Annuities get a bad rap, but is it time to look more closely?
Marc Westlake CFP, TEP, EFP, APFS
Managing Director @ Everlake | Financial Planning Expert
Joe is 66 and just retired. He and his wife Mary are now in receipt of their State Pensions which come to about €24,000pa combined.
He has a private pension worth €1.5M and, in common with most people in Ireland today, he is thinking about setting up an Approved Retirement fund (ARF). He understands that the alternative, an annuity, is bad value and means that all of the pension fund is lost in the event of his death. His adviser hasn’t done anything to challenge this belief.
When we look more closely at Joe’s needs,
He has been advised to take his lump sum of 25% of the value of his pension and to put the rest into an ARF with a low-risk investment strategy.
Establishing a benchmark
Typically an ARF investor and their adviser will look to protect their original investment or seek to meet the 4% withdrawal.
This is a huge mistake. The most relevant benchmark for an investor in an ARF is the annuity that they didn't purchase at outset.
This helps us to establish a "critical yield" that is to say the level of return the ARF needs to achieve on average just to keep up with the income payments that would have been guaranteed by the annuity most suited to the client's circumstances.
In this case we need inflation protection and a spouses pension.
An inflation protected annuity with 2%pa increases and a 50% spouses’ pension to Mary in the event of his death is currently paying €37,582pa (3.346%) which when added to his State Pension income of €24,000 would provide a total annual income of around €61,500pa gross.
An estimated critical yield can therefore be established as follows
Annuity Rate (increasing by 2%pa compound) + charges differential + plus allowance for mortality cross-subsidy of annuity
3.346% +2% +1% =6.346%pa (increasing by about 0.067%pa to match the inflation protection)
This means that the ARF would need to have a very significant equity bias in order to keep up with the annuity that could have been purchased at the outset.
As annuity rates improve with increases in interest rates it should be clear that the relative attractiveness of an annuity also increases.
Equally, we need to consider what the realistic prospects for investment returns might be for an ARF for a conservative investor which is comprised of large positions in cash and Bonds. Putting this into context, the yield on the Vanguard Global Bond Index fund is currently 3.6%.
If an ARF with a suitable risk profile for Joe sought to match this annuity, the projected benefits in real terms would look like this.
Since the income is fixed in real terms there is some possibility of the value of the ARF bombing out in this scenario
Estimated Tax 2022
Source PWC
Net Annual Income???????€50,721
Total deductions????????????€10,861
Average Tax in 2022??????17.63%
Of course, an ARF investor can’t just take an income of 3.346%. The minimum deemed distribution is 4% rising to 5% when Joe is 70 years of age, so the actual profile of the ARF income looks like this.
We can see that as the withdrawals reduce as the capital balance drops there is little practical chance of running the account down to zero
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Estimated Tax 2022
Annual net income €54,838
Total Deductions €14,162
Average tax in 2022 20.52%
So, we can see that the ARF income isn’t particularly tax efficient.
Mary isn’t using her €13,000 exemption from USC as her State Pension isn’t subject to USC.
Our Advice to Joe and Mary
They need to structure their income so that it is
A possible strategy.
Transfer the pension into a PRSA and split into 2 parts
€800,000 to provide tax free lump sum of €200,000 and €600,000 to purchase an annuity.
A level annuity with a 10-year guarantee and 100% spouses’ pension is currently paying €24,090pa (4.025%pa).
Source Irish Life
The €200,000 tax free lump sum should be invested in a dividend portfolio in Mary’s sole name to make use of her tax exemptions and reliefs. This will generate a gross income of approx. €4,000pa currently.
Estimated Tax 2022
Annual net income €47,235
Total deductions €4859
Average tax in 2022 9.32%
Comparing the three options we therefore see the following
The hybrid plan is almost exactly in line with the income target of €4,000pm net but is only using €800,000 of the pension to achieve it since the tax payable is so much less.
The balance of €700,000 is to remain in the PRSA as “unvested” benefits to be deferred up to age 75 (9 years)
Having locked in and guaranteed Joe's income requirements, arguably he has to risk capacity to take more investment risk with his unvested pension.
Taken to it's logical conclusion, Joe has theoretically no need for the remaining pension fund and therefore could consider a full equity strategy.
With the following projected results
The benefits of this approach are as follows:
???? France-based Certified Financial Planner, ???? U.K. Pension Specialist, ???? USA Investment Adviser Representative, and ???? South African FSP Key Individual.
2 年Lovely stuff, Marc. Planning and modelling at its finest.