Chapter 12 Decisions on Retirement

A note on terminology
An annuity is a type of pension. In exchange for giving a lump sum to a life insurance company, the life insurance company pays the annuitant/pensioner an annuity/pension for life. If the pensioner dies shortly after starting the annuity, the annuity will have been very bad value. If the pensioner lives for longer than expected, the annuity will have been very good value. This is the basic annuity - there are also indexed annuities which increase at a fixed rate each year and with profits annuities which rise and fall in line with the stockmarket.

TAX FREE LUMP SUM OR HIGHER PENSION?

If you have a defined benefit pension scheme, you will be faced with this decision which is best illustrated by way of example:

Joe retires at age 65.
He can take a pension of £30,000 per year
or
a £60,000 tax free lump sum and a reduced pension of £23,000 a year.

This is a very complex calculation requiring consideration of a lot of factors:

What is the "exchange rate"?
For this example, we are offering a £60,000 lump sum or £7,000 extra pension a year. The pension scheme might offer a different exchange rate e.g. £60,000 or £5,000 a year, in which case the lump sum is relatively more attractive.

What investment return can Joe expect on the £60,000? A deposit account will pay him 5% a year, which would only be £3,000, so sacrificing £7,000 pension wouldn't make sense. However, if he invests it in the stockmarket and gets a 12% return, he would be getting £7,200, which is more attractive.

What is Joe's attitude to risk?
The extra £7,000 is guaranteed for life. Joe will know what his income is going to be for the rest of his life. If he invests the £60,000, he is taking an investment risk and a longevity risk. He might get a bad return on his investment and he might live a lot longer than average. If Joe has no other income or no other assets, he might be more comfortable with the extra guaranteed income. If Joe is wealthy, he might not need the reassurance of the extra £7,000.

What will Joe's tax rate be? If Joe is single, he will pay 42% tax on the £7,000 extra pension. This reduces its net value to only £4,000. The stockmarket return will be taxed at about 20% which would reduce the £7,200 to £5,800.

Will the pension increase with inflation? Joe's pension might increase in line with inflation, which makes the extra pension option a lot more attractive. Sometimes this inflation protection is in the scheme; sometimes it's at the discretion of management.

How is Joe's health? At one extreme, if Joe is in very poor health and does not expect to live for very long, then he will not benefit from the extra pension for very long. Therefore the cash in his hand now is more attractive.

Will his spouse get a pension when he dies? If Joe's wife continues to get a pension when he dies, then the pension option is more attractive. If his spouse gets no pension, the lump sum can be invested to provide her with an income.

What is Joe's current need for cash? If Joe needs cash now to help his son buy a home or to pay off expensive debts, then that makes the lump sum more attractive.

WHAT TO DO WITH AVCs

If you have made additional voluntary contributions to your pension scheme, you may have the following choices:

Buy an increased annuity
Cash them now and pay income tax at your marginal rate
Put them in an Approved Retirement Fund

These are dealt with in more detail in the section ARF or Annuity ?

WHICH ANNUITY?

With a defined contribution pension scheme, you will have accumulated a pension fund on retirement.
You will be able to take a tax free lump sum of 150% of your final salary. Whatever is left must be used to buy an annuity from a life insurance company.

Most people buy the annuity directly from the insurance company which managed the pension fund's investment. What they don't realize is that they are entitled to shop around. Go to a discount broker and get a selection of quotes. Try the following direct insurance companies yourself: Quinn Life, Lifetime and Ark Life.

Annuities are linked to the rate of return on long term government gilts. In periods of low interest rates, they appear to be very bad value. You can try to improve on this level of return by investing in a with profits annuity. The guaranteed element of the pension is lower but there is an opportunity to increase the level of pension if the stockmarkets rise in the longer term. Companies offering with profits pensions include Irish Life's Secured Performance Fund (Any other information of with profits annuities welcome)

ARF OR ANNUITY?

If you have a personal pension, a PRSA, AVCs or if you are a controlling director, you will have more choices with what to do with your pension fund when you retire. After taking up to 25% of the fund tax free, you can:

Take the balance as a lump sum subject to PAYE or
Invest it in an Approved Retirement Fund or
Buy an annuity.

However, if you don't have a guaranteed income of £10,000 a year, you must use the first £50,000 to buy an annuity or you must invest it in an Approved Minimum Retirement Fund.

Unless you have an urgent need for a lot of cash now, putting it in an Approved Retirement Fund will nearly always be better than taking it as a taxable lump sum now immediately. The ARF is a tax exempt fund which means that it will pay no income tax or capital gains tax on the growth of the fund. You will be able to draw down cash from the ARF whenever you want. This means that you might draw down just sufficient to use up your 20% tax band to avoid paying tax at the top rate. If you draw down all the cash in one lump sum on retirement, you will pay 42% tax on most of it. If we assume that the top rate of tax is going to come down over time, then an ARF is more attractive as the income from it will be taxed at the later, lower rates. When you die, you will be able to pass on the ARF to family members in a more tax efficient manner.

Annuities and ARFs compared

ANNUITY ARF
You will have a lifetime income no matter how long you live If you live a lot longer than average, your ARF might run out
The level of that income is guaranteed Investment Risk - you might get a poorer return on your investment
Your pension will stop when you die When you die your pension fund passes to your estate in a tax efficient manner
  Flexibility - you can draw down the income when you need it and when it is most tax efficient
  An expected higher return - in exchange for the above risks, you can expect a higher income for the rest of your life

GUEST CONTRIBUTION

In reply to a question on Askaboutmoney as to whether an ARF or an annuity was better, our regular contributor UDS answered:

It depends on the individual's circumstances and objectives. My approach would be as follows.

1. Have a long, hard think about what is the minimum level of income you want from your retirement savings to supplement the old age pension (and any other income you may have) to provide the lowest total income you would feel comfortable with in retirement. Be realistic about what this minimum is; we're not talking about an amount that will keep you from starving, but an amount that will let you live the kind of life you will find satisfying. It must bear some relationship to the standard of living you want, and to the earnings you enjoyed before retirement. It must take account of your dependent spouse, if any, and your dependent children (although by the time you reach retirement age your children are likely to be grown up.) Your first priority is to use your retirement savings to secure this level of income, almost certainly on an indexed basis.
2. Now have a look at your retirement fund. If it is just enough, or just a little bit more than enough, to secure an index-linked annuity at the level you have identified, your choice is clear; you should buy the annuity. You might do better by investing otherwise, but you might do worse and, if you do, your income will fall below the minimum you consider acceptable.
3. If, on the other hand, your fund is comfortably more than needed for this purpose, or vastly more, other options are open to you. You could spend part of your fund on the basic annuity, and invest the rest quite adventurously - equities or whatever. Or you could invest a significant part of the fund in some reasonably stable product, such as a with-profits contract designed to provide income, giving yourself a comfortable margin above your minimum level of income. To an extent what you do here depends on what you envisage doing with the "surplus" fund, over and above the amount need to provide the basic income you have identified. Will you use it to provide extra income? Will you let it accumulate, against the risk of needing residential or medical care in later years? Do you want to put it by as an inheritance for your selfish, grasping, greedy, 55-year old children?

HOW AN ARF WORKS

An ARF is provided by a qualifying manager. This can be a stockbroker, bank or life insurance company. Life insurance companies provide the normal range of funds - with profits and unit linked. Stockbrokers will provide a product which allows you to invest in shares of your choice. This will only be attractive to very large funds as the administration charges are high.

You can draw down an ARF in whole or in part at any time. If you don't need the money, it makes sense to draw down sufficient to allow you use up your tax free allowances and perhaps your lower tax bands.

There are complex rules about what happens to an ARF when you die.
If your spouse gets the ARF, she will be subject to the normal rules i.e. they pay income tax when they draw it down.
If your son or daughter under 18 gets it, he will be subject to Capital Acquisition Tax only, so it makes sense to leave it to any minor children who may be able to use their tax free thresholds to avoid any tax on the ARF.
If you leave it to a son or daughter over the age of 18, they will pay tax at standard rate on it, which is more attractive than your spouse paying tax at the top rate.

APPROVED MINIMUM RETIREMENT FUND
If you don't have other income of at least £10,000 a year, you must either buy an annuity or leave at least £50,000 in an Approved Minimum Retirement Fund (AMRF). You can only draw down any profits from the fund. At the age of 75, it becomes an ARF and you can cash it in whole or in part as it suits you.

CHOOSING AN ARF

As with any unit linked investment, you should invest it all in the stockmarket and look for the lowest available charges.

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