One pension, two paths
It's worth taking advice on what to do with a pension lump sum, to make sure your money lasts a lifetime. Picture: iStock
Most pension conversations tend to focus on the benefits of starting early, while scant attention is paid to what happens at the other end of the journey. At its most basic the choice boils down to two options – put the pension pot into an annuity which gives you a guaranteed income for the rest of your days or invest it in an approved retirement fund (ARF) which may offer superior returns but comes with investment risk and no guarantees.
In both instances, you can take a tax-free lump sum on retirement – up to 25 per cent of the fund value for self-employed individuals or an amount related to salary and service depending on occupational scheme rules.
“Retirement planning should reflect an individual’s circumstances and priorities rather than follow a standard formula,” says Stephen Darcy, senior director of wealth management with LifeSight Financial Advice.
For many people, taking a retirement lump sum will form part of the plan, he adds. “The lump sum can provide useful flexibility. It may be used to repay debt, make home improvements, build up accessible savings or support other financial goals. However, the amount available should not be the only factor driving the decision. It is equally important to consider how much capital and income will be needed throughout retirement.”
That calculation will influence what is done with the rest of the pot. Ultimately, it comes down to the income in retirement people would like to have and what they want it for.
“Most people want to enjoy a reasonable lifestyle when they retire,” says Retirement Planning Council of Ireland programme leader and former pensions ombudsman Paul Kenny. “The first thing to do is a balance sheet. Look at your assets and liabilities. For a lot of people, depending on the lifestyle they’ve had, it’s worth doing a high-level budgeting exercise – not down to every cup of coffee.”
That exercise should give people a fairly good idea of what their outgoings will be. The next step is to figure out how to generate the income to cover it. That brings us back to ARFs and annuities.
“An annuity is an insurance contract purchased with some or all of a pension fund,” Darcy explains. “In return, a life assurance company provides a regular income, generally for the rest of the person’s life.” The key advantage is certainty. On the other hand, the annuity dies with you with any remaining money reverting to the assurance company.
An ARF offers a more flexible approach, Darcy adds. “Rather than using the pension fund to purchase a guaranteed income, the money remains invested after retirement. The individual can then take withdrawals from the fund over time, subject to the relevant tax and Revenue rules. Unlike an annuity, an ARF does not guarantee an income for life. The value of the fund can rise or fall depending on investment performance, and the amount available in the future will also be affected by the level of withdrawals taken.”
Kenny points out that a lot of people don’t understand what an ARF is. “You’re in control of withdrawals and investment. But you’re exposed to investment market risks and the risk of outliving the money in the ARF is on you rather than the insurance company.”
If you wish to provide for loved ones after you die, an ARF allows for inheritance. “The money is still there in your estate. There is also potential for growth if it invested properly. It is very important to get proper advice when deciding on an ARF investment.”
There is a need to take at least some degree of calculated risk with ARF investments, according to Bernard Walsh, head of investments and pensions at Fairstone Ireland. “People tend to think they should be cautious or conservative in retirement,” he notes. “The reality could be the opposite. They need to look for investment growth. People shouldn’t be too cautious. Inflation is running at 3 to 4 per cent and can be significantly higher in retirement due to proportionately higher healthcare and heat and light costs. They should look for growth to cover that at least.”
Kenny points out that there is what is known as a “deemed drawdown” of 4 per cent annually on an ARF from age 60 to 70 and 5 per cent after that. This means that even if the retired person takes nothing from their ARF they are taxed as if they had taken 4 per cent of it.
“It doesn’t make sense not to draw down at least that much, because you are paying tax on it anyway,” he says.
People should look at the annuity option as the baseline before deciding on the ARF option, according to Munro Dwyer, who leads PwC Ireland’s retirement and pensions consulting business. “If you can get €20,000 a year from an annuity and are looking to get €30,000 from an ARF, that extra money has to come from somewhere. That means taking on risk and people need to be comfortable with that level of risk.” Tax also comes into the equation. Dwyer explains that there is no point in taking a large income from an annuity and paying a lot of tax on it if the individual can use other assets such as savings and the tax-free lump sum to fund their retirement in the early years. That would allow their investment in an ARF to grow tax efficiently until such time as they need to start drawing it down.
He also explains that it is possible for ARFs to cater to varying levels of risk. This sees a portion of the ARF invested in low-volatility assets to meet retirement income needs in the early years while the remainder is invested in higher-risk assets targeting higher returns while the individual is safe in the knowledge that they won’t have to draw down those funds for a number of years.
There is no one-size-fits-all answer. For some, the certainty of an annuity outweighs the potential upside of an ARF. Others may value flexibility more highly. The challenge is to strike a balance that matches your income needs, risk tolerance and retirement goals, so take professional advice to make your plan.
