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ARF v Annuity – How Do I Decide Between the Two?

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Jul 26

Choosing between an ARF and an Annuity is one of the biggest financial decisions you will face in Ireland.

So if you’re planning on maximising the value of your pension then it’s important to get this decision right first time.

When claiming your pension benefits you will be entitled to take a portion as a cash lump sum.

You will then have a choice with the remainder that’s left over.

  1. You can either swap it with an insurer in exchange for a guaranteed income for life. This is the annuity option.
  2. You can transfer it all into an investment fund where you can withdraw cash as you need it. This is the ARF option.

All sounds relatively simple but there are a lot of things you need to consider when deciding between the two.

And the reality is that your individual circumstances will dictate the best option for you so it’s important to get advice.

But, in the meantime, here is a direct comparison between the two so you can make the best decision you can.

ARF v Annuity

Annuity (Advantages)

  1. Guaranteed income for life i.e. your income will continue to be paid regardless of how long you live.
  2. You have peace of mind as ongoing income sustainability is not a concern.
  3. Stock market volatility and economic cycles won’t affect your income.
  4. Your income can be set to keep up with inflation every year.
  5. One time commission up to 2% which is deducted from the purchasing fund.
  6. No ongoing advice required once set up.

Annuity (Disadvantages)

  1. Pension money is no longer a personal asset as it’s irrevocably exchanged with an insurer at the outset.
  2. Income levels are relatively low as rates are linked to mortality rates and interest rates.
  3. The income benefit ceases on death unless a spouses provision is put in place from the start.
  4. Inflation protection and/or spouse provision can be expensive extras.
  5. No future changes or alterations of any kind can be made once it’s set up.

The annuity is focussed on providing a guaranteed income.

The Approved Retirement Fund (ARF) is focussed on preserving wealth.

An ARF works in the same way as a pre-retirement pension plan.

The difference now is that money is being withdrawn from a fund instead of accumulating within one.

As such it’s an investment fund that needs to be managed.

The market for ARF’s is very big in Ireland (estimated to be worth €30B by 2030) and one can invest into anything from cash funds, active and passive funds, ETF’s, direct shares or property.

Approved Retirement Fund (Advantages):

  1. Preservation of wealth is the key advantage of an ARF as it survives the death of its owner.
  2. An ARF be inherited as a tax-free ARF by your spouse on death or left to your children as cash.
  3. The value of your ARF asset can grow post-retirement.
  4. Your income level and subsequent tax rate can be controlled.
  5. An ARF is custom built to your own individual risk tolerance and/or investment preferences.
  6. The requirement to put aside the first €63,500 of your pension fund has been done away with.

Approved Retirement Fund (Disadvantages):

  1. If improperly invested there is a risk that some or all of the fund could be exhausted prematurely i.e. you could outlive your fund.
  2. Stock market volatility will have a direct effect on the level of income you would be taking at any given point in time.
  3. Sequence of returns risk is a factor that can reduce the expected lifespan of an ARF if initial returns are negative.
  4. Investment strategy needs to be managed carefully in order to maintain income sustainability as returns are not guaranteed.
  5. There is a mandatory withdrawal rate of 4% per annum which increases to 5% per annum from the year you reach 71.
  6. Annual management fees are ongoing and will depend on funds chosen but usually between 1% and 1.5% per year.

The biggest consideration between the two:

The biggest difference is that the annuity payment dies with the holder while the proceeds of the ARF are inheritable tax-free by the surviving spouse.

So the choice is between guaranteed income and wealth preservation.

ARF’s have been the more popular route for Irish retirees in recent years.

One reason is because annuity rates are historically low so annuites can be seen as bad value.

The other is that ARF holders value the fact that their accumulated funds are kept in the family on death.

Consisderations with an Annuity

An annuity purchase is permanent so you need to be absolutely certain that;

  1. It’s the right option for you
  2. You get the best annuity rate you can
  3. It’s structured correctly from the outset.

These are one product you really need to shop around for because the difference in offered rates between providers can be big.

With the ECB increasing interest rates this will have a very p[ositive knock-on effects for annuities.

The higher the rate you get the higher your income.

Consisderations with an ARF

An ARF is an investment fund which requires ongoing advice as there are 7 universal risks that need to be managed in retirement.

1. Reduced earnings capacity – Less flexibility to earn an income from work which can act as a cushion from the impact of a devalued portfolio and reduce the need for increased withdrawals from them.

2. Visible spending constraints – Pre-retirement is all about accumulating assets but retirees now have to turn assets into income and this acts as a very big restraint on their investment decisions.

3. Heightened investment risk – This is very relevant to an ARF holder because most retirees are very vulnerable to market shocks. Sequence of return risk can also dramatically reduce the sustainable withdrawal rate from an ARF if a big devaluation occurs in year 1.

4. Unknown longevity – Income planning would be a lot easier if the exact date of our demise was known in advance. As it’s not, it poses a challenge as to how long a portfolio needs to generate an income. Our clients are no different to others in that there’s a very real fear that they’ll outlive their savings.

5. Spending shocks – Living off a portfolio income can greatly reduce the capacity to absorb unexpected expenses like home repairs, new car, divorce, children requiring financial assistance, long-term health and/or residential care. This is why it’s important to have an element of liquidity in a portfolio. For example, liquidating an ARF holding an investment property can be problematic and expensive if access to cash is urgent while liquidity from equities is more or less immediate.

6. Compounding inflation – Long-term inflation dictates the need to take on investment risk for long-term sustainability. A 1% rate of inflation over 20 years would increase the cost of living by 22% while a 2% rate would increase it by 48%. The options to combat this are to gradually reduce spending or to take on more investment risk. The latter would cause more difficulty in volatile markets and, generally speaking, the tolerance for taking on increased risk diminishes massively at this stage.

7. Declining cognition – This is the area that people most reluctant to discuss when it’s brought up. Age related mental decline is an unfortunate part of the human condition but it’s one that should be planned for. Even more so if the financial management of an ARF is undertaken by just one member of a married couple. Impaired decision making can result in mismanagement of assets. This can cause an even bigger problem when the inexperienced spouse has to assume the responsibility if their spouse predeceases them. Many retirees are happy to manage their ARF themselves whilst others prefer to have an advisor to advise them. As usual, it comes down to individual preferences.

Give me a call on (087) 123 2475 if you need help with this decision or send me a quick email.


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