What Is An ARF?

Let’s face it, pensions are boring, complicated and full of jargon. Unfortunately they are also very important to our wellbeing so whether we like it or not, it’s important to know the basics.

If you have a private pension (ie, anything other than the State Pension) you can generally take up to 25% of the value of the fund at retirement in the form of a tax free lump sum. So what happens to the remaining 75%? You will normally then have a choice between an Annuity and/or an Approved Retirement Fund (ARF). An Annuity is a pension product where you buy a (taxable) income for life in return for a once-off upfront payment – I explained more about this in a previous blog, What Is An Annuity?

So then, what is an ARF?

An ARF is a retirement fund where you can keep (75% of) your pension pot invested after retirement. Instead of a set Annuity payment for life, you decide when to withdraw funds as (taxable) income. Key point – unlike an Annuity, any money left in the ARF fund after your death can be left to your next of kin.

Advantages of an ARF

  • You keep control of your retirement fund – a major plus if you are in poor health (as an Annuity dies with you) and/or want to leave your money to your dependants after you die.
  • You have flexibility in terms of when and how much you withdraw from your ARF in retirement – but you must take an annual minimum of 4% in your 60s and 5% after that.
  • You can choose how to invest your ARF and select investments that suit your needs and attitude to risk. Remember, growth in your ARF is tax free, but withdrawals are taxable.
  • You can always use your ARF to buy an Annuity later on, if you decide that you need a secure, regular income – you may be able to get a higher Annuity rate (ie, a bigger income) later on for the same lump sum as you will be older.

Disadvantages of an ARF

  • Your retirement money is not guaranteed to keep its value because the assets in which your ARF is invested may not perform as well as expected – whereas the Annuity income is set in stone.
  • Your ARF funds could run out in your lifetime if you take out too much income or if investment performance is poor or if you live longer than expected.
  • You will have to pay ongoing ARF / investment charges.
  • There is no guarantee that your ARF will be able to buy you a higher Annuity pension later on – annuity rates could be even lower in the future.
  • Revenue automatically assume that withdraw 4% to 5% each year and tax you on that amount whether you like it or not.

To conclude, if and when you face the choice of Annuity versus ARF, it is important to weigh up the pros and cons of both, and consider your total financial and personal situation (perhaps with the help of a financial advisor) before you make a final decision.

What Is An Annuity?

Many people will have heard pension conversations mention the words Annuity and ARF without understanding (or not being interested in) what they actually mean. So here goes.

When you retire your pension fund first provides you with a tax free lump sum. You will normally then have a choice between an Annuity and/or an Approved Retirement Fund (ARF).

An Annuity is a pension product where you buy an income for life in return for a once-off upfront payment from your pension fund.

There are various choices – and prices – of Annuity. A Single Life Annuity is payable for the rest of your life only. A Joint Life Annuity pays a percentage of your pension to your spouse after you die. A Level Annuity pays the same amount throughout your life while an Escalating Annuity pays an increasing payment amount throughout your life.

The drawbacks of an Annuity are …

  1. Once you take an Annuity, you lock in a rate of income for life. There’s no going back.
  2. If you live longer than expected, you’ve got a good deal. If not, the insurance company is the ‘winner’.
  3. Your stream of income ends when you die – there is nothing left to pass on.
  4. Right now a pension pot of €100k might buy you an annual €4k payment for life – twenty years ago you could have got twice this.

An ARF is a pension product where you can keep your money invested after retirement and decide yourself how much income to withdraw.

The advantages of an ARF are …

  1. You retain ownership of your pension pot – which is passed to your spouse / children /estate when you die.
  2. You control investment decisions and continue to benefit from tax free market returns.
  3. You also control income decisions, subject to certain conditions.
  4. You retain the option to buy an annuity later, which will pay a higher income as your life expectancy declines.

If you are comfortable with market risk and have significant resources, an ARF makes sense, but if you value the certainty and simplicity of a guaranteed income above all else, an Annuity makes sense –  or you can opt for a a combination of the two.

Try this Zurich ready reckoner but one way or another, you should talk to an independent financial advisor when you are about to retire, as choosing the right Annuity and/or ARF depends a lot on your personal circumstances and will significantly impact your retirement income.


How Much Do I Need To Retire?

A question I get asked countless times is, how much do I need to retire? While there is no exact answer, and certainly not one figure that applies to everybody, there are two methodologies we can use to come to a conclusion.


The Salary Method

You’ll probably have seen various interpretations of this approach. There has been a traditional general assumption that most people/couples will need total pensions equivalent to two-thirds of salary. This two-thirds rule of thumb has been reached based on an assumption of lower spending in retirement. Some say that if the State Pension takes care of one-third of salary (that’s a big if!) then we should aim to build up private pensions that produce the remaining one-third of salary. I don’t like this methodology for two reasons, 1. Our current salaries may be too high or too low to act as a correct benchmark, and 2. Expenses are too important to be reduced to a secondary consideration.

The Expense Method

I favour this method as it’s far more likely to give you the correct answer (even if hearing it is not particularly comforting). Here we ignore salary and simply estimate what our annual expenses will be in retirement. I like the very user friendly Standard Life online calculator which tells me that my wife and I will face annual expenses of €50k living a comfortable but not extravagant retirement (I multiply the result for a single person by 1.6 to get the estimate for a couple).

So, How Much Do I Need To Retire?

In our case, if I subtract (one) €20k annual State Pension – which we can’t necessarily bank on – that means I will need a pension pot that can pay my wife and I a net €30k (let’s say a gross €40k) per annum all through retirement. Which means (I use a multiplier of 25) that we will need a total private pension pot of around €1 million to secure the retirement we want. Ouch!

That’s a big and scary number (and based on lots of assumptions about the future). Of course in reality, some of us will have additional capital (from non-pension savings or perhaps a property downsize) and some of us will maybe retire a bit later than planned. But the clear message for us all is that we really need to think very seriously about how much we need to retire and make every effort to maximise our pension contributions.

Need independent pensions and investment advice? Just call Money Smart on 01 276 0006 or email info@moneysmart.ie.

Pensions Made Simple (ish)

Pensions Made SimpleMade simple, really? OK maybe I’m setting the bar too high but I want to tell you all you need to know about pensions.

I’m bored already. Wait, this is important. Just give me 2 minutes of your time.

OK, go on then, why do I need a pension?  Because your income could drop to €12,000 a year if you only have the State Pension to rely on. That might pay for your annual cruise but not much else!

But I’ve got my work pension, right? If you’re in the public sector, yes. In the private sector only 6 out of 10 people have a work pension. Even then, most of us still won’t have enough, especially in the gap between retirement (55? 60?) and getting the State Pension (68?).

So I just need to put some money on deposit and watch it grow. Simple. Not so fast. Deposit rates are close to zero. You need to invest in a pension.

Why a pension? It’s too complicated. I know. Even the Bank of England chief economist says he can’t understand pensions. But he’s alright because he has a work pension that will pay him £80,000 a year. The rest of us mere mortals really need to invest for retirement in a pension – and the simple reason is tax relief.

Tax? Zzzzzzzzzzz. Stay with me.  If you contribute €100 to a pension the tax man gives you up to €40 back. So a €100 investment costs as little as €60 and it grows tax free until you retire.

Free money? There’s got to be a catch. No catch. OK you can’t touch the money until you retire but that’s a small price to pay for free money.

Yeah but I’m taxed on the money when I take it out! Yes but not much. The combination of being allowed to take a large lump sum tax free and the retirement income tax exemption means that most people end up paying minimal tax on retirement income.

OK but aren’t there lots of complicated rules about how I can actually get my hands on the money? You’ve got me there – that is true. But those constraints are being relaxed all the time. Now you can control your money in retirement and it doesn’t die with you (like it used to).

What about fees and charges? I’m probably going to get ripped off? Not if your financial advisor is on the ball. True it’s easy to hide all sorts of charges in complicated financial products but pensions are getting cheaper and much more transparent.

But hasn’t investment performance been rubbish? Ok yes in the bad old days some Irish pension companies thought a diversified portfolio was a Bank of Ireland bond, some Dublin commercial property and a shareholding in Anglo Irish Bank (doh!). Now you, or your financial advisor, can pick and choose your own globally diversified portfolio.

OK sounds like a good idea but how do I ‘get’ a pension? The paperwork alone must be a nightmare. Believe me, with the right financial advisor (ahem) it’s as easy as opening a deposit account. And the sooner you start the better. Over to you…

Call Money Smart on 01 276 0006 or email info@moneysmart.ie.

Ireland’s Pension Crisis

watching timeYou may have noticed (or hopefully missed!) various news headlines recently about the terrible state of pension coverage in Ireland.

Here’s a quick summary of the depressing facts.

  • The Chairman of the Pensions Authority said that what people expect to receive in retirement income is way out of line with what they will actually get. He said too few workers had pensions and many of those that have a private pension in place are putting too little into it.
  • Standard Life released research showing that the average person has only put enough into their pension to give them a weekly income of €60, excluding the State pension. Half of people want to retire to live in the sun or by the sea but the average person has only enough in their pension pot to give them a retirement income of €3,000 a year (excluding the €12,000 a year State pension) versus the (quite low!) €31,000 a year that those surveyed said they would need to live comfortably.
  • The Government’s Fuller Working Lives Report noted that once the public sector is excluded, six out of ten workers have no supplementary pension coverage. And over half of men and women have already stopped working before they reach State pension age.

Unfortunately the situation is only going to get worse. All of the above experts agree that the €233 a week State pension is not sustainable, pension investment return expectations are too high and the numbers of people with private pensions is actually falling.

Next month, we will turn away from this pretty grim big picture and take a look at what a private pension actually is, how to start one, why you need one and what you can do to avoid being an unfortunate statistic.

Don’t Get Stuck In Default Mode

too many choicesDo you think you have free will? How often do you exercise it? You may need to think twice about your answers because every time we make a decision there are powerful behavioural forces hampering our ability to choose.

The dominant force I want to talk about is inertia, our deep psychological resistance to change. In many situations we seek to minimise the effort or cost of thinking. For example, as Nobel Prize winning author Daniel Kahneman points out in “Thinking Fast And Slow”, 12% of Germans are organ donors versus 99% of Austrians. The reason why? Inertia. Germans (like us Irish) have to opt-in but Austrians have to opt-out. It’s easier to do nothing than to do something. Default settings are therefore powerful tools in framing our choices.

Whether it be a pension plan, a privacy setting or a car rental agreement, any change to the default requires effort on our part. This may be a good thing if product providers are acting in our best interests but as Cass Sunstein notes, “Choosing Not To Choose”  is often not the right decision. For example, we end up with some unwanted and expensive holiday insurance when all we actually wanted was to book a budget flight online.

In my business I see a lot of people whose pension details are not just buried in a dusty shoebox, they are also stuck in an inappropriate asset class. Because pensions are boring/complicated/opaque, no great effort is made to match asset allocation to the clients’ circumstances. Some surveys show that up to 85% chose the default option – which in my experience is often too conservative for a lifetime investment strategy. Similarly, I know of many instances where fear and loss aversion has driven money into cash after the 2008 crash but inertia has resulted in many years since of low/no performance.

The solution? In the case of pensions, ensure your financial advisor has an ongoing hands-on approach to your pension investments. If you don’t have an advisor you will need to make a little bit of effort to rescue your pension from the doldrums.

More generally we have to hope that governments and corporations take more responsibility so that our pre-wired inertia bias is no longer used against us when it comes to product sales.

Talk to Money Smart about maintaining a pension portfolio appropriate to your needs by calling 01 276 0006 or emailing info@moneysmart.ie.

Beware Your Inner Chimp

Chimp sticking his tongue outWhat do Ronnie O’Sullivan, Bradley Wiggins and Liverpool football team have in common? They have all benefited from the sports psychology coaching of Dr Steve Peters, author of The Chimp Paradox. The inner chimp is the primitive part of the brain that is impulsive and emotional by nature. If we allow our inner chimp to control us, our decision-making will be irrational and, most likely, detrimental.

Now despite recent hiccups (let’s not mention Mark Selby or Crystal Palace!), the sports stars mentioned have all converted better mind control into improved performances. So much so that Peters’ latest client is the England football team. Let’s see how that works out this summer, particularly in a penalty shoot-out situation!

The inner chimp theory is very much related to the arguably more scientific work of Nobel Prize winning behavioural economist Daniel Kahneman, most notably in his ‘bible’, Thinking, Fast and Slow. Both Peters and Kahneman agree that we are creatures of sub-optimal thinking, prey to impulsive, emotional, irrational ‘fast thinking’.

Now while most of us no longer need controlled minds for high pressure sports events, we do need to think rationally when making money decisions, and unfortunately, our default ‘fast thinking’ is very much in evidence in our financial lives. For example…

  1. Confirmation Bias. We tend to only use information that matches our existing beliefs and ignore data that suggest otherwise. For example, when we buy a house we tend to seek out only opinion that supports such an investment.
  2. Overconfidence. We think we’re better than average at almost everything, including investing. This leads to costly overtrading and is, perhaps not surprisingly, more prominent in the male of the (human and chimpanzee) species.
  3. Anchoring Bias. We rely too heavily on the first piece of information offered when making decisions. Advertisers use this flaw to nudge us, very successfully, into economically irrational choices.
  4. The Endowment Effect. We place a higher value than others would on things we own. Often as a result of our pre-wired Loss Aversion – we prefer avoiding losses to making gains. Four words. Bank of Ireland shares.

So how can we control our minds when making important financial decisions?

1.   Be Aware. Try to recognise situations where you may not be thinking rationally.
2.   Slow down. Disengage your fast thinking brain by delaying decisions.
3.   Outsource. In other words, use an (emotionally detached) independent advisor.
4.   Have a Plan and a Process. Make money decisions based on a Financial Plan and executed with reference to a rational consistent process.

 Investment and pension decisions are the key to your financial future. Silence your inner chimp and give Money Smart a call.

Are Annuities Always The Worst Option?

Road sign which says 'Retirement ahead'

The sweeping reform of pensions in last week’s UK budget has put the much-maligned pension annuity back in the headlines. With annuities no longer compulsory in the UK, some newspapers began writing obituaries for the centuries-old annuity and one specialist annuity provider saw its shares drop 55% on budget day. This ignited a wider political debate about the pros and cons of a ‘nanny state’, with the UK Pensions minister saying he wouldn’t worry if those once annuity-destined savings were now spent on a Lamborghini!

So, what is a retirement annuity? An annuity is a pension product where the retiree buys an income for life in return for a once-off upfront payment.

Here in Ireland, an annuity is not necessarily compulsory. Many of us will have the option to retain pension funds in an Approved Retirement Fund (ARF) if we have a guaranteed annual income of at least €12,700 or if we put €63,500 into an Approved Minimum Retirement Fund (AMRF), from which we cannot draw funds until we are 75.

The drawbacks of an annuity are that:

1. Once you take an annuity, you lock in a rate of income for life. There’s no going back. 

2. You have exchanged your pension pot for an income, based on your life expectancy. If you live longer than expected, you’ve got a good deal. If not, the insurance company is the ‘winner’.

3. You no longer own your pension pot, just a stream of income which ends when you die – there is nothing left to pass on.

4. Your income is based on prevailing long term interest rates, which at the moment are around 300-year lows. Right now a pension pot of €100k will buy you an annual €4.5k (approx.) payment for life – twenty years ago you could have got more than twice this.

Compared to an annuity, the advantages of the ARF route are clear.

1. You retain ownership of your pension pot – which is passed to your spouse / children /estate when you die. You are not gambling on your own life expectancy.

2. You control investment decisions and continue to benefit from market returns and tax free roll-up.

3. You also control income decisions, subject to certain conditions.

4. You retain the option to buy an annuity later, which will naturally pay a higher income as your life expectancy declines.

So, coming back to the headline, are annuities always the worst option? Despite everything I’ve said so far, no, not always. I believe we should not mourn the death of the annuity just yet. True, rates are at historical lows but they are creeping back up again. Also, we must judge the annuity ‘return’ against future market returns (which of course we don’t know), not against historical market returns. We may look back in 20 years’ time and say 5% annuities were actually a decent return versus a balanced fund ARF. Those who mismanage their ARF funds due to poor investment decisions or a flawed income strategy will certainly regret not taking an annuity. And for many, the ARF option is effectively (because of their smaller pension pots) the less attractive AMRF option.

Ultimately, it’s all about horses for courses. For those of you that are comfortable with market risk and have significant resources, the ARF advantages over an annuity are significant, but I would recommend that you retain an advisor to plan your income flows and to manage your investment strategy.

For those of you who value the certainty and simplicity of a guaranteed income above all else, an annuity is the product for you. However, you should talk to a financial advisor when you are about to retire, as shopping around for the best annuity deal can make a big difference to your future income. You will also need to be aware of annuity options such as joint-life, guarantees and index-linking, how they affect your future income and how suitable they are to your circumstances.

And if you don’t want to totally gamble on either your life expectancy (annuity) or on future market returns (ARF), you can ask your advisor to provide you with a pension pot combination of annuity and ARF, perhaps including a delayed annuity purchase if suitable. One way or another, I strongly recommend you take independent financial advice at this juncture of your life.


Watch Your Pounds, Not Your Pennies

Pennies and pounds“Take care of the pennies and the pounds will take care of themselves” is a well-worn piece of money advice. As advice goes, it may be old but it’s certainly not wise.

My advice to you is the exact opposite, “Watch Your Pounds, Not Your Pennies”. In life we face no more than a handful of major money decisions and these are the “pounds” that need care and attention. These financial life-changing events revolve around your choice of job, your house/mortgage decision, your marriage/kids situation and your investment approach. In my opinion, these are the four big decisions that will determine your lifelong financial wellbeing.

Now, most people spend a lot of time on job, family and house decisions, and rightly so. But how many of us give sufficient attention to investment planning? Very very few of us.

In fact, lots of us spend far more time on watching the “pennies”. By this I mean comparing energy providers, contrasting smartphone packages, etc, rather than thinking about, say, how an old company pension should best be invested – and yes, I know pensions are boring and complicated.

To illustrate further, I recently switched landline and broadband provider, after a lot of research, about 10 hours in all. This will save me €10 a month from now on, let’s say for the next 40 years (touch wood!). Assuming 2% inflation, this equates to a total saving, in today’s money, of €3,300.

I also recently switched an old company pension to a cheaper provider platform and re-invested in cheaper but more diversified funds. This will save me 2% annually on my €50k pension fund.  Assuming 2% inflation, this equates to a total saving, in today’s money, of €27,400, and I’m excluding the expected better performance of the new pension.

So in theory, if I spent 10 hours analysing broadband options, I should by rights have spent at least 80 hours researching pensions.

And if you don’t have the time or inclination to put in the necessary investment planning hours, then that, in a nutshell, is why you need a financial advisor.