If you are wondering ‘how does an ARF work’, may I suggest we consider instead the question; ‘how should an ARF work’!? Given that your draw-down strategy in retirement will be one of the biggest financial decisions you will make in your mature life, this really is a topic worth doing some homework on.
Unfortunately, ARFs are generally managed in a pretty laissez-faire manner by most providers. They take your money, stick it into a mid-volatility fund and hand you a cheque every month for 4% of the average over the month, and let your hard-earned pot do whatever it will do.
This approach prioritises maintaining the portfolio, quite often at the expense of your retirement lifestyle. From a provider’s perspective it is easier to give you bugger-all income than it is to try and maximise your income! If you want to hear more about the basics of Approved Retirement Funds, please do check our Blog 115 or Podcast 44.
Stabiliser – How Does an ARF Work?
We all need Guardrails from time to time. Some of us might remember when we learned to cycle a bike. As an aside, our eldest decided he wanted to learn to ride his bike, so rather than stick stabilisers on his bike, we discovered that it can be more helpful in the first instance to actually take his pedals off! So we did that, turning it into a balance bike of sorts. He learned to use his legs then as stabilisers. Once he mastered that we popped the pedals back on, and within 5 minutes he was away – roaring with delight!
One way or another, when learning something new, or when traversing lumpy terrain, some form of additional stability is a god-send. The fact that the vast majority of non-public sector employees and self employed will have litle or no defined benefit pension incomes will mean most of us will have to manage our pension pot income ourselves. This can be fraught with errors, fear, anxiety and mis-calculation, as we have covered before. The measures of success in taking an income from an ARF are:
- Does your pension pot from which you are drawing your retirement income outlive you (good), or do you outlive your pot (bad)?
- Does your income from said pension pot increase in line with inflation or not?
- Assuming you live long enough, do you get to take out more than you put in?
ARF Income Guardrails – How Does an ARF Work?
One route which can help achieve the above successes is implementing the a retirement income Guardrail strategy. As covered in Blog 120, this is an active approach to managing your retirement income. The fact that it is an involved process explains perhaps why it is so very rare here. In cycling terms, if you start leaning too far to the left or right, and are in danger of falling-off, this strategy will help to re-align your retirement income back on track!
This strategy is the Guyton-Klinger approach, developed by Jonathan Guyton and William Klinger in the US a couple of decades ago. As a rules-based approach, you are essentially signing-up with your advisor to have some flexibility around your spending, dependant on the performance of the underlying funds, and the income you are drawing up to that point.
Like any retirement income strategy, perfect it is not. In many respects however it is just a little less imperfect than many of the others!
Traditional Route – How Does An ARF Work?
Lets first look at how ARF-holders are traditionally told to go about it. Very quick summary, you have a pension pot of €1m (don’t you!?) and you are 65, you want to start drawing income from it. lets assume you have already taken the tax free lump sum.
In line with rules, you are planning to take the minimum 4% income per year. This income increases to 5% per year from 71 on-wards.
This is where your first major choice is to be made, though most are not actually offered any choice! In the vast majority of cases in Ireland, you get this 4%/5% of the ARF pot based on it’s value over time. If the average value of your pot over a particular year where you were drawing 4%, was €1m, you would get €40,000 income paid to you over the year. If the value was an average €600k over the year where you were drawing 4%, you would get €24,000 income, and so on and so forth.
It is a roller-coaster of income. You have zero consistency of income over your retirement years, zero. Yes, we all know that equities are up over 7 of every 10 years, and over the longer term they have always been an unrivaled wealth grower, but that is not much use to you if your income drops from €40k to €24k from one year to the next is it!?
To add insult, if you are invested in the same way as the vast majority of traditionally-advised ARFs, you are invested in really conservative portfolios, with a shed-load of Bonds and Alternatives. These have little or no chance of benefitting from the real power of diversified equity investing. This is partly due to the mass of Bonds and Complex products in them, but also due to the fact that you are probably paying 1.5 to 3% per year in fees. See Blog 121 from Aug 2019 for our thoughts on the fees in ARFs.
Last year we analysed the long term success for you of this approach, and it was terrible. It is still terrible! In February 2020 your income was whopper-high, and in March your income fell by 30-40%. You might say that is all fine and dandy if this ARF imcome only covers the discretionary spending of the house-hold. For many people in Ireland however it is one of the main incomes, and covers basic living expenses. Consistency, or at least some semblance of consistency is very welcome for many.
This approach certainly may tick the ‘conservative’ box, and it may make you feel secure. However, your retirement income, increasing with inflation is not being prioritised here. As mentioned before, this approach prioritises the preservation of the fund, and really nothing else! Instead of going cycling, it is the equivalent of instead sitting in the safety of your sofa, looking at a picture of a bicycle!
ARF Income Guardrails – Practical Example – How does an ARF work?
Now lets turn our attention to an alternative way of managing your ARF income. Again, you have €1m in the ARF and are 65 years of age. Again, you are told you have to take 4% till 70 and 5% from 71. You are paying 1.5% in fees in your pot. You ignored the conventional ‘wisdom’ and invested in a sensibly constructed 80% equity and 20% bond portfolio.
Instead of the traditional route of taking 4% and 5% of the value in a given year, you opt for 4% rising to 5% of the initial pot value, so €40,000 and €50,000 annual income per year respectively. In another break from tradition, you are also aiming to increase your income from the ARF pot in line with inflation. Your advisor may be looking at you with two heads at this point, asking it this is even allowed! You see, you realise that your shoes which cost €100 yesterday will cost a heck of a lot more than €100 to replace in 15 years from now. No doubt you will have many replacements between now and then, but you get my point I hope!
We put in place our ‘Guardrails’ at this point. We commit to a strategy on that income draw-down. Our withdrawal rate is starting at €40k or €1m, or 4%. We commit to taking a 20% increase in the level of income we take if that current withdrawal rate falls by 10% or more on each anniversary. On the flip, we commit to only a 10% decrease of our withdrawal (within revenue limits) if our current withdrawal rate (4%) increases by 10% or more on each anniversary. Clear as mud?? Practical example:
We start the above strategy in January 2020, drawing our 4% (€40,000) from our €1m pot. When we have an annual planning meeting Jan 2021, we find that our pot value, even after taking our €40,000 (1 years income), is now valued at €1,120,000. We can now see that if we then taking €40,400 next year (we got a 1% increase in line with inflation!) from a pot of €1,120,000 our withdrawal rate for 2022 will be 3.6%. Never mind that it is below the Revenue limit, we follow our strategy and increase our income by a healthy 20%! Your income for 2021 will be to €48,480. Paddy is a great chap!
However, when we meet again in January 2022, your portfolio is in a temporarily decline, as we fully expect and accept most years.
Same over-arching strategy here, except in reverse. We have taken €48,480 income last year, which was 4.3% of that years’ start pot value. The pot value as of Jan 2022 though is in temporary decline, standing at €950,000.
If we were to take the same income for 2022, adjusted for 1% inflation, it would be €48,964. That would however represent 5.15% of our pot value, which is more than a 10% increase from 4.3% of the previous year. We follow our strategy, and take a 10% cut for 2022. So we accept an income of €43,632, which is still a very decent 4.5% of the current pot value!
Do this each and every year, once per year over your spending life and you can give yourself a significantly better probability of long term retirement income success and consistency.
As we said last year, you will have to suck it up a little bit in the years where we reduce income draw-down to the bone. But the big win is that you have consistency of income AND a very very high probability of still realising your 30-40 years income from your ARF pot.
You don’t have to worry about the number that will hit your account on a month to month basis . How does an ARF work? You won’t need to even think about that! From the January (in this case) you know your number, you don’t have to worry about what markets are doing or not doing – we set it in January and we then turn our attention to spending it and enjoying it. It really is a very very positive way to manage your ARF income and investment strategy.
It may be a mute point for some but if you use this approach you also stand a very high probability of leaving a decent legacy behind by way of unused ARF pot. And, if like many, you say ‘to hell with leaving a legacy’, we can happily loosen or indeed discard the Guardrails after the first 5 or 10 years of retirement. Essentially we take the stabilisers off and let you do some wheelies! But know this, we will still be there put TCP on your hands and knees if you fall over – you’ll more than likely survive!
Conclusion – How Does An ARF Work?
I believe that we need to acknowledge the merits of alternative and proven approaches to anything in life. We must too recognise that the vast majority of ARF holders in Ireland are set up with their ARF in a sub-optimal way in many respects; fee, portfolio and income draw-down.
The trouble is, they have absolutely no idea that there are alternatives. Yes, alternatives do require a little more attention and care from your advisor, and do require bending a little to ensure compliance with the revenue income rules. However, the alternatives can often help you to enjoy a more consistent level of income in retirement. The alternatives can help you to enjoy a rising income through your spending years, and hence enjoy a better level of comfort and choice.
It is really scary that the awareness of this alternative is practically zero. Hopefully we can plant a few seeds – perhaps encourage a few to get up on their bike. I trust research and all of historical evidence, not what is convenient for someone to tell you to do! On yer bike!
P.S. This piece ‘how does an ARF work’ is for information only. Past performance is no guarantee of future performance – you could get back less than you invest (particularly if it’s a rubbish portfolio with high fees) – retirement income is a serious aspect – make sure you get decent help to support you achieve your goals.
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