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Annuities or ARFs: what’s the correct decision?

Choices on where to put your pension fund when you retire are very much down to your own views about financial security and investment

Opting for a pension annuity or an approved retirement fund is a delicate choice based on your preferences. A pension will, for most people, be their most valuable financial asset. Photograph: iStock

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Dominic Coyle
Tue Apr 16 2024 - 05:00

I saw somewhere recently that you were writing about annuities. I will be retiring in four years’ time and I am trying to understand what my options are when I get there. I don’t want to wait until it is just in front of me. I understand how an annuity and a retirement fund work differently, or I think I do. What I don’t really know is why I should choose one or the other? Or is it possible to do both?

Mr JM

There’s nothing wrong with planning early for retirement. Life would be a lot easier for folk if they were to do that.

Of course, the first bit of retirement planning is to start investing in a pension in the first place, a step all too many people leave far too late, if they do it at all. Given the tax relief on offer, never mind the contribution that most companies will make to an employee’s pension, it simply makes no sense.

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To your credit, you’ve clearly got that bit covered. The next issue, as you are doing is to plan ahead on what you would like to do with your pension fund when you retire. A pension will for most people be their most valuable financial asset – in many cases amounting to more even than the value of your home. Making last-minute decisions on how best to draw it down is a recipe for regret.

You’ll have a couple of things to decide. First up, you will be entitled to take a cash lump sum. Given this is tax-free while everything else you draw down from your pension will be liable to tax, it makes sense to do that. It is a substantial sum – generally 25 per cent of your pension fund up to a maximum of €200,000.

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Unless you have outstanding mortgage or other debt that you want to clear before your earning capacity diminishes in retirement, you will need to plan for where to invest this sum. That decision is clearly up to you but there are a few ground rules.

First, do not be talked into investing in anything that you are not comfortable with; second, never be shy about asking what any investment is costing you in fees and charges and avoid anyone who is reluctant to be upfront on that; finally, always bear in mind that the older we are the less time we have to recover from investment setbacks. There’s a reason most pension funds will transfer you into lower-risk investments as you draw close to retirement. The gains might be less spectacular but so too is the volatility.

But back to the rest of your pension fund. Here, you really have two options – an annuity or transfer of your pension fund into an approved retirement fund.

There are fairly fundamental differences between the two but it has only really re-emerged as a serious discussion in the past year or so. Until then, for a generation, annuity rates were at such historic lows that they constituted very bad value for money for the vast majority of retirees.

Annuities

Annuities are basically a product which you buy from an insurance company. You hand over your pension pot in return for a guaranteed income for life.

How much you will get in a monthly or annual pension will depend on how you want to customise your annuity. For instance, you can arrange that when you die, your spouse continues to receive a monthly payment – generally half of what you were getting for the rest of their life. If you don’t, the annuity will die with you, regardless of how many years you have been drawing down the pension.

It is possible to stipulate that the annuity will be paid for a minimum period – generally five years.

You can also arrange to inflation-proof your payment. Inflation will eat away at the value of your annuity. Without inflation proofing, you will continue to receive the same amount every month for life while prices of everything around you are rising. Most annuity providers will offer to increase your annuity either by 3 per cent per annum or by the actual rate of increase in the consumer price index or that 3 per cent, whichever is the lower.

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Of course, each of these options comes with a price tag – and inflation-proofing in particular can knock a decent slice of income off what a straightforward single life annuity that is not inflation-proofed might offer. A word of caution: annuity rates are changing all the time. These rates were secured from five providers in the Irish market last month. They were accurate at the time but might have changed slightly since then.

Making last-minute decisions on how best to draw down your pension is a recipe for regret

One of the things you might find awkward is actually getting the companies to give you a figure that you might get in an annuity. They certainly will not tell you today what you might get in four years’ time but even getting a figure of what you might expect at today’s rates to allow you to compare your options has proved inordinately difficult for people in the past. It was just such a query that led to the piece you probably saw recently from me on the subject.

In terms of tax, you will pay income tax on what you are paid assuming it brings you above the tax-free threshold.

ARFs

ARFs, or approved retirement funds, are an option that allows you to keep your money invested – and hopefully still growing – in a fund of your choice even after you retire.

You can draw down only what you need from the fund. However, you should be aware that Revenue will tax you on the assumption that you will withdraw 4 per cent of the value of your fund once you are retired and over 61. When you turn 71, they increase this “presumed drawdown” to 5 per cent.

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And if you are one of the fortunate few with a pension fund that is worth more than €2 million, the figure will be higher – 6 per cent from the outset. And clearly if you are going to be taxed on the basis that you are drawing a certain amount, it makes sense to draw it down.

It can sound like a no-brainer but, like all investments, there are risks. If investment returns are lower than expected you may find your fund running out before you die. Equally, if you live longer that average, you might also run the risk of seeing the ARF fall short in later years.

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An annuity on the other hand is guaranteed to be paid for life, regardless of how long you live or the performance of your money. Essentially the insurance company is taking that risk – although they will be charging you for the privilege.

And while the insurance fund has your money once you sign up to an annuity, you do keep control of your ARF. This means particularly that when you die, your fund passes into your estate and can be passed on to your beneficiaries under the terms of your will.

That can be a deal changer for a lot of people.

Both

Turning to your final query, there is nothing stopping you doing both. You can put part of your pension fund into an annuity giving you some level of guaranteed income for the whole of your life alongside your State pension, and keep the rest invested in an ARF.

How you allocate your pension fund between the two is entirely down to you and is essentially a case of finding a balance between your need for financial security or your desire to keep control of your fund and, hopefully, see it continue to grow over the balance of your life.

Please send your queries to Dominic Coyle, Q&A, The Irish Times, 24-28 Tara Street Dublin 2, or by email to dominic.coyle@irishtimes.com. This column is a reader service and is not intended to replace professional advice

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