest missed financial opportunity in life — we know it’s hard for a pension contribution to compete against buying a shiny new car, an additional holiday, or some other immediate lifestyle purchase.
But retirement planning is very much a young person’s game — starting your pension early in life has lots of benefits.
Paying tax is a necessary evil and we all do what we can to legitimately reduce our personal burden. Pension contributions are one of the last bastions of gaining tax relief at your marginal rate.
If you are a 40% taxpayer and decide to put €10,000 into a pension, the government is effectively contributing €4,000 to your pension as a result of the income tax avoided. So you want to start benefiting from this important tax break as soon as you possibly can.
Unlike bank deposits that are subject to DIRT tax at 33% on interest earned (there’s not much of this available at the moment) or investment funds that are subject to exit tax at 41%, pension funds grow tax-free. Over the long term, this makes a significant difference to the gains that remain within your fund.
Obviously the later you start planning for your retirement, the more that you’re going to have to save to build up a meaningful fund.
How much is enough? Well like many financial conundrums, there’s no simple “one size fits all” answer. It depends on many factors including when you want to retire, your income requirements in retirement and how long you’re likely to live, among other factors.
But this doesn’t answer the question, so as a very rough rule of thumb to achieve a moderate lifestyle in retirement, you should aim to save a minimum of “half your age” from when you start.
So, if you’re 30 years old when you start saving for retirement, you should aim to save 15% of your income each year from now until retirement. If you wait until you are aged 50 to start, you should then aim to save 25% of your income each year. Of course, this is only a rough calculation and the key to identifying the right amount for you is to get expert advice.
Most people are aware of the relationship between risk and return. Given a meaningful timeframe of at least 10 years, assuming more risk usually offers up better opportunities for higher returns. However time is such a critical factor, as taking risks can result in losses too, which require time to recover from.
Contributions started into a pension plan in your 20’s or 30’s have the benefit of time on their side to grow very significantly from the time they are made, to your retirement age. Yes, losses should be anticipated along the way too if more risk is taken. But given enough time, history has shown that long-term investments offer greater potential for higher rewards where a level of risk is taken.
But be careful, risk is a double-edged sword. Again, expert financial advice that helps you to identify your appetite for risk and an appropriate investment approach is so important.
Albert Einstein said: "Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn't, pays it.”
Saving early into a retirement fund puts you on the right side of this.
Consider the “Rule of 72” which determines how long a sum of money will take to double, given a fixed annual rate of interest. All that you do is divide 72 by the expected rate of return. The answer is the number of years it will take for the amount of money to double.
If you are young, aiming for a very bullish return of (say) 8% p.a., it will take 9 years for your investment to double (72/8% = 9 years) However if you are older and rightly more cautious, you may only be aiming for a return of (say) 3% p.a., In this case, it will take 24 years for your investment to double (72/3% = 24 years).
So starting early, having the opportunity to take on a bit more risk in the hope of achieving higher returns and then having the benefit of time can have a seriously positive impact on your pension fund. And underpinning all of this is the need for expert financial advice to ensure your retirement plan offers you the best chance of success.