John Lowe of MoneyDoctors.ie takes a look at the growing trend of converting defined benefit pensions at retirement age to Approved Retirement Funds (ARFs) – the only alternative to annuities brought into law in 1999.
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 their DB scheme of a whopping €478 million - 80% of DB schemes were under water 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.
For example, 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 were due after death, while there is also an initial guaranteed period, usually five years. If they both die in the sixth year, the insurance company keeps the fund, not the family or estate.
James' annuity rate in this case was 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. Therefore, to justify this decision, he has to live until at least 86 years of age.
The alternative? James can transfer the fund over to a Personal Retirement Bond (or Buy Out Bond), and immediately, he can opt for retirement benefits:
1. Take 25% tax free - €120,000.
2. Invest the balance into an ARF.
3. The balance of €360,000 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 (4% withdrawal plus c. 1.5% annual management charges) until he is 71 and 6.5% once you go over this age (5% withdrawal plus c.1.5% annual management charges):
- He MUST take out 4% (taxable) each year up to age 71, which is called imputed distribution, and 5% once he is 71 years old. PRSI is chargeable until age 66, while USC and income tax is chargeable til you die.
- There are also annual management charges of c. 1.5% each year from the insurance company managing the ARF hence it is important this fund grows, otherwise, it will run out of money.
- Effectively, that 4% monthly withdrawal from the ARF equates to €14,400 annually (taxable).
4. If there is a fund balance at time of death, no matter when that is, this balance goes to the spouse first as if it is his/her ARF, and then if any children (they pay 30% tax) and receive outside of inheritance 70% into their hands equally and 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 spouse and family (the latter taxed at 30%).
- The ARF 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 - from 1991 to 2020, the annual growth in the stock market was 10.72% per annum.
So if you are in a DB scheme, think about the long term and the retirement options…and take expert professional advice or call me directly.
The views expressed here are those of the author and do not represent or reflect the views of RTÉ.
For more information, click on John Lowe's profile above or on his website.
