2nd September 2019
Welcome back to Ireland’s award-winning Financial Planning Blog & Podcast, with me Paddy Delaney. Delighted you have decided to join me! This week we are going to explore an approach to retirement income planning that I mentioned months ago. It is customary for retirees in Ireland to decide to generate pension income by using either an annuity, or an ARF. In Blog113 we explored the pros and cons of both of these in isolation. However, as we like to look at things a little differently here we’re going to dissect the merit or otherwise of using a combination of the two.
If you google it you’ll find millions of results for articles and pieces outlining why an ARF or why an Annuity, but you might struggle to find one which addresses the topic we are about to! We will briefly summarise the probable outcome from using an ARF only, an annuity only, and only then will we analyse using a combination of both.
Using ARF Only:
Running with the well-worn scenario of a €1m pension pot, retiring at 60, and with a partner to enjoy your retired years with. We have shown that, based on historical data, we could aim to take 4-4.5% per year from an ARF and have a 60-90% probability of successfully drawing that income for 30 years, depending on several factors. The major determinants in the success or otherwise of this income is the level of fees we pay, the portfolio we adopt, and the market returns achieved in the first decade of retirement.
Using an ARF most investors, irrespective of what the research suggests, will fall into taking the revenue-imposed 4% withdrawal per year, increasing to 5% per year from 71. In income terms our scenario will generate €40k Gross increasing to €50k Gross. We have shown that this approach will generally work well, provided fees, portfolio and returns are reasonably favourable over the long term. Having said that, the level of pot-value volatility may lead some to fear it as a strategy, and therefore look to annuity only.
Using Annuity Only:
If you are retiring at 60 today, have a €1m pension pot and want to avoid the feelings of uncertainty that an ARF can generate, there is obviously the option of buying an annuity. If this pot represents the source of all your future income, apart from the state pension, you will most likely opt for one which ensures your partner will receive annuity income if they survive you. The scary thing here is that if we bought an annuity today, aged 60, with even a 50% income for our partner if we die before them, we will be offered in the region of 2.7%.
In € terms that is €27,000 Gross income for life if we hand over the €1m. If we die our partner will get €13,500 Gross per year. These numbers are a far cry from the 4/5% we’d be aiming for with the ARF. The annuity does however remove the need to be in any way concerned about the security of our future income (provided your annuity provider remains in operation and capable of paying your income for the next 3 decades of course!).
At a high-level, based on a 30 years survival of the principal owner, incomes not increasing with inflation, and assuming ARF does last the 30 years, the incomes stand at:
Income from Annuity over 30 years = €810,000
Income from ARF over 30 years = €400,000 + €1,000,000 = €1.4m
With a difference of €610,000 of potential income some may feel that the annuity is a complete waste of time, but let’s explore the merits of using a combination of both before you write them off entirely!
A Combined Approach:
In our scenario let’s assume you have no other forms of income other than your pension pot and the state pensions, purely in the interest of simplicity here. You and your partner have spent time to consider what your income requirements will be in retirement.
In order to cover your ‘basics’ you’ll need Gross income of €30,000 per year. This will cover what you deem essentials such as utilities, food, health insurance and motoring expenses. Your mortgage is cleared and you have no other loans.
You also reckon that you will need another €20,000 Gross per year to subsidise the ‘discretionary’ aspects of your future lives. You hope to spend this money on travelling, gifting, hobbies, socialising and upgrading your home and cars over the years.
In total you estimate therefore that you need €50,000 per year from age 60 to age 90. As it stands you will have no other income coming in from age 60 to 65, after which time you will have €12,911 per year for your own state pension, and €11,726 for your ‘adult dependant’, totaling €24,637 per year. So you essentially need to bridge €50,000 from age 60 to 65, and €25,363 from age 66 onwards.
A Combined Approach, The Figures:
There are many ways to try bridge these figures using a combined approach, practically unlimited in fact. Let’s assume you want to use an annuity to bridge 30% of the shortfall for the initial years, and to have that annuity income obviously continuing on once the state pensions kick-in at 65. The remaining balance of 70% of income will be delivered by drawing income from an ARF.
You need €15,000 of Annuity Income, this will eat approx €560k of your pension pot.
As this will ensure you have the minimum €12,700 of income you will not need to place any funds in an AMRF, so you will be be left with €440,000 of an ARF. If you draw 4% from that that’ll generate another €17,600. This approach would only provide €32,600 per year from 60 to 65, which is €nearly €18,000 short from what you want to get. Back to the drawing-board!
What about taking your €1m pot, and from the age of 60 to 65, draw 5% per year, which will provide the €50,000 per year. At the age of 66, once the state pension income of €24,600 kicks-in, you could look at purchasing an annuity to bring this ‘guaranteed income’ to €30,000. In this instance this would mean using €201,000 of your remaining ARF pot at this stage to purchase the annuity required.
From 66 onwards you would essentially have the €30,000 boxed-off from the state and annuity, meaning that you should feel assured about having your ‘must-spends’ covered for the rest of your life. You would continue drawing €40,000 (4%) from your ARF increasing to €50,000 from age 71.
Using this strategy you therefore could have income of €50,000 Gross from age 60 to 66, €70,000 from age 66 to 70 and then €80,000 from 71 onwards! Does such a strategy hold water in terms of historical data analysis? We based on my own research it certainly does. Provided that the fees are kept sensible, that the portfolio had a high exposure to equity (80%+) and that you stuck to the plan, there was a 70-80% probability of success of your ARF lasting, and a 100% probability of your State Pension and Annuity income lasting you until the end of your days. Be warned however that due to the large withdrawal of €200k after 5 years of your ARF, the worst-case scenario was that your ARF ran-out after only 15 years. 1 in 10 occassions it expired when you reach 82. However, on the flip-side, the median (50/50) pot size when you reach 90 is actually €2.2m in nominal value terms.
I’ve siad it before, and I’ll say it again, annuities have their purposes, and for some they are a suitable approach. I wouldn’t be suggesting they are a great fit for most of us, but in certain instances they may well be a tactically smart tool in conjunction with an ARF.
Despite their value in generating ultimately concern-free income, for many of us they have one major draw-back versus the ARF. In handing over our cash to purchase an annuity, we are handing-over any possibility of every leaving a significant legacy in the form of an ARF pot to our loved-ones. Even aside from the significantly better income that an ARF has historically provided for us, an annuity robs us of the chance to simultaneously generate a sustainable income for ourselves, and to leave a meaningful legacy to our dependants and/or our loved-ones.
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Paddy Delaney QFA RPA APA
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