Now I think everyone reading this will be familiar with the basic rules and features of Snakes and Ladders. So I won’t bore you on that front.

As a child I enjoyed playing this boardgame with my siblings so it pleased me to see the reactions of my own children when they scaled the heights of the ladders or slipped back down the snakes.

Investing in pension funds and stocks and shares has been a lot like ‘Snakes and Ladders’ for many people over the last number of years. However, it has been a less than pleasant experience for most. It seems that when investment markets are on a good run they hit a ‘snake’ and drop downwards. A steep ‘ladder’ is then needed to rebound.

Many people I speak to feel investing is akin to just rolling the dice and seeing where you end up. They believe it is all luck and no skill.

When your pension fund suffers a drop due to poor investment conditions it can become extremely disheartening when you calculate how much of a return is required simply to get your fund back to where it was at.

To emphasise this point consider the following table. It shows the level of positive investment performance that would be required to bring a person’s pension or investment fund back to where it was after suffering different levels of negative investment performance.

Table 1

Please note this simply applies to lump sums or pension funds where no further contributions are being made. Where regular contributions are being made a phenomenon known as ‘Euro Cost Averaging’ takes effect. I will explain this in my next post.

The obvious message is to avoid funds that can provide severe drops in fund value in a year. Although they can also produce years of high positive investment growth the volatility levels are not suitable for many investors.

It is extremely important to conduct a review of your ‘investment risk profile’ to determine whether the investment fund in which your pension contributions are invested meets your expectations.

This will ensure you avoid the really snakey funds producing more ladders – even if the ladders are more akin to regular foot ladders.

In my April 2012 post I will provide a real life case study of two different industry funds using actual returns achieved over the last 10 years and comparing how both performed in the good years and the bad.

Recently I was asked to take over the running of a group pension plan for an SME.  The main reason for my appointment was they felt they were not getting the required level of service or advice from the previous pension provider.

When I ran through the data I noticed that certain staff had not joined the scheme.  What was strange was that the employer told me that all staff members were allowed to join with the employer making a minimum contribution of 1/10^th of the employee’s contribution.  These particular staff members had simply ‘opted out’ of joining the scheme.

On closer inspection I discovered that the two staff who had opted out of the scheme were ‘over 50s’.  When I spoke with them they explained that they felt it was too late to start funding now.  They would have to contribute too much to produce a meaningful pension in retirement – the last adviser had shown them some ridiculous contribution figures that they simply couldn’t afford.

When I asked whether the last adviser had explained how they could avail of a tax free ‘golden handshake’ at retirement they both replied ‘no’.

One of the employees was aged 53 with a salary of €47,000.  I shall call him Joe for the purpose of this real life illustration.  On discussion with Joe he tells me the following:

• He aims to work to age 65
• He has worked with the company for 9 years.
• He never believed in pensions. He jointly owns an additional property (inheritance) that will either support him in retirement from rent roll or he will sell on agreement with his brother (joint owner).
• He has recently paid down his mortgage but has two children to support in college costing him ‘an arm and a leg’.
• He is about to commence saving €300 per month into a credit union account for his retirement.
• He intends to increase this saving by about 3% p.a. in line with what he hopes will be his annual salary increases.  He may increase this more in the future depending on affordability.
• He is not concerned with investment returns.  He just wants to ensure his money is safe.  He understands the negative effects of inflation but is unwilling to invest in any risk assets to offset inflation as this is ‘too risky’.  He just wants to ‘put by’ today money that he would otherwise spend.
• He reckons that he will have about €51,100 in the CU when he reaches 65 – better than the proverbial ‘kick in the backside’.
• He will be entitled to the contributory State Pension from age 66 and will get the transitional pension at 65.  He will have the credit union money and the 50% of rent roll or 50% proceeds from sale of the property asset to support him in retirement.

I commended Joe on two things:

• The fact that he had no borrowings and had managed to pay off his mortgage by age 53.
• The fact that he was at least saving something towards his retirement i.e. he had given it some consideration.

However, I explained to Joe that his approach to retirement planning was ill conceived for two main reasons:

1)      He is ignoring pension tax laws that would allow him to increase his lump sum at retirement substantially without increasing his net outlay.

2)      He is confusing pension plans (the savings vehicle) with ‘risky investment funds’ (just one of the investment options) – he didn’t realise he had the option to invest in secure cash funds or high yielding deposit accounts free of DIRT in a pension.

My Message to Joe

Under current pensions legislation by the time Joe reaches retirement he will be entitled to a tax free lump sum of 1.5 times his final salary (subject to an overall limit of €200,000).  Assuming his salary does increase in line with inflation then by age 65 his final salary will be €65,059.  Therefore, he will be entitled to a tax free lump sum of €97,589 at age 65.

But how does he build up this fund?

A gross payment each month of €509 will cost €300 in net terms after allowing for 41% tax relief*.  His employer is more than willing to meet 10% of Joe’s contribution i.e. a monthly payment of €50.  This means a total of €559 goes into his pension pot each month.  As Joe does not want any investment risk he can simply put the contributions in a cash fund that produces no net return.  His payments will increase by 3% each year in line with salary just like our credit union example.

Why take this approach?

After 12 years a total of €95,200 will have been paid in and the plan will be worth €95,200.  The total net cost to Joe will have been €51,100**.  Joe will be entitled to take the entire fund of €95,200 tax free.  So now he has increased his pension pot at retirement by €44,100 or 86% without incurring additional costs. Not bad for someone who didn’t believe in pensions!!!

And the gross cost to Joe’s employer will have only been €8,500 over the 12 years.  Assuming corporation tax relief of 12.5% the net cost to the employer will have only been €7,438 approximate.

‘Nobody ever told me that’ is what Joe said to me.

And this is just one area where a good pension adviser can add value within group pension arrangements.  Too many advisers don’t take the time to look at the circumstances of individual employees.

Summary contrasting the pension approach versus Joe’s approach to saving for his retirement

*Assumes Tax Relief at 41%.  This could change in the future.

**Assumes tax relief of 41% on all Joe’s contributions.  The issue of tax relief is still being looked at.  It was proposed to reduce to 34% in 2012 but the government postponed the implementation of the reduced rate for the time being.