Allan Lewis, Contributor"THERE IS no such thing as a free lunch" is an adage suggesting that in life, and especially with respect to financial matters, one is not usually able to get something valuable for nothing. However, employees fortunate enough to be members of occupational plans, are able to take advantage of the favourable tax status of pension plans in order to improve their financial
security.
Approved superannuation funds and retirement schemes enjoy significant tax benefits for the sponsor (e.g. employer) and members (e.g. employees). The investment income and appreciation earned by the assets of pension funds accrue tax free. Moreover, pension contributions by employers and employees are tax deductible. For employees this is significant because income taxes and some other statutory deductions are calculated after pension contributions have been deducted from the employee's gross compensation.
Consider an employee who earns a gross annual salary of $800,000 and is a member of a pension scheme. Let us also assume that the member is required to contribute five per cent of gross salary to the scheme, and has the option to contribute up to an additional five per cent. Finally, our illustrative employee is preparing for the future by saving $500.00 per month.
A number of interesting points are evident from the table. Firstly, the employee will reduce his or her tax liability by making voluntary contributions to a pension fund. Secondly, the employee is the beneficiary of the decrease in income taxes payable: He or she will reduce after tax income ($2,433,33), and increase net savings by an amount ($3,333,33) in excess of the reduction in after tax income, thereby increasing net worth ($900.00). In fact in this example, the employee will be better off even if he or she increased current consumption and stopped saving the $500.00 per month!
When presented with this analysis, employees often respond by claiming that the investment returns exhibited by their pension plan are very low when compared with investment opportunities in the bond, equity and money markets. This assertion has an intuitive appeal. After all, it is true that some pension plans provide members' voluntary contributions with anaemic returns even though the overall pension fund has earned returns comparable, or in some cases, better than those of other investment vehicles. In such instances, trustees should be encouraged to review these arrangements in consultation with their plan administrators and ensure that the investment returns that accrue to employees' voluntary contributions are directly related to the returns achieved by the overall fund.
Notwithstanding its apparent attractiveness, the fact is that the aforementioned rejoinder has no merit even if the voluntary contributions exhibited a negative return of as much as 27 per cent! More specifically, members of approved superannuation funds and retirement schemes are still better off making the maximum voluntary contribution allowed by their respective schemes even if the voluntary contributions declined in value by 27 per cent in the year after the voluntary contributions were made. This counter-intuitive result stems from the fact that the tax advantage provided to pension plans are so valuable that it more than compensates for the possibility that the pension fund may earn negative returns.
Employees face choices every day: Do I consume today for instant gratification or save instead and enhance my future financial security? Inflation is one significant complicating variable in determining the relative merits of this common dilemma. However, members of pension plans who maximise the use of their scheme as a savings vehicle will be better off in the future, other things being equal.
Members of pension plans should contact their human resource departments and commence making voluntary contributions. In addition to enhancing their financial security, they may just get to earn a "free lunch" or two.
Disclaimer. This article was prepared by Allan Lewis who is the Managing Director of Prime Asset Management Limited ("Prime"). Prime provides pension fund administration and investment management and advisory services. The information contained in this article has been obtained from sources that Prime believed to be accurate and reliable. Prime does not purport to be giving any specific advice, legal or financial, and readers are encouraged to seek advice on any specific issues raised in this article. Prime does not deal in or make a market in any securities mentioned in this article. Please do not hesitate to contact the author at allanl@primepensions.com with comments and questions.
Taken from the Financial Gleaner, Friday, September 30, 2005.
