Despite the tremendous gains made by the markets over the last 11 years there is still over €108 billion sitting in deposit accounts in Ireland.
This came up in a conversation with a friend of mine recently who still declared that he would be better off putting €1,000 a month into a deposit account rather than €1,000 into a pension fund.
The argument was that the money would be more secure in a bank account and that any lost growth potential would be worth the cost over the next 25 years.
This argument needs to be debunked once and for all because it ignores the fundamental tax advantages that pensions have (i.e. tax relief and tax free growth) so here’s the assumptions I’m using;
– We will be looking at the same net spend of €300,000 i.e. €1,000 p/m x 12 mths x 25 years.
– €1,000 grosses up to €1,667 after tax relief at the highest rate with a pension.
– We’re comparing asset values only, not liquidity.
– Pension values include an AMC of 1.25% with 100% allocation
Deposit v Pension Fund
So, with that, here’s how they compare.
1) Deposit account paying 0.5% net interest:
€1,000 x 12 x 25 = €300,000 @ 0.5% p.a. = €318,709.
Return On Investment = 6.24%
2) Pension Fund with –2.5% (i.e. negative) growth:
€1,667 x 12 x 25 = €500,000 @ –2.5% p.a. = €328,209.
Return On Investment = 9.4%
3) Pension Fund with 0% growth:
€1,667 x 12 x 25 = €500,000 @ 0% p.a. = €431,718.
Return On Investment = 43.91%
4) Pension Fund with +5% growth:
€1,667 x 12 x 20 = €500,000 @ 5% p.a. = €805,422.
Return On Investment = 168.47%
5) Pension Fund with +8.92% growth:
€1,667 x 12 x 25 = €500,000 @ 8.92% p.a. = €1,393,296.
Return On Investment = 364.43%
Why 8.92% for the last one?
Well, I deliberately chose it to illustrate the fact that if you invested €1,000 a month and got an average of 8.92% p.a. you would end up with a fund which would net you the same €318,709 in liquid cash as the deposit account.
The difference of course is that you would be left with an additional pension balance of €1,074,587.
Invested money is at risk but, even when you compare the deposit account with the 0% pension, the difference still clocks in at over €113k.
However, assessing this in terms of future value is only one way of look at this proposition.
Net Present Value
Inflation will play a huge role over a 25 year timeframe so let’s account for it using the standard discount rate of 2.5% p.a. which will allow us to make a more relevant comparison in terms of net present value (NPV).
Applying this rate would depreciate our €300,000 net spend to €161,817 in today’s money which now serves as the new benchmark for comparison.
The impact on the other component values are that;
-The €318,709 deposit account reduces down to €171,909
-The €328,209 pension reduces down to €177,033
-The €431,718 pension reduces down to €232,865
-The €805,422 pension reduces down to €434,437
-The €1,393,296 pension reduces down to €751,531.
As such, we can now look at this investment proposition in terms of net present value.
1) Deposit account @ 0.5%
Net investment gain of €10,092 (€171,909 – €161,817)
2) Pension Fund @ –2.5% growth:
Net investment gain of €15,216 (€177,033 – €161,817)
3) Pension Fund @ 0% growth
Net investment gain of €71,048 (€232,865 – €161,817)
4) Pension Fund @ +5% growth
Net investment gain of €272,620 (€434,437 – €161,817)
5) Pension Fund with @ +8.92% net growth:
Net investment gain of €589,714 (€751,531 – €161,817)
A deposit account offers very limited growth potential but counters this with liquidity, accessibility and security.
A pension fund is more restricted but it more than makes up for this with higher growth potential, tax relief at 40%, tax-free growth until retirement and tax-free cash when you get there.
So, like any financial decision, there is a tradeoff to be made between security & performance which means that there is a big opportunity cost to consider.
But the key takeaway is “Don’t save for retirement in a deposit account”
Start a pension instead.