Should I buy an Annuity or Approved Retirement Fund (ARF)? Unless we are retiring from a defined benefit (DB) pension scheme we will have this decision to make in regards how to access our pension benefits. Once we take out tax free lump sum we will have this decision to make with the balance. It is a big decision with multiple complexities involved, both financial and emotional.
Do I want the predictable route or do I want the less predictable but potentially more lucrative route? Do I want the peace of mind knowing that I'll get €x every month for the rest of my days, or do I want the potential to get more every month and potentially leave a legacy? Do I want a piggy-back down Everest or do I want to navigate it on my own two feet? That last sentence might seem odd but bear with me. Before I outline the considerations I believe we should make before deciding on annuity or ARF, I want to put this decision in a little context.
I was speaking at a recent 'Point of Retirement' event in Croke Park. As part of my piece I compared managing one's income in retirement to climbing and descending Everest. I made the comparison that when we are in 'accumulation' phase of building and preparing for leaving full-time work we are on the 'ascent' of the mountain. We reach the peak at the time we depart full time employment - however as anyone who has ever climbed a mountain will confirm - the descent is far from easy. One stumble and it could be damaging or indeed fatal. This is a much lesser risk when we are ascending, a fall or stumble has a much lesser probability of significantly screwing-up our accumulation plan.
While some could argue it is slightly dramatic, I do believe that managing our income in retirement is very similar to ascending and then descending Everest. Given the potential dangers, the impact of a stumble financially, and the significant importance of staying on track draws many comparisons. One of the attendees at the session sent me a link that very night, which was breaking news of the Irish climber who had unfortunately gone missing on the descent of Everest, only for another Irish climber to be confirmed dead a week later, again on the descent. It was obviously a pure (and really awful) coincidence but it surely hammered home the point about the dangers of descending, or in this situation, of navigating our 'spending phase'.
How Long Will I Live?
Now there's a million-euro question. This is one we'll be re-visiting due to it's significance. In essence, if we knew the answer to this it would make the 'spending phase' far easier. That is for the simple reason that we would know how long we need to make our money last. And that is the single biggest challenge with managing our retirement income, we have no idea how long we'll need it for!
Sure, we can look at average life expectancy figures and make some sort of informed estimate based on that, but as with all averages, there are wild variations around that norm! In addition, the averages keep going up!
In 1960 the following were the life expectancy of males and females from age 65:
- Male: 12.5 years (78year)
- Female: 16 years (81)
By 2016 these avearages had shifted to:
- Male: 18 years (83)
- Female: 21.5 (86.5)
Developments in health, health-care, standards of living have resulted in an additional 5.5 extra years for both sexes over past 60-odd years, or 1 year per decade roughly.
The significance of the duration you will live is huge if we are trying to decide between an ARF or Annuity for several reasons. This will impact on the duration over which you will need to generate the income, AND the impact that inflation will have over the period of your retirement. Check out Blog 112 from a couple of weeks ago for more on the impact of inflation.
So now that we've established a little context it's time to jump right in and explore the 2 options, Annuity or ARF, 'Costly Certainty' or 'Uncertain Abundance'!
Why Should I Pick An Annuity?
By choosing an Annuity you are handing the entirety of your pot over to an insurance company, who in turn guarantee to pay you (and as an option to pay a partner or dependant should they survive you) a set income each and every month, quarter or year as you wish. Why choose an annuity?
- A set income for the rest of your days
- A set income for your partner/dependant if they outlive you, for the rest of their days
- There's an option to have your income rise each year to keep abreast of inflation
- Your income is unaffected by equity or bond market values - so no worries about markets having drastic temporary declines
- If you have poor health you might get a better-than-normal or 'enhanced' rate as the expectation is that you will die before the average
- You never have to think about it again - you buy your annuity and go about your life, knowing that the income will arrive in your account
- If you live beyond the average age you may have received more than you initially handed over
Why Should I Avoid An Annuity?
Like everything in life there are pros and cons to either option here. Below are the main cons of choosing an annuity, in no particular order:
- Annuity rates offered by insurance companies here are typically based on European Government Bonds - which are at seriously low levels right now
- When you hand over your entire pension pot you never get access to it again
- When you die there will be no lump sum paid out - no legacy
- If you die before the average age you probably will receive less than you initially handed over
- If annuity rates increase in future you are probably fixed into the original deal, so it may really frustrate you
Annuity rates were upwards of 10% in the 80's,. For example if you had 250,000 of a pot you could buy an annuity and receive 25,000 per year for life. Massive. Now you are looking at annuity of approximately 3.5%, or instead of 25,000 per year you'll get 9,000 per year. If you die your partner, if they survive you will then get 50% of what you were getting, or 4,500 per year. Personally I believe that some of the negative perspectives of pensions is as a result of these very rates. If someone has a pension pot of €250,000 they may feel that they have a really significant pension, however when it is converted into annual income based on these sort of rates it might not seem so fantastic a sum of money.
Why Choose An Approved Retirement Fund (ARF)?
It is largely due to these reducing annuity rates that those who are planning their retirement income are turning their back on annuities. It is for that reason that the area of retirement income planning is becoming a profession within a profession. I have read a half dozen books on this specific subject, and there are a dozen more credible ones if you were of the mind to do so! It is a fascinating topic, optimising one's income draw-down from a volatile asset-class over an unknown period of time, while also striving to leave a meaningful legacy when one does eventually die! No mean feat, and it requires a lot of considerations as you can image, and as I'm sure some of you can testify. Anyway, here are some of the reasons why you would opt for an ARF:
- Gives you more flexibility in how much income you take
- If you die your partner/spouse steps into your shoes tax free, and draws an income from it
- If you die and kids of 21 years or more are beneficiaries it can pass to them tax efficiently under income tax rules
- You can invest in a broad range of funds & asset classes such as property, equity, deposits, Bonds
- If you invest it and your choices perform well, you can potentially take a large % each year for life
- If you have AVCs or other pensions from previous employments they can potentially all be combined, consolidated in one ARF
- You can, if you so wished, use your ARF to buy an annuity at a future date
So is an ARF a perfect solution? Well lets have a look at the other side of this coin.
Why Avoid An Approved Retirement Fund (ARF)?
- If your draw-down in not monitored and managed effectively your pot could run out well before you do!
- Your financial well-being is likely exposed to market performance and inflation
- Revenue essentially force you to take at least 4 or 5% of your fund each year based on your age, even if you don't need the income (so they can increase their tax revenues each year)
- Depending on how you invest your ARF you will be exposed to market volatility, which could be a cause of concern to you at any given time
We covered The 4% Rule in Blog 83 (Podcast102). The 4% rule is based on Bill Bengen's research of a couple of decades ago. His research suggested that an ARF, invested in a portfolio of Equities and Bonds, could comfortably afford to support an income draw-down of 4% per year and for it to last for most people's life-times, irrespective of what they most volatile markets could throw at it. I am really looking forward to sharing some more recent research in this whole area, and with getting slightly technical with you when we dig deeper on that particular topic in the coming weeks....so tune in if you are into that!
So Which Is The Best Option?
We've looked at the pros and cons of annuities, and of an ARF. What is most appealing to you? It is a personal choice. Financially ARFs may stand to provide you with a higher income, with the upside of leaving a legacy when you die. However annuities are a far more comfortable ride. It is a personal choice. Oh, there is also the idea that an effective strategy is one where an investor would buy enough of an annuity to cover their essential expenses. They would then avail of an ARF for the rest of their pot (assuming there is some left over) which would be maximsed to deliver their income which would be used to fund their discretionary spending, the non-essentials. It's one we will come back to in the near future but sometimes a little from 'column A', and a little from 'column B' is indeed a worthy strategy for those who want a balance of both camps.
When you need help in developing your own retirement income strategy, and need an expert practitioner I'd be delighted to explore if we might be a good fit for you.
Thanks for reading,
Paddy RPA | QFA | APA | Coach