If you're 50 years or over, and haven't yet started to think about what you're going to do with your retirement fund when you become a pensioner, it's time to knuckle down and consider your options.
At present, if you're currently enrolled in a defined contribution (DC) scheme, your two big options heading into retirement are going to be either an annuity, or an approved retirement fund (ARF). But both are very different, and both require different planning strategies in the years leading up to retirement.
So, if you’re aged 50 or over, it’s time to get planning.
As Trevor Booth, chief executive of Mercer Financial Services, advises, "The more informed you are, the better the quality of the decisions you're going to make." And when you consider it's about ensuring you don't end up penurious in retirement, the quality of your decision-making is crucial.
Annuity v ARF
In years gone by, pension savers would generally find themselves in a defined benefit (DB), or final salary, scheme, of which an annuity was an essential part. Essentially, your employer guaranteed a set level of retirement income as a proportion of your final working earnings – generally two-thirds, for those with full benefits.
The advantage of annuities is that they offer a guaranteed income until you die, and sometimes even after, with some products offering spousal income. You can also provide for inflation-proofing, at a cost. So there’s no fear of your pension fund bottoming out with an annuity, and this guaranteed income offers peace of mind.
What we've been seeing across the board is a move away from annuities to ARFs
However, the problem for many people who are now coming to retirement is that they aren’t coming with the bounty offered by a DB scheme. DB schemes are a vanishing species, at least in the private sector, as the cost of providing them – and accounting for the liability on their books – proved too onerous for companies. DC schemes are now the norm.
In addition, current annuity rates mean that a lifetime of savings can equate to a less-than-expected income in retirement.
"What we've been seeing across the board is a move away from annuities to ARFs," says Cian Hurley, a senior consultant in Willis Towers Watson's investment practice, because "annuities are quite poor value at the moment".
Booth agrees, noting that about two in three retirees will now opt for an ARF over an annuity. These with larger pension funds tend to go for an ARF, while those with smaller funds choose an annuity.
Current annuity rates are about 4-5 per cent, depending on your age. For example, a 61-year-old might get a rate of 4.179 per cent with Irish Life; but this rate could increase if you have a history of poor health and qualify for an enhanced annuity.
With such rates, however, Booth notes that someone retiring at 65 will have to wait 23 years, or until they’re 88, to get all their capital back from an annuity. Not only that, but he says that statistics show that a 65-year old has just a one in two chance of getting all their money back by living that long.
If you want to inflation-proof the annuity income or provide for a spouse, the rate on offer would be noticeably lower and the time to recover your capital even longer.
“There will be winners and losers on it [an annuity],” he says.
An ARF, on the other hand, can give you substantially more flexibility. In effect, this brings your pension fund with you into retirement, once you draw down your tax-free lump-sum.
When you die, it can be passed tax-free to your spouse, or to your children – although tax issues will arise for them.
It means that you can continue to grow your capital, as you are still exposed to market movements, although there is a mandatory draw-down, of 4 per cent a year if you are 60 years or over, increasing to 5 per cent at 70, or 6 per cent if you have pension assets of €2 million or more and are over 60 years of age for the full tax year.
But – and it’s quite a big but – ARFs also face the risk of running out of money. Depending on how much is in your ARF, if the return on your ARF after charges fails to match your draw-down rate (ie 4-6 per cent a year), the capital will reduce each year, eventually potentially running out. This can also be hastened if the investments perform poorly.
“What also comes into play is longevity risk,” says Hurley. Should you stay alive for a very long time, it will put more pressure on your funds should you opt for an ARF.
ARF then annuity?
Remember, your decision doesn’t have to be final at retirement. There’s nothing to stop you from going into an ARF at retirement, and then switching to an annuity at a later date. However, according to Booth, “it’s very rare that we see this.” Rather, “people feel intuitively that one route or another works best for them.”
And there may be a reason why. Due to “mortality drag”, someone aged 75 might be expected to live longer than the 88 years that was predicted when they were 65; and this means they will get a lower annuity rate at 75 than they might have expected.
For this approach to make sense, Booth says that you’ll need to either:
a) generate a return on your ARF, or;
b) hope that annuity costs will fall and you get a higher rate.
At the moment, there is no hybrid product between the two, but “perhaps that’s something we need to look at”, says Hurley.
The tax question
Whether you opt for an ARF or an annuity might also be a factor of how much of a tax-free lump sum you can get. Under current rules, if you opt for an ARF, you can immediately draw down 25 per cent of your pension fund tax-free. If you opt for an annuity, however, your maximum lump sum will be 1.5 times your final salary.
So, if you retire with a pension fund worth €450,000, you will be able to draw down €112,500 tax-free with an ARF. If you were on a final salary of €100,000, you will be able to get €150,000 tax-free if you opt for an annuity, although it should be noted that the rules on 1.5 times salary are a bit more complicated than this, and not everyone may get the full amount.
So this is also an important consideration.
"Generally, if the retirement fund is small, 1.5 times your earnings is likely to be more attractive, and you'll buy an annuity with the remainder," says Shane O'Farrell, head of products, Irish Life Corporate Business.
But more flexibility is still called for. Booth and others in the industry would like to see the rules loosened on this, so that people opting for the 1.5-times salary option are also given the option to buy an ARF.
Lifestyling shift
Another reason why it is important to start thinking about these issues many years from retirement is that your DC fund manager will likely be positioning you towards a certain outcome if you are in a default fund – which is where the vast majority of people are likely to be.
The goal of lifestyling is to make sure that members are in the right type of fund at the right time – for instance to avoid a situation where someone with a year to retirement is not 100 per cent invested in equities and therefore extremely exposed to a potential drop in markets.
The benefit of a lifestyling strategy is that it “takes out having to make active decisions about when and where to invest your assets”, says Hurley. It is aimed typically at members in a scheme who opt for the default option.
However, you need to make sure it matches your end goal. For example, there’s no point in switching your portfolio to bonds – which will match an annuity – if you want to stay invested in an ARF at retirement.
Given the shift in preference to ARFs, fund managers have started to adapt their lifestyling strategies in recent years.
Pension savers in New Ireland’s Individual Retirement Investment Strategy, for example, used to transition portfolios to 75 per cent in “long bonds” and 25 per cent in cash at retirement. Now, however, aware of the preferences for ARFs, savers will end up with 75 per cent in low- to medium-risk assets at retirement, and 25 per cent cash.
Similarly, Irish Life has moved to adapt its lifestyling approach. O’Farrell explains that funds will now have longer to grow, as the de-risking phase has been cut from 20 years to 11 years before retirement. This reflects the use of a multi-asset range of funds which it now offers pension savers, that have lower volatility and greater diversification than the equity heavy pension funds of old.
In the last six years before retirement, Irish Life will assess your most likely benefit route at retirement and place you in either an annuity targeting fund (where the multiple of salary route gives the highest tax-free lump sum) or into an ARF targeting fund (where 25 per cent of the retirement savings will give the highest tax-free lump sum).
If you want to retire early, at 60, then your lifestyle strategy may have more risk than it should
“Of course, people can also make their own active decision and select another investment option, but very few do,” says O’Farrell. But for some people, making their own decisions, rather than the default one, will be crucial.
“What’s suitable for majority may not be suitable for you,” says Booth, while Hurley adds that lifestyling can be a “pretty blunt instrument by its very nature, because it doesn’t really take into account members’ unique circumstances”.
“Where they don’t work, is where people want to retire early, and want to take more risk or less risk,” he says, adding, “if you want to retire early, at 60, then your lifestyle strategy may have more risk than it should.”
When to decide?
For Hurley, you should be meeting your pensions adviser about 10 years out from your proposed retirement date to discuss how you expect you’ll take your benefits in retirement.
Booth agrees, adding that factors to think about include understanding what average life expectancy is , how long will it take to get the capital back, and what your current health state is.
And when it comes to picking a product, do shop around. Remember, you have the right to purchase an annuity or ARF from any provider – not just your current pension provider.
