They have been out of fashion for quite some time now – with defined contribution (DC) members at least – but with interest rates starting to rise once more, could an annuity be the solution to your retirement income?
When you reach retirement in Ireland, you typically have a couple of options on how you will draw down your pension savings. If you are in a defined benefit (DB) scheme, which offers a guaranteed income in retirement, you will be required to set up an annuity.
But more and more people these days find themselves in defined contribution schemes where their income in retirement is determined by how much they have managed to save during their working life and the investment performance of that money.
This cohort has two options: they can set up an approved retirement fund (ARF), which sees their money remain invested in markets with the potential and the risk that entails, or they can buy an annuity, which gives you a guaranteed income until you die. How much income is determined by interest rates and by how much you have saved.
The advantage of annuities is that they offer a guaranteed income until you die, and sometimes even after, with some products offering spousal income. You can also provide for inflation-proofing, at a cost. So there is no fear of your pension fund bottoming out with an annuity and this guaranteed income offers peace of mind.
There is also the possibility of an enhanced annuity which means that, should you have health issues, an insurance company may be willing to up the level of payment under an annuity it offers. Irish Life for example, says that up to 60 per cent of retirees may qualify for an enhanced annuity.
For many, opting for a guaranteed income can seem like the preferred option, particularly given the uncertainty of ageing and related health issues.
As Fergus Collis, a partner with Lane, Clark & Peacock notes that “there can be a lot of challenges with managing an ARF”. This is often true for those who are risk averse, with Collis pointing to a “lot of ARF retirees whose money is sitting in cash”, which, he notes “can be deadly in an inflationary environment”.
“With an ARF you have to be taking risk,” he says.
However, the issue with annuities in recent years has been the low rate of income they offer, a function of the historically low interest rate environment. Aoife Lavan, a tax and pensions specialist with Goodbody who has close to 20 years experience in the area, says she cannot recall ever looking to buy an annuity for a DC client.
So how much can you get with an annuity? Back in January of this year, Collis says, a 65-year-old could expect to get a rate of about 3.75 per cent on €100,000. This translates into an income of about €3,750 a year for every €100,000 saved in your pension fund.
On that basis, the retiree would need to live until they were about 92 to make their money back. And the latest CSO figures show that life expectancy at the age of 65 is only 18.3 years for men, and 21 years for women.
Since then however, the environment has changed rapidly. With interest rate increases of as much as two percentage points predicted at the European Central Bank by year-end, annuity rates have already started to increase. Collis points to such dynamic pricing practices, noting that annuity rates have already jumped by about one percentage point.
“It basically means that a 65-year-old is getting 25 per cent less in retirement income if he bought an annuity in January than he would have gotten now,” Collis says.
Irish Life currently has a rate of about 4.7 per cent for a 65-year-old. This would translate into annual income of about €4,700 – almost €1,000 more than the same retiree would have gotten earlier this year. On that basis, you will get all the money you saved back almost six years earlier – at the age of 86, should you live that long.
Ten years ago you could expect to get an annuity paying about 6 per cent, Collis says, so latest rates are getting closer to this “normal” level. But could they go higher yet?
Annuities do not rise in direct correlation with interest rates; rather their pricing is more closely related to bond yields, which in turn are related to interest rates. If bond yields are higher, insurance companies earn a higher return by investing in these, which they can then pass on to their annuity clients.
However, just because interest rates at a European level are set to increase over the course of this year, doesn’t mean that annuity rates will jump accordingly.
Joe Prendergast, global strategic adviser at Goodbody, notes that recent movements in the interest rate environment are “the kind of change that makes an annuity viable again”, but notes that “4-5 per cent is still not great for an annuity as you’re giving away your capital”.
And the upside may be limited.
“I think the problem is that bond yields have anticipated so much in terms of interest rate adjustment from the ECB, that rates will have to go up just to justify where we are today,” Prendergast says.
As such, noting that bond yields/inflation expectations may have already peaked, he says that yields are “unlikely to go an awful lot higher”. This means that while there is further upside in annuity rates, it may be limited.
Prendergast says ECB rates will likely have to go above 2 per cent before annuity rates might shift further upwards.
Nonetheless, with annuity rates at least becoming a viable option for the first time in a long time, it is something that impending retirees and those already retired should be thinking about.
“ARFs are often bought and parked and thought of as a one-off decision,” agrees Collis. But this does not have to be the case. Someone who bought an ARF some years ago, when an annuity looked poor value, should “absolutely” come back and revisit that decision, he advises.
“An annuity mightn’t be right at the point of retirement, but it might be 10 years further on when you don’t want to take the risk any more,” says Lavan.
In addition, with annuity rates now looking more viable, it does not have to be all or nothing; retirees can consider parking some of their retirement fund in an annuity, and benefiting from the guaranteed income that brings while continuing to hold on to some of their capital in an ARF.
And there is always the possibility that you will live longer than expected and thus get an income in excess of what you had saved.
“Some people will do very well out of an annuity, that’s why a combination suits a lot of people,” says Lavan.
On the subject of annuities, impending retirees should also check the terms and conditions of their pension schemes. There is a possibility that they have the right to a guaranteed annuity rate upon retirement, with Lavan noting that some schemes from the 1980s/early 1990s offered guaranteed rates of about 10 per cent. This is particularly attractive so scheme members need to check this out when making any decision.
Remember, opting for an annuity also has an impact on how much of a tax-free income you will get in retirement. And, depending on your finances, an annuity may end up giving you more – or less – than you would get with an ARF. Under current rules, if you opt for an annuity on retirement, your maximum lump sum will be 1.5 times your final salary; if you opt for an ARF on the other hand, you can immediately draw down 25 per cent of your pension fund tax-free.
So, if you retire with a pension fund worth €450,000, you will be able to draw down €112,500 tax-free with an ARF. But if you were on a final salary of €100,000, you will be able to get €150,000 tax-free if you opt for an annuity, although it should be noted that the rules on the 1.5 times salary are a bit more complicated than this, and not everyone may get the full amount.
Finally, if you are considering an annuity, it is also important to understand what happens when you die. A clear disadvantage of an annuity is that it will generally die with you. So, all the money you have saved throughout your working life is gone.
While it is possible to buy a joint life annuity that will retain an income for your spouse, these are expensive and will reduce your own income in retirement, so it may not be an option for all.
It is a somewhat different picture if you have an annuity as part of a DB scheme, as spousal provision will likely be included in this and may not impact your “guaranteed” final income.
With an ARF on the other hand, the fund can pass after your death to your spouse or civil partner and become an ARF in their name. As a spouse or civil partner, they will not pay any inheritance tax on the transfer, but will be liable to income tax on any money they withdraw from the fund.
