Providing for retirement is probably one of the most important but one of the most neglected aspects of personal financial planning. When people are setting up a business, they rarely think about putting aside adequate funds to enable them to live comfortably during their retirement. And how many self-employed people think to provide for a period when they might be unable to work due to illness or injury or to ensure their dependants are provided for if they die before retirement?
Making provisions for uncertain future events is a difficult financial concept for many people. There are a number of considerations which will vary from individual to individual. To make retirement provisions, for example, a person must consider at what age they plan to retire, how long are they likely to live after retirement, what level of annual/monthly income they will require to maintain their current lifestyle and what amount of their current income can they afford to put by to provide for the future.
But there is plenty of help about. Actuaries employed by insurance companies can work out life expectancies. They can calculate the amount that needs to be invested now to provide various levels of income in the future. And there are tax incentives to encourage people to provide for their future. But the decision to make the investment can only be made by the individual and the earlier they start to make provisions the better their final pension will be.
Research has given rise to serious concern about the lack of pension provision by self-employed people and employees of small companies. An Economic and Social Research Institute (ERSI) survey in 1996 found that only 27 per cent of all self-employed people had made any form of personal pension arrangements. Only 46 per cent of the working population had any form of pension coverage other than the State pension. Within the 27 per cent level for the self-employed only 12 per cent of farmers had made any pension provisions, only 11 per cent of women and 11 per cent of temporary workers. And only 7 per cent of employees working for small companies had a company pension plan.
Any self-employed person who has earned income can take out a personal or self-employed pension plan. Taking out a pension plan involves making regular payments to a life assurance company. These payments go into a fund which is invested on behalf of the individual. As the earnings from the investments grow in a tax-free environment the "fund" from which the individual will get his/ her pension is built up. The size of the fund available to provide the pension will depend on how much the self-employed person has invested, the age at which he/she started investing and the investment performance of the fund over the investment period.
When the individual reaches the agreed retirement age there is a choice: the entire fund can be used to buy an annuity which will produce the regular income that becomes the pension. Or 25 per cent of the fund can be taken in a tax-free lump sum with the balance used to buy an income generating annuity which will provide a regular pension payment.
The size of the pension payments will depend on the type of pension the self-employed person wants. The choices include a single life pension, or one which provides for a spouse after his/her death, or a pension that carries a guarantee of payment for a minimum of five or 10 years - that is the payments will be continued for the agreed period even if the insured person dies - or a pension that is index-linked - that is it increases with the rate of inflation.
Self-employed people can get tax relief for pension fund contributions. A person taking out a pension plan can get tax relief on contributions of up to 15 per cent of net relevant earnings (basically profits less charges allowed). For example, if a trader had net profits of £50,000 he would be able to invest £7,500 in a personal pension plan. That £7,500 of his income would not be taxed but the remaining £42,500 of his income would be liable to income tax.
For a person aged over 55 years tax relief increases to 20 per cent of net relevant earnings. Within a pension plan the self-employed person can use up to 5 per cent of the 15 per cent tax-free sum allowed to provide life assurance cover. This insurance makes a payment to dependants of the insured person if he/she dies during the term of the policy. As Mr Barry Skelton of Irish Life advises: people should take out pensions to provide for income when they retire and life assurance cover to provide for their dependants if they die before they reach retirement age.
But for self-employed people he considers Permanent Health Insurance (PHI) to be the most important personal finance provision. A PHI policy provides a weekly/monthly income for a period in which the insured person is unable to work due to an injury or illness.
The payout will usually be restricted to about 75 per cent of normal earnings and no payment will be made for a set initial period - usually 13 to 26 weeks.
The benefit will be paid until the person recovers or until he/she retires. A taxpayer can get tax relief for the cost of a PHI policy up to 10 per cent of income.
"It is important for self-employed people to get PHI in place. For employed people part of their PRSI contribution covers disability payments when they are unable to work. But there are no State allowances for the self-employed."
The cost of pension, life cover and PHI provisions will vary from customer to customer and often from life assurance company to life assurance company. The age of the customer is one factor which will influence the price charged for all types of cover. Other factors which influence the cost of life cover include the customer's state of health, whether he/she is a smoker or non-smoker and the sex of the customer.
Among the factors affecting the cost of PHI cover are the occupation of the insured - manual workers will pay more than clerical workers because injury or illness is expected to render them unable to perform their jobs for longer - and how long the initial payment is deferred for.
The cost of providing a pension will depend on the size of the pension the self-employed person wants to provide and the age at which they start making provisions. Whatever the amount the self-employed person needs to invest to provide the required pension - and actuaries can use statistical techniques to work out the amount - the insured person will only get tax relief on up to 15 per cent of net relevant earnings.
Insurance industry sources say people always underestimate what it will take to provide the pensions they require and that most people wait too long before they start to make provisions.
With a pension what you are trying to do is to provide replacement income for the rest of your life. The length of the retirement period is unknown, but for most people it will range between 10 and 25 years. Pension industry sources advise starting contributions early because the cost of providing a pension rises dramatically as the self-employed person gets older.
For example, Mr Skelton explained that a 29-year-old would have to make a monthly contribution of £200 now to provide a monthly income of £1,000 (in today's terms) at age 65 years. But for a 39-year-old the monthly contribution rises to £321 and for a 49-year-old it would be £610 to provide the same benefit. A complicating factor in current markets is that the cost of pensions is rising. There are three main reasons for this. The first is that as interest rates fall it takes more capital to generate a specific income figure, the second is that life expectancy is increasing so the income is required for longer periods, and, the third is that more people want to retire early.
Early retirement is very costly for three reasons. If a person who was due to retire at age 65 years decides to retire at 60 years his contribution period will be five years shorter so that less capital will be contributed. The period of investment of the fund will be five years shorter and because payment will start at age 60, instead of age 65, the length of the payment period will be longer. But retirement provisions through life assurance companies are not the only option. Self-employed people can look at other routes to provide an income in retirement. The sale of their business could generate the investment capital needed to provide an income, or they could invest in property, equities or other assets and count on the appreciation of these assets to provide for them in the future.
Since the tax relief on pension plan contributions is currently limited to 15 per cent of earnings and there are restrictions on the tax-free amount people can withdraw from their funds on retirement, many self-employed people may decide to make additional provision for their retirement in these other ways. But changes in the pensions legislation are expected following the Pensions Board recommendations in its report Securing Retirement Income. Legislation expected in early 2000 is likely to allow more flexibility with provisions to allow people to buy temporary annuities for a period after retirement. All employers are likely to be required to provide workplace schemes but the current rule that employers must fund one-sixth of contributions is likely to be removed. And the 15 per cent earnings limit for tax relief is expected to be increased.
