Making the most of your pension

To coincide with Positive Ageing Week, Claire Shoesmithlooks at what happens when you reach retirement age and your pension is available for collection

By the year 2011 it is estimated that people over the age of 65 will account for more than 14 per cent of the Republic's population, up from 11 per cent in 2002.

With recent figures showing that more than 27 per cent of people in this category are at risk of poverty, the importance of saving for retirement has never been more prevalent. After all, the State contributory pension of €193.30 a week is a small sum for even the most budget-conscious of us to live on once we stop working.

However, with the onslaught of publicity in recent years surrounding personal pensions and their importance, it is a difficult subject to ignore. While a substantial number of people still haven't taken one out, the proportion of the working population with a personal pension is slowly increasing.

This week, to coincide with Positive Ageing Week, we look at what happens when you reach retirement age and your pension is available for collection.

What happens on retirement?

At retirement there will be a number of options open to you. These include: taking a tax-free lump sum from your pension fund, subject to limits set by the Revenue; receiving a regular payment from your fund (usually through an annuity); transferring some or all of your retirement savings to an Approved Retirement Fund (ARF) or an Approved Minimum Retirement Fund (AMRF); or taking a taxable lump sum.

All pension plans allow you to take a tax-free lump sum. With a Personal Retirement Savings Account (PRSA) or a Retirement Annuity Contract (RAC), the maximum you can take is 25 per cent of your fund. With a company pension plan, the maximum you can take at normal retirement age with 20 years' service is 1½ times your final salary. Lower amounts are payable if you retire early or have less service.

Once I have taken the lump sum, what happens to the rest of my pension fund?

This depends on the type of pension you have. If you are lucky enough to have had a defined benefit pension organised by your employer, your pension will be calculated in relation to your final salary at the time of retirement and a monthly payment will be made to you for the rest of your life in the same way you received your salary.

For those with defined contribution schemes, the situation is similar, though the value of the pension will usually depend on the value of the pension fund at the time of retirement.

If, however, you had a personal pension - you held a PRSA, were a company director holding 5 per cent or more of a company's shares or were an employee who made additional voluntary contributions (AVCs) to a company scheme - you will have the choice of whether to use the rest of your fund to buy an annuity or an ARF.

"The advice given to any two people will be different," says Eamonn McDwyer, managing director of MDL Financial Services. "Some older pension contracts have attractive annuity rates - some as high as 11 per cent - and it is hard to achieve these returns in the current environment. If an individual has these guaranteed annuity rates they should go for it, and seek a guaranteed 10-year term, otherwise it is worth considering your alternative options."

What is an annuity?

An annuity is a contract between you and a life assurance company or investment manager that will pay you a guaranteed, regular pension income for life in return for a capital sum.

The amount of the regular pension sum depends on the size of the capital sum that you decide to invest, the type of annuity you want, your age, gender and state of health when you buy the annuity, and the annuity rate the life assurance company offers you at the time.

While an annuity usually ends with the death of the holder, it is also possible to buy one that continues to be paid to a surviving spouse or pays out for a minimum guaranteed period even in the event of death. These options make the annuity more expensive, effectively cutting the level of your pension. Thanks to a combination of much higher life expectancy and lower interest rates, annuity rates have fallen dramatically since the 1980s, meaning the amount of guaranteed monthly pension a person can get with the same size of fund has dropped significantly.

As a result, the popularity of annuities is decreasing.

Still, if you are looking for an annuity it is worth shopping around, says Brian Culliton, director of Forest Hill Financial Planning. "There are considerable differences in all financial products and it is important not to just take the first one offered by your current pension provider as it might not offer the best value."

What are the advantages of an annuity?

An annuity affords the holder a guaranteed regular income for the remainder of their life.

The charges are lower than with an ARF and you can sit back and enjoy retirement without having to worry where your money is coming from. As McDwyer says, you effectively become an employee of your life assurance company and they pay you a monthly salary in the same way that your employer did when you were working.

What are the disadvantages of an annuity?

A standard annuity dies with you, meaning that there is no opportunity to pass any of your wealth on to your estate. As a result, there is no point in buying an annuity if you are in poor health unless you can obtain a guarantee that it will continue to pay out to your spouse or children for a certain number of years.

What is an ARF?

An Approved Retirement Fund is a personal retirement fund where you can keep your money invested as a lump sum after retirement. You can withdraw from it regularly to give yourself an income, though you will pay tax on the withdrawals.

What are the benefits of an ARF?

The main advantage of an ARF is that, provided you don't overspend, the assets in the fund will outlive you and can be passed on to spouses, children or any of your beneficiaries at relatively beneficial tax rates. In addition, as the money remains invested during retirement, a personal pension holder can benefit from further growth on the investment markets after they stop working. It also enables you to keep control of your retirement money.

What are the disadvantages of an ARF?

The drawback of an ARF is that it is impossible to predict exactly how long a person is going to live.

While an annuity guarantees an income for life, an ARF can run out. As a result, a person might decide to budget for a retirement lasting a couple of decades only to find themselves celebrating their 100th birthday with little or nothing left in their fund.

In addition, your ARF is not guaranteed to keep its value because the assets in which your money is invested may not perform as well as expected. It is also worth noting that some ARFs have quite high management fees.

What is an AMRF?

An AMRF is like an ARF but with a minimum amount of capital that must remain in the fund until the fund holder reaches 75.

Under current legislation, anyone with a guaranteed income at retirement of less €12,700 must ringfence a sum of €63,500 in an AMRF. This money can't be drawn down until the holder reaches the age of 75, although the investment gains on the capital can be taken as income.

When the AMRF holder turns 75, the AMRF automatically becomes an ARF.

What is the tax situation for the transfer of remaining ARF funds to a deceased person's estate?

In the event of death, an ARF will pass directly to the deceased's spouse and continue operating in exactly the same way.

For children under the age of 21 at the time of the ARF holder's death, the ARF will be exempt from income tax.

The child should also be able to avoid inheritance tax on a lot of it by using the tax exemption thresholds for inheritances passed between parents and children.

Children aged 21 and over are exempt from inheritance tax and only pay tax at the standard rate on the money.

Points worth noting:

From this year it is no longer possible to keep your full ARF intact without paying some tax.

Holders will be deemed to have drawn down 1 per cent of their fund whether they have accessed the fund or not and will pay income tax on this amount.

This deemed withdrawal rises to 2 per cent next year and will settle at 3 per cent from 2009 onwards.

And finally, as with any investment product, there are a variety of options available and it is worth shopping around to find the one most suited to your needs. If you are unsure you should seek independent professional advice.