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?
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.
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.
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 …
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 …
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.
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.
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.
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).
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.
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…
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.
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.
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.