Wouldn't retirement (for those lucky enough to get there) be so much easier if we knew when we were going to die? At least financially it would. There's a New Yorker cartoon that pictures an older couple considering their finances and exclaiming "if we take a late retirement and an early death, we'll just squeak by".
But of course we don’t know how long we have ahead of us – despite the best efforts of actuaries. This makes working out how much of an income should and could be drawn down in retirement is difficult for those not lucky enough to be locked into final salary defined benefit schemes.
Deciding how to generate an income from your pension pot is one of the biggest financial decisions you’ll ever make if you’re a member of a defined contribution pension scheme. And the current environment – where rock bottom interest rates mixed with pronounced market volatility – has conspired to make the decision even more complicated.
"It's probably in the top three financial decisions a client will have to make in their lifetime – whether to use their pension funds to purchase an annuity or invest in an ARF/AMRF [approved retirement fund]," notes Barry Mooney of Bellwether Financial Planning.
The shift
But are we asking too much of people? Previously, employees never had to consider either what they were putting into their pension or what would happen to their pension funds when they retired. Now they’re being asked to do both – take responsibility for a DC fund during the “accumulation” phase, and decide on whether or not they should opt for an annuity, or keep their money invested in an ARF, during the “decumulation” phase. And for some, it may just be a step too far.
"In the world of DC, it's a lonely journey," says Gerry Hassett, managing director at Irish Life Financial Services, noting that, when you retire, your link with the company is gone.
The conundrum
This means that you may be left to face one of the biggest financial decisions of your life on your own – and it’s one you may feel ill-equipped to make. The question you have to answer is: how are you going to make your pension fund last for up to 30 years – or maybe even more – in retirement?
It is is a question we all need to be asking ourselves but, unfortunately, the answer is far from simple. The average female retiring at age 65 has a 50 per cent chance of living until she’s 91, while the average male has a similar chance of living until he’s 87.
“I don’t think we, as a society, have adjusted to that; the thinking hasn’t joined up,” notes Hassett.
Of course if your pension pot is overflowing, the decision will be an easier one. But as we know, just 50 per cent of us have a private pension at all and, even if you do, most pension funds are increasingly under-funded. This makes the decision critically important.
“We’ve yet to see a generation on DC retire but we’ll start to see it in the next decade,” says Hassett, noting that, in the US, which started the shift to DC earlier, it wasn’t until one generation retired on DC style pensions that the younger generation committed to saving more.
“I’m not sure people have adjusted to that, to the idea of living to 90,” says Hassett, adding “I wouldn’t be retiring at age 65 if I was to live to that age”.
In this respect, Irish Life have launched its Empower initiative, which aims to get people engaging with their retirement at an earlier age – and considering such decisions.
Income in retirement
Income in retirement typically comes from one of four sources:
1) Tax-free cash from pension fund – employees can draw down 25 per cent of the fund’s value or up to 1.5 times their salary tax free upon retirement;
2) An annuity – buying this insurance product guarantees you a regular income until you die;
3) The State pension – currently running at €233 a week but not certain to stay at this;
4) An approved retirement fund (ARF), which allows you to keep your pension fund invested beyond the point of retirement.
An annuity guarantees a regular income for life, much like a salary, and is paid into your bank account each month. It’s an insurance product, sold by insurance companies, and if set up as a single life product, it ceases when you die.
A joint life annuity on the other hand will continue to pay your spouse an income after you die – but it is more expensive, and hence will reduce your monthly income, as the table above (?) shows. You will also pay for “inflation-proofing” your annuity to take account of rising prices in retirement.
It’s possible to boost your income by looking for an “enhanced annuity”, which pays out more if you are suffer from particular ailments, or smoke, and hence are more likely to die earlier. In the UK, “postcode annuities” are offered, which can boost your income depending on where you live – ie annuities pay out in areas where life expectancy is lower – but the level of sophistication in the Irish market tends to be lower.
Don’t discount an annuity
Annuities have plummeted in popularity for DC members in recent years given what’s happened to interest rates and the bond markets. With bond yields at historic lows, Mooney notes that retirees can expect to get half the income today on an annuity of what they might have received even five or six years ago – and that was well down on the previous generation.
As the table above shows, if you have a pension pot of €100,000, you can expect a guaranteed income of just €4,224 a year with Standard Life, based on an annuity rate of 4.2 per cent. So to get an income of about €12,700 a year, which, along with the State pension, would give you an annual income of about €23,800, you would need a pension fund of €400,000 if you opted for an annuity.
Many will find that they won’t have saved this level of a pension fund.
“It’s a reality check,” says Mooney, noting that many clients are disappointed when they realise what kind of retirement their savings will offer them. The vast majority of people haven’t saved enough through their working life.
While Mooney recommends retirees shop around for the best rates, as life companies tend to move in and out of the market, improving their rates at different times, the market is not hugely competitive, with rates very similar across all the major providers.
As the table above shows, the difference between the best and worst rate on the market at present is just €16 a month, or €192 a year – although over 20 years this differential does increase to €3,840, so it is still worth getting the best rate on offer.
Despite the poor rates, an annuity may still be the right decision for some.
“It might look like poor value – but it may be the best option,” notes Mooney.
“It’s incumbent on advisers to give [clients] the context in which to make the decision,” he says, noting that this should involve a detailed financial plan assessing income and expenditure in retirement. Once you have this clear picture, you may find that an annuity is sufficient to your needs – and gives you the peace of mind, and guaranteed income, you may desire.
“I think it’s all in the framing. Here’s what your future income and expenditure is going to look like at the moment and here’s what an ARF will look like.”
Hassett agrees that “there is definitely a role for an annuity”.
Indeed given that, at the age of 65, you have a 50 per cent chance of living until you are 90, you may really start to see the benefit of an annuity after the first 10 years when you won’t be anxiously checking your investment statements – at a time when others may be doing so, fearing that their pension fund is running out.
A report last year on the ARF v annuity debate by the Society of Actuaries in Ireland (SAI) warned: "Once annuities become a niche product, a herding effect means they can quickly become redundant".
ARF
risks
Introduced in 1999, ARFs allow you to keep your money invested after retirement as a lump sum. You can withdraw from it regularly and the main attraction is that you may end up with a better income in retirement than you would with an annuity, as you are not paying for a guarantee on this income.
In addition, should you die, your ARF won’t die with you but will pass to your estate.
However, they can be risky. Draw down too much or suffer too many losses and your ARF could “bomb out” or deplete before you die.
“It’s a relatively new animal,” notes Mooney, so we haven’t yet really seen the full impact of people investing to provide for their retirement.
For your ARF to work as you intend it to, you may require an annual investment return of 5.5 per cent a year but, as Mooney notes, in this investment climate that means taking on medium to high risk which is not really appropriate for older people with little prospect of recovering from losses.
Moreover, the ability of your ARF to provide for you in retirement may depend on the quality of the financial advice you receive. As the SAI notes, despite being called “approved retirement funds”, there is, in fact, no regulatory approval process for ARF structures, and there is no requirement under the Central Bank’s Consumer Protection Code to regularly review an ARF. This means there is no compunction to show consumers a comparison on the relative merits of the ARF versus an annuity, and the SAI would like to see greater modelling amongst advisers of longevity and “bomb-out” risk.
Charges can also be heftier on an ARF which can eat away at your income, in the way a poor rate on an annuity can. As the SAI points out, ARFs typically offer higher initial sales remuneration of about 5 per cent, compared with a typical maximum of 3 per cent on annuities, while trail commissions, of about 0.25-0.5 per cent can also hit an ARF fund.
Opt for both
If making a decision is too fraught with fear, it can be delayed. Investing the proceeds of your pension fund into an ARF today doesn’t preclude you from buying an annuity in a couple of years when rates may be more preferential. Of course the risk in postponing a decision is that the value of your ARF may have eroded substantially by then, leaving you with a reduced income from an annuity.
Another option – provided your fund is substantial enough – is to spread the risk and opt for both an annuity and an ARF.
“For most people a combination of an ARF and annuity could be the right option,”notes Hassett. As the SAI notes, “some combination of ARF and annuity would seem optimal as an “efficient frontier of risk and reward trade-off”.
For a detailed annuity v ARF comparison see the SIA paper at this web address: http://iti.ms/1WouGIH
