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Aged 50 or over? Consider your retirement fund options now

If you haven’t yet thought about what to do with your retirement fund, here’s some advice

Source: Fiona Reddin, www.irishtimes.com

 

If you’re 50 years or over, and haven’t yet started to think about what you’re going to do with your retirement fund when you become a pensioner, it’s time to knuckle down and consider your options.

At present, if you’re currently enrolled in a defined contribution (DC) scheme, your two big options heading into retirement are going to be either an annuity, or an approved retirement fund (ARF). But both are very different, and both require different planning strategies in the years leading up to retirement.

So, if you’re aged 50 or over, it’s time to get planning.

As Trevor Booth, chief executive of Mercer Financial Services, advises, “The more informed you are, the better the quality of the decisions you’re going to make.” And when you consider it’s about ensuring you don’t end up penurious in retirement, the quality of your decision-making is crucial.

 

Annuity v ARF

In years gone by, pension savers would generally find themselves in a defined benefit (DB), or final salary, scheme, of which an annuity was an essential part. Essentially, your employer guaranteed a set level of retirement income as a proportion of your final working earnings – generally two-thirds, for those with full benefits.

The advantage of annuities is that they offer a guaranteed income until you die, and sometimes even after, with some products offering spousal income. You can also provide for inflation-proofing, at a cost. So there’s no fear of your pension fund bottoming out with an annuity, and this guaranteed income offers peace of mind.

What we’ve been seeing across the board is a move away from annuities to ARFs

However, the problem for many people who are now coming to retirement is that they aren’t coming with the bounty offered by a DB scheme. DB schemes are a vanishing species, at least in the private sector, as the cost of providing them – and accounting for the liability on their books – proved too onerous for companies. DC schemes are now the norm.

In addition, current annuity rates mean that a lifetime of savings can equate to a less-than-expected income in retirement.

“What we’ve been seeing across the board is a move away from annuities to ARFs,” says Cian Hurley, a senior consultant in Willis Towers Watson’s investment practice, because “annuities are quite poor value at the moment”.

Booth agrees, noting that about two in three retirees will now opt for an ARF over an annuity. These with larger pension funds tend to go for an ARF, while those with smaller funds choose an annuity.

Current annuity rates are about 4-5 per cent, depending on your age. For example, a 61-year-old might get a rate of 4.179 per cent with Irish Life; but this rate could increase if you have a history of poor health and qualify for an enhanced annuity.

With such rates, however, Booth notes that someone retiring at 65 will have to wait 23 years, or until they’re 88, to get all their capital back from an annuity. Not only that, but he says that statistics show that a 65-year old has just a one in two chance of getting all their money back by living that long.

If you want to inflation-proof the annuity income or provide for a spouse, the rate on offer would be noticeably lower and the time to recover your capital even longer.

“There will be winners and losers on it [an annuity],” he says.

An ARF, on the other hand, can give you substantially more flexibility. In effect, this brings your pension fund with you into retirement, once you draw down your tax-free lump-sum.

 

When you die, it can be passed tax-free to your spouse, or to your children – although tax issues will arise for them.

It means that you can continue to grow your capital, as you are still exposed to market movements, although there is a mandatory draw-down, of 4 per cent a year if you are 60 years or over, increasing to 5 per cent at 70, or 6 per cent if you have pension assets of €2 million or more and are over 60 years of age for the full tax year.

But – and it’s quite a big but – ARFs also face the risk of running out of money. Depending on how much is in your ARF, if the return on your ARF after charges fails to match your draw-down rate (ie 4-6 per cent a year), the capital will reduce each year, eventually potentially running out. This can also be hastened if the investments perform poorly.

“What also comes into play is longevity risk,” says Hurley. Should you stay alive for a very long time, it will put more pressure on your funds should you opt for an ARF.

 

ARF then annuity?

Remember, your decision doesn’t have to be final at retirement. There’s nothing to stop you from going into an ARF at retirement, and then switching to an annuity at a later date. However, according to Booth, “it’s very rare that we see this.” Rather, “people feel intuitively that one route or another works best for them.”

And there may be a reason why. Due to “mortality drag”, someone aged 75 might be expected to live longer than the 88 years that was predicted when they were 65; and this means they will get a lower annuity rate at 75 than they might have expected.

For this approach to make sense, Booth says that you’ll need to either:

  1. a) generate a return on your ARF, or;
  2. b) hope that annuity costs will fall and you get a higher rate.

At the moment, there is no hybrid product between the two, but “perhaps that’s something we need to look at”, says Hurley.

 

 

The tax question

Whether you opt for an ARF or an annuity might also be a factor of how much of a tax-free lump sum you can get. Under current rules, if you opt for an ARF, you can immediately draw down 25 per cent of your pension fund tax-free. If you opt for an annuity, however, your maximum lump sum will be 1.5 times your final salary.

So, if you retire with a pension fund worth €450,000, you will be able to draw down €112,500 tax-free with an ARF. If you were on a final salary of €100,000, you will be able to get €150,000 tax-free if you opt for an annuity, although it should be noted that the rules on 1.5 times salary are a bit more complicated than this, and not everyone may get the full amount.

So this is also an important consideration.

“Generally, if the retirement fund is small, 1.5 times your earnings is likely to be more attractive, and you’ll buy an annuity with the remainder,” says Shane O’Farrell, head of products, Irish Life Corporate Business.

But more flexibility is still called for. Booth and others in the industry would like to see the rules loosened on this, so that people opting for the 1.5-times salary option are also given the option to buy an ARF.

 

Lifestyling shift

Another reason why it is important to start thinking about these issues many years from retirement is that your DC fund manager will likely be positioning you towards a certain outcome if you are in a default fund – which is where the vast majority of people are likely to be.

The goal of lifestyling is to make sure that members are in the right type of fund at the right time – for instance to avoid a situation where someone with a year to retirement is not 100 per cent invested in equities and therefore extremely exposed to a potential drop in markets.

The benefit of a lifestyling strategy is that it “takes out having to make active decisions about when and where to invest your assets”, says Hurley. It is aimed typically at members in a scheme who opt for the default option.

However, you need to make sure it matches your end goal. For example, there’s no point in switching your portfolio to bonds – which will match an annuity – if you want to stay invested in an ARF at retirement.

Given the shift in preference to ARFs, fund managers have started to adapt their lifestyling strategies in recent years.

Pension savers in New Ireland’s Individual Retirement Investment Strategy, for example, used to transition portfolios to 75 per cent in “long bonds” and 25 per cent in cash at retirement. Now, however, aware of the preferences for ARFs, savers will end up with 75 per cent in low- to medium-risk assets at retirement, and 25 per cent cash.

Similarly, Irish Life has moved to adapt its lifestyling approach. O’Farrell explains that funds will now have longer to grow, as the de-risking phase has been cut from 20 years to 11 years before retirement. This reflects the use of a multi-asset range of funds which it now offers pension savers, that have lower volatility and greater diversification than the equity heavy pension funds of old.

In the last six years before retirement, Irish Life will assess your most likely benefit route at retirement and place you in either an annuity targeting fund (where the multiple of salary route gives the highest tax-free lump sum) or into an ARF targeting fund (where 25 per cent of the retirement savings will give the highest tax-free lump sum).

If you want to retire early, at 60, then your lifestyle strategy may have more risk than it should

“Of course, people can also make their own active decision and select another investment option, but very few do,” says O’Farrell. But for some people, making their own decisions, rather than the default one, will be crucial.

“What’s suitable for majority may not be suitable for you,” says Booth, while Hurley adds that lifestyling can be a “pretty blunt instrument by its very nature, because it doesn’t really take into account members’ unique circumstances”.

“Where they don’t work, is where people want to retire early, and want to take more risk or less risk,” he says, adding, “if you want to retire early, at 60, then your lifestyle strategy may have more risk than it should.”

 

When to decide?

For Hurley, you should be meeting your pensions adviser about 10 years out from your proposed retirement date to discuss how you expect you’ll take your benefits in retirement.

Booth agrees, adding that factors to think about include understanding what average life expectancy is , how long will it take to get the capital back, and what your current health state is.

And when it comes to picking a product, do shop around. Remember, you have the right to purchase an annuity or ARF from any provider – not just your current pension provider.

 

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Planning to retire in style? Managing your income in retirement is key

As people live longer it’s more important than ever to take an active part in planning our retirement funds, says Pòl Ó Briain of Zurich

‘Getting financial advice is not the preserve of the wealthy’. Photograph: iStock

In our parents’ generation, retirees lucky enough to have a pension had little option but to use it to buy an annuity. This provided them with a guaranteed income for life. About the only decision to be made on retirement was what brand of watch to look for!
The advent of Approved Retirement Funds (ARFs) changed all that. A more flexible retirement option, they allow the retiree to remain invested during retirement, drawing down an income as and when they need it. The flipside, however, is that ARFs require ongoing financial decision-making throughout retirement.

“Annuities were very popular in the past, and indeed for some people they remain the preferred option,” says Pòl Ó Briain, head of retail products with life and pensions company Zurich.

Pòl Ó Briain, head of retail products with life and pensions company Zurich

Pòl Ó Briain, head of retail products with life and pensions company Zurich
However, the annuity rate – which, together with the amount of money you have accumulated in your pension fund, determines the fixed payment you receive each month in retirement – is set according to the prevailing interest rates. These have remained at historic lows for nearly a decade.

“As a result, annuities are increasingly perceived as not offering good value, particularly if you want to provide a pension for your spouse in the event of your death. You can quickly find that what looks like a very healthy pension fund at retirement may not provide you with as much annual income as you might have expected,” says Ó Briain.

On top of that, once an annuity is purchased there’s no transferring an annuity to your estate. “Plus, with an annuity, once you set it up, that’s it, there’s no going back,” he says.

With an ARF any money left in the fund after your death passes to your estate. On the downside you stand to lose out if the value of your investment falls.

Given that retirees typically see their income-generating capacity reduced, ARFs require a more active approach to managing investments.

And while an annuity may provide a lower income at outset than an ARF, it does at least have the advantage of providing that guaranteed income for life. With an ARF there is the risk of exhausting the pot of money due to poor management of withdrawals or poor investment performance.

As people live longer, they are going to need to take more action to ensure their funds last throughout their retirement. “You need to ensure you are investing your ARF in an appropriate way, taking into consideration your overall risk tolerance,” says Ó Briain.

It’s important to have regular reviews with a financial broker or advisor, to ensure you are managing your retirement funds in the most effective way

When annuities were the norm, the bulk of pension decisions were made as people approached the final years of their career. Traditionally, retirement savers would move from higher risk investments to lower risk options, de-risking in the years approaching retirement. It was seen as important to shield savings from market volatility before the purchase of an annuity.

Now however, if you decide an ARF is the better option for you, that de-risking strategy may need to change, to reflect the fact that you are going to remain invested post-retirement, possibly for decades.

Post retirement, ongoing decisions will be required. “It’s important to have regular reviews with a financial broker or advisor, to ensure you are managing your retirement funds in the most effective way,” he says.

Getting financial advice is not the preserve of the wealthy, nor are ARFs themselves, he points out. “There is still a misconception that ARFs were introduced for people with a lot of money, but that is not the case,” he says.

As people live longer in retirement generally, it’s more important than ever that they take an active approach to their retirement funds. “For example, if you have an ARF investment fund of €100,000 and you plan on taking €10,000 a year to live on, which might seem reasonable, it’s not going to last 20 years,” he says.

“You therefore have to figure out the best way to manage your money, being conscious both of your tolerance for risk and your capacity for loss, which is why having an advisor to assist you will become so important in retirement. After all, while you are still working in an organisation, you are likely to have all sorts of workplace supports to help as you approach retirement. When you are in retirement, you no longer have that support.”

Changes to an individual’s health and personal circumstances as they age will also require regular review. In some cases those who eschewed an annuity when they first retired may want to consider one at a later stage – especially as annuity rates increase with age. If so, the option of converting some or all of an ARF to an annuity may be worth exploring.

Managing ARFs throughout retirement is increasingly likely to be the norm.  As ever when it comes to retirement, the best advice is to take advice. “It is most certainly not something that should be done without proper guidance,” says Ó Briain.

Reference: The Irish Times

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