Savers and investors – especially high net worth individuals – are likely to start moving money from cash holdings and direct investments into pension funds and other tax-efficient structures following changes announced in last week’s budget, according to financial advisers.
Higher taxes on interest income and capital gains – plus clarity on how the pensions regime will operate in the coming years – have created greater incentives for investors to favour retirement schemes, where contributions and capital gains are tax-free, over other investment vehicles, especially in light of historically low yields on deposits and fixed income products.
While capital gains tax (CGT) and deposit interest retention tax (Dirt) were both put up by Minister for Finance Michael Noonan from 30 per cent to 33 per cent last Wednesday, cutting real returns on cash and other assets, tax relief on pension contributions remained untouched.
The minister also extended 4 per cent PRSI withholding to all income – a further blow to those who save and invest outside of pensions, especially property investors with rental income who will also be paying property tax. Yet Noonan’s commitment to end the 0.6 per cent annual pension levy after two more years represented a rare tax cut in the budget.
The effect has been to make pensions more attractive relative to other ‘old reliable’ investments, such as equities and buy-to-let houses. As a result, financial advisers are expecting inflows to pensions in the next year as investors avail of the 41 per cent tax relief to top up their pension pots ahead of the new €60,000 drawdown cap which comes into play in 2014.
“People are forgetting that the benefits of pensions as an investment vehicle are getting stronger because it is becoming more punitive to hold investments directly,””said John Sheahan, investment manager at Smith & Williamson in Dublin, which caters to high net worth clients with at least €250,000 to invest.
“Now is definitely a time to look at different structures.” With a lot of investors holding cash due to fears of market volatility because of the ongoing financial crisis, taxes will start to bite harder in January. Not only is Dirt going up by a tenth, but Revenue will be taking 4 per cent from interest income in the form of PRSI, bringing the total tax take on investment returns to 37 per cent.
“As banks cut deposit rates to improve their margins, cash savings are looking less and less attractive.
“Dirt coming up again is very big. It’s going from 20 per cent just a few years ago. Coupled with lower deposit rates, net returns are a lot less. Every single basis point counts.””
The emphasis now – especially for anyone coming up against the pensions cap – is on sound planning and developing the right balance between ordinary savings and pension funds, in occupational schemes as well as self-invested schemes.
“The need for members to manage the right combination of pension and savings over time throughout their working lives, into retirement and beyond has never been more important,”” said Michael Madden, partner at Mercer. “Employers who demonstrate flexibility and can deliver solutions which are tax and cost neutral will have created a significant retention tool for employees.”
“But there is also concern in the financial industry that the new pensions measures, while more welcome than the feared cut in the top rate of tax relief, might be storing up problems for the future for those with high incomes who want to shelter their earnings for retirement. One concern is that the €60,000 limit to pension income availing of tax relief might be too low in a few years if it is not indexed to inflation.”
Patrick Cosgrave, director of pensions at Deloitte, said: “The reduction in tax effective pension pots will affect higher earning self-employed, private sector employees and senior civil servants. These will now have to reconsider their pension planning. Those with larger accrued pensions will be most immediately affected, but many others may be affected over the longer term if this cap is not indexed.””
Reactions to Noonan’s concession on annual voluntary contributions were mixed. For the next three years, savers who have made AVCs can withdraw up to 30 per cent of their value. This money was previously locked up until retirement. But the downside is that the income will be subject to the top marginal rate of tax – 41 per cent – reducing its appeal.
“Withdrawing pension savings does not make economic sense if they are going to be subject to a 41pc tax rate,”” said Diarmuid Kelly, chief executive of the Professional Insurance Brokers Association, which lobbied before the budget for AVC withdrawals to be allowed. “We would anticipate that the measure will, as a result, have little appeal, if any, for consumers.””
Other advisers said most people with a pension pot – and disposable income – big enough to have made significant AVCs would be close to the minimum retirement age of 60, anyway, when they could take out a 25 per cent lump sum from their fund without paying tax on the first €200,000.
But for those whose most pressing financial need is debt repayment, the tax on AVC withdrawals will come as a real blow, according to pensions expert Aidan McLoughlin.
“I would think this is a mean-spirited measure,”” said McLoughlin, managing director of Independent Trustee Company, a pensions advisory firm with €750 million in assets under management. “This is tax the government would not otherwise have got as most pensioners are tax exempt or on the standard tax rate.
“An individual, in financial crisis, attempting to resolve his or her financial matters is prepared to sacrifice a portion of his retirement income and the government decides they want to take half it in tax. It’s the financial equivalent to putting a levy on lifeboats! Bear in mind this money will have already paid USC, PRSI and pension levy.”While the environment has certainly improved on balance for pension investors, those who bought investment properties as their pension did not have anything to cheer in the budget, as Noonan introduced a property tax for the first time and slapped PRSI on rental income. Coming at a time when more than a quarter of buy-to-let borrowers are in arrears, the new measures could spell the end for the Celtic Tiger generation of part-time landlords.
“With very few property investments paying for themselves, these new taxes will simply widen the monthly cash gap, which will cause greater financial pressure potentially increasing arrears,”” said Christine Keily, senior tax consultant with taxback.com. “It’s difficult to see the benefit of this change, with buy-to-let investments at tipping point, further taxes may increase bank arrears, potentially costing the taxpayer more money.”
Yet institutional property investors will no doubt be pleased that they will now be able to invest in Irish commercial property via real estate investment trusts (Reits), as in other countries, rather than buying properties directly.
Reits allow investors – usually institutions but also individuals with large cash amounts to invest – to buy tradeable shares in a portfolio of properties to spread risk and increase liquidity, providing a more stable investment base for the sector. In Ireland’s case, it could help re-establish transactions.
“The introduction of Reits allied with €2 billion of Nama vendor finance is an extremely positive development and will help underpin the recovery of the Irish commercial real estate market,”” said John Heffernan, tax partner with Ernst and Young. “The country has previously been disadvantaged when attempting to attract foreign investment in real estate as investment in the sector, via Reits, was not facilitated as was the case in other economies including the US, UK, France and Germany.””
From a macro-economic perspective, Ireland’s record of sticking to the tough schedule of fiscal adjustments laid down by the troika remains unblemished. This has so far helped the state – and the banks – return to the capital markets in a limited way this year.
Next year will be decisive, as full market access will be needed to exit the bailout programme in 2014, but the weak economic outlook could still prove troublesome, even though future budgets are expected to be easier.
If outside investors keep faith, conditions should improve for domestic investors. If it goes the other way, the local mood could sour.
• Pensions look more attractive from an investment point of view following new taxes introduced in last week’s budget
• Financial advisers say money should flow to pensions and other tax-efficient investment vehicles as direct holdings are becoming more expensive due to higher capital gains taxes and charges on interest income
• Direct property investing is far less attractive due to the new property tax and the application of PRSI to rental turnover rather than net profits, but institutions should benefit from the introduction of Reits