There was a time when defined contribution pension scheme members had just one option on retirement – to invest their pension pot in an annuity, an insurance product that pays out an annual income until their death. That all changed in the 1990s with the introduction of approved retirement funds (ARFs), investment products that delivers an income based on market returns.
While both are still valid options for those ready to retire, annuities and ARFs have distinct differences and may suit different people, depending on their attitude to risk and their personal income requirements at retirement.
Most people at retirement will take a portion of their pension as a lump sum, explains Chris Carlile, principal with Mercer. For the balance of the fund, they can either purchase an annuity or an ARF, or else take the balance as taxable cash.
According to Carlile, annuities may be more suited for people who wish to avoid potential risks such as stock market volatility and would prefer a guaranteed income in their retirement. Several variants of annuity are available; for example, many people buy annuities that provide an ongoing income at some level for their spouse in the event that the spouse lives longer.
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“It is also possible to specify that an annuity should increase annually,” adds Carlile.
An ARF, on the other hand, is placed in a fund, investment or deposit facility, where any growth achieved will be free of tax. However, its value can go down as well as up.
“An ARF allows you to remain invested in the market, with the ability to control your investment and take a flexible income in retirement,” explains Carlile, who notes that holders of an ARF can withdraw as much as they like at any time, although this is subject to normal PAYE and any associated levies.
It isn’t an option for the risk averse in retirement, however; while low-risk deposit ARFs are available, Carlile says these offer quite “conservative growth expectations”.
“The main advantages associated with an ARF are that you have much greater flexibility regarding how much income you draw down from the ARF in any year and that any remaining funds at your death are inheritable by your dependents, whereas an annuity generally ‘dies with you’ unless you pass away prematurely within the guarantee period or there is a spouse’s pension attaching,” explains Gavin Moran, head of the wealth management division at WTW in Ireland.
Moran also emphasises the disadvantages of an ARF. “You will be now exposing yourself to investment risk along with the possibility that you could outlive your money,” he says. “With an annuity, this cannot happen as you will continue to be paid for as long as you are alive.”
Suzanne Cashin, divisional director in financial planning with RBC Brewin Dolphin, agrees that the choice can be difficult.
“Each client will have differing attitudes to risk,” she says. “Some may want the safety of a guaranteed income from an annuity to meet their essential needs and, if they have no other assets or income streams, may need that guaranteed income. Other clients may like the flexibility of the ARF and ability to retain the capital value of their pension fund, and the prospect of it continuing to their children as a real asset.”
Age at retirement is a factor, adds Moran. “The younger you are, the lower the initial annuity income that you will be paid – as the life company will expect to pay out for a longer period of time,” he says. “Hence, for clients who are accessing their funds early and only looking to access the lump sum element of the pension and are still working, it might make sense to invest the balance in an ARF, from which they do not need to take an income until the year that they reach 61.”
For those who still aren’t sure, Cashin says there is the option of combining both. “There is always the option to use some of the fund to purchase an annuity and the balance for an ARF and get the best of both worlds – there are so many varying choices or options that good financial advice at retirement is crucial.”