ARFs or annuities – which to choose?

Many investment options simply come down to numbers but choosing whether to invest your pension in annuities or Approved Retirement Funds (ARFs) can be an exercise with some surprisingly existential elements. "Retirement planning is challenging simply because we are planning for a finite, but precisely unknown, retirement period. How does one estimate how long one will live?" asks Tony Doyle, head of retirement planning at AIB.

“In the case of an annuity, the retiree hands over their money to an insurer for an income for life.

“It simply doesn’t matter how long one lives, the annuity is payable for life. Up until the financial crisis of 2008/09, annuities were good products and were used by the majority of retirees to provide certain income for their retirement,” he says.

“The financial crisis was the turning point for annuities, when central banks across the world started quantitative easing in an attempt to stabilise the financial system. Simply put, annuity rates took a beating, and became demonised, but in my view wrongly so.”

Despite the drop in rates, annuities can still be attractive options for some people, however, there are pros and cons, Trevor Booth, head of financial planning at Mercer explains. “An annuity is payable for the remainder of your life so provides certainty on the income you will receive, and if you live longer than average you could do very well from it,” he says. “However, if you die at a young age then you will not get the benefit from the full amount used to purchase the annuity. The current cost of purchasing an annuity appears very high relative to the average life expectancy for individuals and it could take a 65-year-old 30 years to recoup the initial capital used to purchase the annuity.”

Because of this, most people now looking to invest their pension are doing so through Approved Retirement Funds. “An ARF gives you flexibility in the amount of income you draw, and when you draw it,” says Booth. While deductions from ARFs are treated as income and so subject to tax, they promise a more appealing prospect should you die earlier than expected.

‘Inherited’

“The value of the fund remaining when you die can be inherited. You also have the opportunity to achieve investment gains on the fund,” explains Booth. “However, with the opportunity for investment gains is the risk that your fund might suffer investment losses. Poor investment returns or living a long life could lead to you outliving your pension fund and having no private pension in your later years.”

While ARFs are the more popular option for most, ultimately the choice comes down to individual circumstances and desires for retirement and it can be a decision that sees many seeking professional financial assessment and advice. "Once you choose the annuity route, you cannot reverse the decision," says Bernard Walsh, head of pensions and investments at Bank of Ireland. "So it is vitally important that you understand whether you will go down the ARF or annuity route at retirement.

“Many of our customers use a lifestyle approach to managing their pension pot. In early years, your money is invested to maximise growth. As you near retirement, your fund automatically de-risks into more cautious assets. This makes perfect sense if you intend to buy an annuity,” says Walsh.

“However, if you intend to draw down most of your money as tax-free cash, you should adopt an alternative de-risking strategy. If you plan on going down the ARF route, your investment horizon is not your retirement age,” he says. “Statistically, you are likely to live 20 years or more following retirement and therefore your investment term is substantially longer.”