Mention the word pension, and eyes glaze over. It is amazing the high percentage of the population that do not understand how pensions work. Some think the fund they have been saving into all their lives can be withdrawn tax free on retirement. Sadly there are rules and regulations governing the operation and eventual withdrawal of pension funds but in reality, it is relatively simple and you do not need to be a rocket scientist to understand the concepts or operation.
A defined benefit (DB) pension is one where the holder is guaranteed a fixed monthly income by their company irrespective of the fund performance 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. 14 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 € 478million. 80% of DB schemes were under water – did not have the funds going forward to maintain payments to their retired members – which is why many companies stopped their DB schemes and swapped them into Defined Contribution (DC) schemes. With DC schemes, the pension holder’s fund is subject to the vagaries of the annual stock market performances.
The main issue therefore with DC schemes is performance, performance, performance. If your DC fund hits a BEAR ( falling ) market, your pension is also hit. John Lowe of Money Doctors.ie takes a look at the growing trend of converting these DB pensions at or before retirement age from an annuity structure to an Approved Retirement Fund (ARF) – the only alternative to annuities brought into law in 1999.
Let me give you an 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 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 entire 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. This rate once struck, never changes and as long as the pension holder lives, monthly payments will continue. 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.
The alternative ? If the company agree, James can transfer the fund over to a Personal Retirement Bond (PRB or Buy Out Bond) and immediately opt for retirement benefits once he is over 50 years old. Then he can
- Take 25% tax free – € 120,000
- Invest the balance, € 360,000 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 because
- He MUST withdraw 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 (AMC) of c. 1.5% each year from the insurance company managing the ARF hence it is important his fund grows between the imputed distributions and AMCs otherwise he will eventually run out of money.
- Effectively that 4% annual (or monthly) withdrawal on the € 360,000 ARF equates to € 14,400 annually ( this is taxable as is the annuity )
- If there is a fund balance at time of death no matter when that is, this balance goes to his wife first as if it is her own ARF and then if only children survive, a special tax of 30% is applied to the ARF with the 70% going to the children. If no children, then to his estate and distributed along with any other assets according to his Will instructions.
In James’ case, he decided the benefits outweighed the disadvantages… this apart from the possibility that his former employer may incentivise his ARF transfer from the company annuity structure by “enhancing” the fund – offering a sweetener of perhaps up to 33% more than the current fund …
- He receives an immediate € 120,000 tax free into his hand as a result of going the Pre-Retirement Bond – ARF route
- He will be taking € 14,400 from the funds every year…or 4% …as opposed to his €18,300 annuity…
- If he dies, the balance is available to his wife ( as if it is her ARF ) and family ( if both parents die, the balance is 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 ( 10.72% was the average annual growth in the stock market from 1991 to 2020 )
- 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…look for any enhanced options for your DB scheme and take expert professional advice.