Case study ARF v Annuity

[Marc]

The average 10 year gilt yield (a proxy for average annuity rates) between 1970 and 1990 was a little over 11%.

The inflation rate for consumer prices in Ireland moved over the past 61 years between -4.5% and 20.9%.

During the period from 1960 to 2021, the average inflation rate was 5.3% per year.

So we can conclude that those investors who purchased an annuity during the twenty years from 1970 to 1990 typically obtained a much higher annuity rate than the average rate of inflation over the last 61 years.

We also know that on average a 65 year old lived for around 16 years in retirement over this whole period.

Any analysis must also consider the mortality cross subsidy that exists in annuities compared to an ARF.

Finally, as I have already noted above you also need to consider that the observed spending of the population in general typically declines by 1 to 2% pa during retirement.

So, as I set out in detail in my analysis
as it pertains to a typical retiree in Ireland today what really matters in this decision is one’s unique risk capacity.

The ARF vs annuity decision shouldn’t be based on one’s risk tolerance or willingness to take investment risk.
As I set out in detail in this post Post in thread 'Looking for Advice on managing a windfall sum. Family of Four'

it should be based on one’s risk capacity or ability to bear financial losses.


The U.K. regulator the FCA defines capacity for loss as;
” a client's ability to absorb falls in the value of their investment. If any loss of capital would have a detrimental effect on their standard of living, this should be taken into account when assessing the risk the client is able to take.”

If you have a married couple both with defined benefit pensions and full state pension entitlements no debt and other investment capital in very poor health then objectively an ARF is probably a good option.

By contrast a healthy, but not wealthy, individual who needs a high level of guaranteed income in retirement to meet unmet expenses would most likely be better off purchasing an annuity.

It all comes down to the circumstances and needs of the individual. But the fact remains that for everyone approaching or in retirement the decision to buy an annuity for some or all of the pension fund is a relevant one

 

[GSheehy]

I did some sums recently and concluded that charges by advisers and insurance companies eat up more than a quarter of each year's income withdrawal for many, probably most, of their clients. It's far more than 25% in many cases. That level of fee extraction is unconscionable

What would be useful here is a breakdown of the sums based on the average amount of money available for ARF (circa €110K) and a comparison with the alternative/s that are/might/could be available to most buyers of ARFs or other post-retirement products, who want/need advice. If most consumers are drowning in charges it's of little use describing the water.

Gerard

www.prsa.ie

 

[Duke of Marmalade]

Any analysis must also consider the mortality cross subsidy that exists in annuities compared to an ARF.

This is the essential difference between an annuity and an ARF. Unfortunately it gets masked by lots of other differences such as advisory costs, inflation, capital costs, guarantee costs etc,
The annual mortality pick up in investing in an annuity is approximately as follows:
Age 65: 1%
Age 70: 2%
Age 75: 3.5%
Age 80: 6%
Now annuities are unlike other insurance. With life and health insurance - delay could either miss the chance of a claim or make insurance more expensive or even not available. Delaying an annuity only gives up that year's mortality subsidy and maybe even makes the annuity cheaper if deteriorating health might warrant impaired lives rates. At age 65 or even 70 there is no compelling reason to annuitize but 75 is probably a sweet spot; 3.5% p.a. pick up and increasing is significant. (I ignore complications such as Fair Deal and greedy relatives.)

In another thread I argue that annuity purchase should be compulsory for the proposed AE initiative but the negatives like inflation risk and cost of capital should be minimised - I recommend state annuities towards that end.

Finally I must repeat what I have stated elsewhere - annuities were totally inappropriate during the QE induced c. zero interest rate period as was lifestyling towards annuity purchase by investing in c. zero interest rate bonds.

 

[AJAM]

A Timely video here, discussing this very topic by Malone Financial

Annuity or ARF | Which Is Best For Retirement?

In this video, we're talking about whether choosing an annuity or an approved retirement fund (ARF) is the best option for retirement. When an individual rea...

www.youtube.com

 

[AJAM]

I'm no expert with either of these but this is my attempt to compare the risks

Risk of losing money	Annuity	ARF
Interest Rate Risk	High at point of purchase
Inflation Risk	High
Early Death Risk	High
Long Life Risk		High
Market Risk		High
Bankruptcy Risk	Med
Risk of Variable Income		High

For Annuities your subject to huge interest rate risk at the time of purchase. If you intend to retire in 5 or 10 or however many years, you have no idea what the rate will be when you retire, so no way to know what your annuity rate will be.
Inflation Risk is very high as if high or sustained it can eat away your income.
If you die early the value of your annuity does not pass to your family.
If you live long, your ARF might run out of money (or run low on money).
The ARF is obviously subject to market risk, which over the long term should result in good returns, but timing risk can take a big chunk out of your pot.
Bankruptcy risk, I'm open to correction here, but if your ARF provider goes under, you still own the funds your invested in. If your Annuity provider goes under, their contract to provide you with income is void. I marked it Med because it doesn't happen often.

 

[Duke of Marmalade]

A Timely video here, discussing this very topic by Malone Financial

Annuity or ARF | Which Is Best For Retirement?

In this video, we're talking about whether choosing an annuity or an approved retirement fund (ARF) is the best option for retirement. When an individual rea...

www.youtube.com

Well produced, but...extremely tendentious.
When an annuitant dies the life company does not pocket your money, the surviving annuitants do.
Annuities enjoy tax free interest in the same way as ARFs.
Compound interest is a red herring (sounds clever though). Deemed Distribution killed any advantage of compound interest - the dividends in the ARF fund would need to exceed the DD before they could be reinvested.

The reality is that as a group ARF holders only enjoy about half their hard earned and saved funds - their relatives enjoy the other half. As a group annuitants can enjoy all of their HESF. ARFs are best for people who are in the position that they have no risk of outliving their savings - in reality all investment decisions are inheritance planning. For those who are likely to need most of those savings at least contingently; (realistically priced) annuities are probably better.
As for life companies ripping off annuitants it is well known that the financial intermediation costs of ARFs are in fact far higher. Malone doesn't mention this.

 

[Duke of Marmalade]

I'm no expert with either of these but this is my attempt to compare the risks

Risk of losing money	Annuity	ARF
Interest Rate Risk	High at point of purchase - I would recommend deferring annuity purchase till about 75 when the mortality subsidy outweighs this factor.
Inflation Risk	High - if you don't buy inflation protection	Med - 9% inflation last year; markets moved sideways
Early Death Risk	High - a risk to your dependents not you
Long Life Risk		High
Market Risk		High - well an ARF doesn't have to invest in risk assets though that is the usual recommendation
Bankruptcy Risk	Med Not applicable - both rank equally on wind-up
Risk of Variable Income		High

 

[Marc]

In addition to the obvious conflict of interest presented by higher commissions I think another factor contributing to confusion here is that ireland doesn’t have a specific higher level of examination requirement in order to give advice on the ARF vs annuity decision. In the UK when flexible income drawdown (equivalent of ARFs ) was introduced the chartered insurance institute introduced specialist papers and I was required to be examined specifically covering matters such as mortality credits before being licensed to advise in this area.

By contrast, in Ireland, anyone with a QFA diploma can give someone advice on a potentially multi million Euro pension fund. I’ve met many financial brokers over the years who frankly don’t understand this subject well enough. Although most can find their way around a life insurance company commission table.

Whilst one might expect successful entrepreneurs and others with large pension funds to seek out specialist advice before reaching retirement, in my experience few do and we frequently see sophisticated investors being sold retail solutions and people with inadequate pension funds being persuaded to use an ARF.

 

[AJAM]

Thanks Duke, some nice nuance there.
However ARF inflation risk is not High. Yes in any given year the markets are not going to compensate you for inflation, but over the course of your 30+ year retirement they certainly will.

 

[Marc]

Thanks Duke, some nice nuance there.
However ARF inflation risk is not High. Yes in any given year the markets are not going to compensate you for inflation, but over the course of your 30+ year retirement they certainly will.

ARF inflation risk is high.

Investing an ARF in risk assets does not guarantee a real return. Equites went sideways for 14 years in the 70s and early 80s.

Taking on more risk assets to try and compensate for inflation risk also exposes the ARF to sequence of return risk and this is especially damaging in the early years.

 

[Duke of Marmalade]

Thanks Duke, some nice nuance there.
However ARF inflation risk is not High. Yes in any given year the markets are not going to compensate you for inflation, but over the course of your 30+ year retirement they certainly will.

Okay, I have adjusted the risk to Medium. Clearly equity investment has more potential inflation protection than fixed rate annuities. But I agree with @Marc that this is much less perfect than the likes of Malone Financial portray.

 

[MaloneFinancial]

Well produced, but...extremely tendentious.
When an annuitant dies the life company does not pocket your money, the surviving annuitants do.
Annuities enjoy tax free interest in the same way as ARFs.
Compound interest is a red herring (sounds clever though). Deemed Distribution killed any advantage of compound interest - the dividends in the ARF fund would need to exceed the DD before they could be reinvested.

The reality is that as a group ARF holders only enjoy about half their hard earned and saved funds - their relatives enjoy the other half. As a group annuitants can enjoy all of their HESF. ARFs are best for people who are in the position that they have no risk of outliving their savings - in reality all investment decisions are inheritance planning. For those who are likely to need most of those savings at least contingently; (realistically priced) annuities are probably better.
As for life companies ripping off annuitants it is well known that the financial intermediation costs of ARFs are in fact far higher. Malone doesn't mention this.

I don't believe there's anything tendentious about my points. Globally, annuities are well recognized as being sub-par options for retirees as compared to continuous investment in retirement. But you're entitled to your opinion of course! To address your points:

When an annuitant dies the life company does not pocket your money, the surviving annuitants do

- This isn't correct. Standard annuities die with the annuitant. Yes, you can purchase a reversion on your annuity which will typically pay 50% of the annual annuity payment to the surviving spouse - but the lump sum is gone. That reversion comes at a cost. The cost being a lower annuity rate (a differential of ~70bps as per Irish Life). Nothing is free with annuities (inflation protection, minimum guarantee periods etc.)

Annuities enjoy tax free interest in the same way as ARFs

- What tax-free interest are your referring to? Annuity income is subject to income tax and USC where applicable. Investment income and gains from ARF investments are exempt from tax. It's only when you withdraw from the ARF that the funds are liable to tax (aside from the imputed distribution where annual withdrawals are insufficient).

Compound interest is a red herring (sounds clever though). Deemed Distribution killed any advantage of compound interest - the dividends in the ARF fund would need to exceed the DD before they could be reinvested

- Compound interest is most certainly not a red herring. ARF holders are required to withdraw a minimum of 4% p.a to age 70 and 5% thereafter. It's more than feasible to achieve an investment return within the fund that counteracts this effect (thus enabling compound interest). Plus, the dividends and gains are tax free, making this even more feasible. Just depends on what you're investing in.

The reality is that as a group ARF holders only enjoy about half their hard earned and saved funds - their relatives enjoy the other half. As a group annuitants can enjoy all of their HESF

- Not sure I follow this logic. Feel free to expand.

As for life companies ripping off annuitants it is well known that the financial intermediation costs of ARFs are in fact far higher.

- Sure, you're always going to have fees, this is Ireland. However, I'd much rather be paying IM fees and for my funds to be enjoying tax-free investment growth throughout retirement than to fork over the whole lump sum to a life company and have no chance of capital appreciation or income growth (with the exception of the annuity escalation option which, again, comes at a lower annuity rate)

Just my two cents, but I appreciate a good discussion!

 

[Sarenco]

Taking on more risk assets to try and compensate for inflation risk also exposes the ARF to sequence of return risk and this is especially damaging in the early years.

This is a hugely underestimated risk of ARFs, IMO, and should really be highlighted in the above chart.

If a retiree drew down €40k, adjusted for inflation, every year starting in 2000 from a €1m ARF invested in an all-equity portfolio tracking pretty much any well known index, he would be flat broke at this stage.

Equity returns over the full period have been broadly in line with long-run averages but the sequence in which those returns turned up would have caused our retiree to bomb out.

 

[AJAM]

ARF inflation risk is high.

Investing an ARF in risk assets does not guarantee a real return. Equites went sideways for 14 years in the 70s and early 80s.

ARF inflation risk is not high (or even Med Duke). Your conflating 2 different things, market risk and inflation risk.

If inflation stays at 7% for the next 20 years, a 40K annual annuity would be worth approx. 9K real. Whereas a 1M ARF would be worth...... who knows, it could continues to grow at 10% like the last 20 years, it could be flat, it could be down 2%, because it's unrelated to inflation.
You are correct that there is no guaranteed real return, but that's market risk not inflation risk.

Taking on more risk assets to try and compensate for inflation risk also exposes the ARF to sequence of return risk and this is especially damaging in the early years.

Very true. Sequence return risk IMO is actually the main risk for ARF holders. Probably deserving of a thread all on its own.

 

[Marc]

ARF inflation risk is not high. Your conflating 2 different things, market risk and inflation risk

I’m not. Inflation risk relates to increases in the cost of living hitting our retirees net income.

An annuity provides a fixed or predictable increasing income.

An ARF has no such guarantees and is exposed to market risk.

In seeking to attempt to keep up with inflation, market risk can unsettle an ARF strategy to such an extent that some retirees and those with long lives in particular may find that they were better off buying an annuity for some or perhaps all of their pension - that’s just the nature of risk

 

[AJAM]

In seeking to attempt to keep up with inflation, market risk can unsettle an ARF strategy to such an extent that some retirees and those with long lives in particular may find that they were better off buying an annuity for some or perhaps all of their pension.

Ahh, I think you and I are making 2 different assumptions here. You (if I'm interpreting correctly) are coming from the point of view that purchaser is using market risk to compensate for inflation risk. I would guess in your professional background you come across this.

I'm not making that assumption, I'm just listing the risks for each one.

From the table it looks to me, like they have very little overlapping risk, which might indeed be an argument for holding both.

 

[AAAContributor]

When an annuitant dies the life company does not pocket your money, the surviving annuitants do.

This isn't correct. Standard annuities die with the annuitant.

Insurance companies make a profit from those dying early and a loss from those living longer, and they use the profits from the early deaths to subsidise the income paid to those who live longer than expected. This is the mortality cross subsidy. If an underwriter in an insurance company did not pass on the profits from the annuitants who died early to the other surviving annuitants in their customer pool, they would not write much annuity business I'd imagine.

Annuities enjoy tax free interest in the same way as ARFs.

What tax-free interest are your referring to?

Perhaps the insurance companies earn income from their gilt investments gross (of withholding taxes etc.) and the annuity customers of insurance companies benefit from this (like ARF customers who don't suffer taxes on their investments whilst in the ARF), but I'd defer to those who are better informed on this particular point.

 

[Duke of Marmalade]

@AJAM I think you are underestimating inflation risk in the case of ARFs, by which I presume you mean equity linked ARFs. As @Marc has stated, it has proved a very imperfect inflation hedge in the past. If the inflation has come from debasing the currency there is an argument that real assets will negate it. If inflation comes from failures in the supply side as is currently happening - equities suffer providing a double whammy.
It is possible to buy an inflation linked annuity but even then is this a perfect hedge? What inflation are we talking about? Medical inflation may be the more relevant. I do think any suggestion that equity based ARFs are a far superior inflation hedge than annuities (with some inflation based increases) is misleading.

 

[Duke of Marmalade]

I don't believe there's anything tendentious about my points.

Welcome to AAM. By "tendentious" I mean with an unjustified bias, which I will elaborate on in further answers to your points below. I do not mean it in any personal pejorative sense. BTW liked your video clip

Globally, annuities are well recognized as being sub-par options for retirees as compared to continuous investment in retirement.

They certainly were during the QE period. There are dysfunctional aspects to the annuity market. I remember a long time ago life insurance companies backed their annuity books at least partially with equities. These days, Solvency II has been a big drag on annuity pricing forcing companies into gilts and to provide for 1/200 risks like longevity improvements. That's why I am suggesting state backed inflation linked annuities for the AE initiative.

Standard annuities die with the annuitant.

@AAAContributor has corrected you on this point. It really is rather basic.

Yes, you can purchase a reversion on your annuity which will typically pay 50% of the annual annuity payment to the surviving spouse - but the lump sum is gone. That reversion comes at a cost. The cost being a lower annuity rate (a differential of ~70bps as per Irish Life). Nothing is free with annuities (inflation protection, minimum guarantee periods etc.)

Sorry, I don't see the relevance. There are no free lunches in this world either with annuities or ARFs.

- What tax-free interest are your referring to? Annuity income is subject to income tax and USC where applicable. Investment income and gains from ARF investments are exempt from tax. It's only when you withdraw from the ARF that the funds are liable to tax (aside from the imputed distribution where annual withdrawals are insufficient).

Another rather basic error. Annuity income is only subject to tax when it is received by the annuitant - just like with an ARF. Within the life company the investment return is tax free.

- Compound interest is most certainly not a red herring. ARF holders are required to withdraw a minimum of 4% p.a to age 70 and 5% thereafter. It's more than feasible to achieve an investment return within the fund that counteracts this effect (thus enabling compound interest). Plus, the dividends and gains are tax free, making this even more feasible. Just depends on what you're investing in.

I hate to say it but you are compounding (see what I did there) the previous error. The investment income backing an annuity within the life company is totally tax free and will compound (if it is not distributed). This is exactly the same as with an ARF. With a level annuity the distribution (annuity payment) will always be higher than the investment income and so compounding does not arise. With an inflation linked annuity the opposite situation will hold initially and compounding will occur. With an ARF if the investment income exceeds the deemed distribution, yes there will be compounding. This might be achieved by investing in high dividend stocks. There is no difference in tax treatment between the two.

- Sure, you're always going to have fees, this is Ireland. However, I'd much rather be paying IM fees and for my funds to be enjoying tax-free investment growth throughout retirement

Sorry, but I hope I have convinced you that this is no different than with an annuity. Let me illustrate.
(a) Punter has €100k in an ARF and earns €4k interest. She receives €4k subject to tax.
(b) Punter uses the €100k to buy an annuity. The life company earns €4k and pays it out as an annuity. She pays tax on the €4k.
Trust me, if it was as you describe the life companies would be up in arms and the Central Bank would withdraw the licence from anyone who was recommending an annuity.

Your basic error explains why you have taken such a tendentious approach in favour of ARFs - it would certainly be justified if your assumptions were correct.

 

[Marc]

This is shaping up to be one of the better threads on AAM helped by @Duke of Marmalade’s relevant financial background