A defined benefit (DB) pension is one where the holder is guaranteed a fixed monthly income by their company until they die. Public sector pensions are an example. They do not have to worry about the stock market performances of their fund unless, of course, the company they work for becomes insolvent. Eight years ago there were 197,000 people who were members of 993 DB pension schemes.
In 2016, Bank of Ireland had a deficit in its DB scheme of a whopping €478million. 80% of DB schemes were underwater which is why many companies stopped their DB schemes and swapped them into Defined Contribution (DC) schemes. The main issue with DC schemes is performance, performance, performance. If your DC fund hits a BEAR (falling) market, your pension is also hit.
Here, John Lowe of Money Doctors takes a look at the growing trend of converting these DB pensions at retirement age to Approved Retirement Funds (ARFs) and Approved Minimum Retirement Funds (AMRFs) – the only alternative to annuities brought into law in 1999.
James is 60 and had a nice tidy €480,000 defined benefit pension fund. He was guaranteed €18,300 per annum until death and if his wife outlived him, she received €9,150 until she died. No benefits after death while there is also an initial guaranteed period usually 5 years. #
If they both die in the 6th year, the insurance company keeps the fund, not the family or estate.
James' annuity rate, in this case, is 3.81% - the percentage of the pension fund he receives each year from the insurance company. More importantly, if he outlives the annuity (taking out more money than is in the fund) he would have to live beyond 86 years of age.
James can transfer the fund over to a Pre-Retirement Bond (or Buy Out Bond) and immediately he can opt for retirement benefits.
- Take 25% tax free - €120,000
- Invest the balance into an ARF / AMRF…
- €63,500 into the AMRF until he is 75 years old OR until he receives a guaranteed income of at least €12,700 (the current state pension is €12,900 ) He can withdraw 4% annually (€2,540) from this fund.
- The balance €296,500 is then invested into an ARF – he can choose the fund but it is important these funds grow by at least 5.5% each year until he is 71 and 6.5% once you go over this age.
- He MUST take out 4% (taxable) each year up to age 71 called imputed distribution and 5% once he is 71 years old.
- There are also annual management charges of c. 1.5% each year from the insurance company managing the ARF/ AMRF hence it is important his fund grows otherwise he will run out of money.
- Effectively that 4% annual and monthly withdrawal from both ARF and AMRF equates to €14,400 annually (taxable)
- If there is a fund balance at time of death no matter when that is, this balance goes to his wife first and then according to his Will instructions.
In James’ case, he decided the benefits outweighed the disadvantages…
- He receives an immediate €120,000 tax-free into his hand as a result of going the Pre-Retirement Bond - ARF / AMRF route
- He will be taking €14,400 from the funds every year…as opposed to his €18,300 annuity…
- If he dies, the balance is available to his wife and family (taxed at 30%)
- He also realises that he still has to manage the pension fund even in retirement but he could benefit greatly as a result. The ARF / AMRF will be carefully managed to maximise that growth… over any 10 year period, the stock market has always been the best return of any asset class
- Warren Buffett, the world’s richest person once stated "the stock market is a mechanism for transferring wealth from the impatient to the patient"
So if you are in a DB scheme, think about the long term and the retirement options…and take expert professional advice.