When retirees are considering options for their accumulated pension fund at retirement, having taken a tax-free lump sum, there are broadly speaking two options. The first option is to use the fund to purchase an annuity – this in effect exchanges the fund for a guaranteed level of income payable for life. The second option is to keep the funds invested in an Approved Retirement Fund (ARF), which can benefit from further tax- free growth and flexibility of drawdown.
Approved Retirement Funds have become more and more popular since their introduction in 1999, which has latterly coincided with a period of low annuity rates. It is annuities which we will focus on in this blog, and how they can form a part of a retirement strategy and overall financial plan.
In simple terms, when purchasing an annuity, you exchange a fixed amount of money (say €200,000) for a fixed level of income, paid for life. In this example, if an individual used a fund of €200,000 to purchase an annuity with a rate of 3%, they would receive €6,000 per annum until they pass away. It is also possible to have this annuity index each year, and also to pass to a spouse on death. All of these ‘added extras’ mean you get a lower rate initially.
Annuity rates have been very low for the past 15 years or so, given we have been living in a world of very low interest rates, and long bond rates. Annuity rates have therefore offered poor value. If you use €200,000 to purchase an annuity of €6,000 per annum, you need to receive this income for over 33 years just to break even. This represents a poor deal for the annuitant, so many in this scenario would have opted to keep their funds invested in an ARF instead. It should be noted that at any time, an ARF can be used to buy an annuity, but an annuity is irreversible once purchased.
However, over the last 12 months, we have seen an increase globally in interest rates, bond yields, and therefore annuity rates. Annuity rates which have previously been viewed as poor value are now appearing more compelling. Current indicative annuity rates are as follows, assuming a couple both age 65:
Single Life, Age 65, Level Annuity
Single Life, Age 65, Indexing Annuity @ 2%
Joint Life , Both 65, Level Annuity
Joint Life, Both 65, Indexing Annuity @ 2%
*Joint Life Annuity includes 50% spouses reversion
These rates are far more attractive than they would have been even at the start of 2022, and are likely to further improve in the months and years ahead, as we are firmly in an era of rising rates.
For a retiree with a pension fund, and a decision to be made, it should be noted that it is possible to use a portion of the fund to purchase an annuity, and invest a portion in an ARF – this isn’t a binary either/or decision.
For example, if we consider the example of the couple above, both age 65. If we assume that they are both in receipt of the full State Pension (currently €13,171 per annum) which would give a total State Pension income of €26,342 per annum.
As they are both over 65, this couple would be exempt from income tax up to the exemption limit, which is currently €36,000 per annum.
By using a portion of the pension fund to purchase an annuity, this gives them a higher amount of guaranteed income. The remainder of the fund can then be invested in an ARF. As a result of having a higher level of guaranteed income, this could allow them to potentially take more equity risk with the ARF.
In terms of drawdown from the ARF, they can also be strategic in this regard. By taking a level of income from the ARF, which combined with the State Pensions and annuity above, gives a total level of income of say €36,000, they would not be liable for any tax at all as they will be under the exemption limit. For a larger pension fund, again the income can be tailored to ensure that all income tax is chargeable at 20% - PRSI does not apply once you are over 66.
Let’s look at a worked example of how this might work in practice for a couple aged 65, and considering how to draw down a pension fund:
If we assume a pension fund of €800,000 at retirement, and an individual taking a tax -free lump sum of €200,000 (25%). This leaves a residual fund of €600,000.
By using €254,828 to purchase a joint life annuity (using the rate of 3.79% as above), this will give an annuity of €9,658 per annum. When added to the State Pensions this couple now have a guaranteed income of €36,000 per annum. As alluded to above, this allows them to consider potentially taking more equity risk within an ARF investment – in this instance, the investment into the ARF would be €345,172.
By dynamically drawing an income of 4% per annum from this ARF, and assuming 4.5% growth, this income can be sustained until age 100, with a residual value of €137,960.
Whereas previously, ARFs were seen as the default option for retirees, a more nuanced approach can be taken, and tailored to your specific needs and tax circumstances.
If you would like to discuss this further, and how it intersects with your overall financial planning, please contact me at firstname.lastname@example.org and I would be delighted to assist you.