Weighing up the options on pension savings

Congratulations: the October 31st income tax deadline has given you the encouragement you needed to take out a personal pension or start making additional voluntary contributions (AVCs), thus reducing your tax bill for 2003 and boosting your future retirement income.

(If it didn't, it may not be too late - the cut-off date for the online filing of tax returns is November 18th.)

You have handed over your birth certificate, chosen your contribution rate and signed all the dotted lines.

All you have to do between now and retirement is watch the money vanish from your bank account into the careful hands of the pension fund manager. But what happens at the end? How do you get back everything you have put in?

The answer to this question will depend on the type of pension scheme you have been paying into over the decades.

Members of defined contribution occupational pension schemes must convert the savings in their pension fund into an annuity.

Annuities, which guarantee an income for life, become the monthly pension sum posted by cheque or lodged into a retired person's account once they have handed over their pension fund to a life assurance company.

The downside of falling interest rates and increased life expectancy is that the amount of annual income that people can get in exchange for their pension fund has diminished dramatically in recent years. With mortality statistics continuously improving, it is unlikely that annuities will ever be as cheap as they were in the past.

What makes the problem even more frustrating is the fact that the value of the pension that people receive for the rest of their life is pegged to the best annuity rate they can get at the point they retire.

As defined contribution scheme members have no choice but to buy an annuity with their main pension fund and must in many cases simply accept the prevailing annuity rates on offer, it is sometimes said they are caught in an "annuity trap".

Holders of personal pensions, including Personal Retirement Savings Accounts (PRSAs), can avoid this trap by availing of another home for their pension savings on maturity: an Approved Retirement Fund (ARF).

Introduced in 1999, ARFs are special investment plans that allow personal pension holders to keep control of their finances during retirement. ARF owners can draw on their funds now and again, whenever they please, giving them the freedom to splurge one month and budget the next.

"ARFs have made it more attractive for people to put in meaningful pension contributions and that would particularly apply to company directors who are close to retirement," says Mr Jim Lee, pensions manager at Friends First.

"They can make one-off withdrawals from the fund to pay for family occasions like weddings. That has tremendous psychological appeal to the person who has been running their own ship all during their working lives."

As the money remains invested during retirement, a personal pension holder can benefit from further growth on the investment markets after they stop working.

On the other hand, if they want to avoid the heart-racing insecurities of a fluctuating stock market, they can choose to keep the bulk of their ARF in a fixed-interest fund or property, according to Mr Lee.

One advantage of an ARF is that, provided you don't overspend, the assets in the fund will outlive you and can be passed on to spouses, children or any of your beneficiaries.

"That is very appealing for self-employed people who would have thought: 'what happens if I die on the way to collect my first pension cheque?' The insurance company is quids in," says Mr Alan Flynn, partner at BDO Simpson Xavier.

More and more people are opting for ARFs, according to Mr James Skehan of New Ireland Assurance.

"Some people still have high guaranteed annuity rates as part of their pension contract, and for them it may make sense to buy an annuity," Mr Skehan says.

But as these high guarantees disappeared from the market around a decade ago, fewer and fewer retirees will have these high guarantees as time goes on, he notes.

ARFs have their drawbacks, the main one being that it is impossible to predict exactly when we will die. An annuity will guarantee an income for life, but an ARF can run out.

A person might decide they will budget for a retirement lasting a couple of decades only to find themselves celebrating their centenary with little or nothing left in their fund. "Let's say you have half a million in your fund and you need to string it out over your lifetime. There's an obvious dilemma there, because you don't know how long your lifetime is going to last," says Mr Lee.

There is a safety net in place. If you do not have an annual income of €12,700 or more, you must put €63,500 of the pension fund into an Approved Minimum Retirement Fund (AMRF) until the age of 75.

You will have no access to that capital, but you can withdraw any gains.

But ARFs are still not suitable for everybody.

"If the ARF is going to be the predominant source of income during retirement, it might not be a wise idea to opt for one," Mr Lee says.

"Quite a lot of the personal pensions we see are quite modest funds and the modest ones do tend to opt for annuities," he says.

"It is actually surprising how many people will go for the security of an annuity," Mr Flynn believes.

"I would have said that out of our clients, 10 out of 10 would go for an ARF, but only around seven out of 10 do."

While it is possible to buy an annuity that continues to be paid to a surviving spouse or pays out for a minimum guaranteed period whether you live or die, these options make the annuity more expensive, effectively cutting the level of your pension.

But not everybody has the choice. ARFs are only open to self-employed people who contribute to personal pensions, PRSA holders and company directors with at least a 5 per cent shareholding.

People in occupational pension schemes, however, can invest their AVCs into an ARF.

"Let's say your AVCs are €75,000. You can put that into an ARF for any contingencies. If your pension is eroded by inflation, at least you have a kitty there to top it up," says Mr Lee. "It's a piggy bank for your retirement."

But not enough people are making AVCs in the first place, Mr Skehan says, the reason being that they often don't know if the type of pension they have and the amount of contributions they are putting in will give them a good, bad or simply average retirement income.

"They don't know whether or not they need to be making AVCs."