Case study ARF v Annuity

[Kev1964]

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

As the OP, I’m certainly getting my money’s worth! No pun intended. Thanks for the all expertise brought to bear.
So far I’m leaning towards an annuity, especially if I was able to achieve 5%.

As a financial novice who is always keen to educate myself in these matters, I was interested in the last point discussed above by DOM, concerning annuity fees. One of the learning points for me from this thread is that the process of setting up the annuity results in a fee (or commission) for someone, be it an IFA or other. That’s only fair I’m sure, the worker is entitled to his wage, but here is my potential learning....perhaps this fee is negotiable from a customer’s perspective....? In other words maybe the IFA (or other) can offer an enhanced annuity rate in return for a lower fee?

 

[Duke of Marmalade]

One thing is for sure is that if you are comfortable enough that you foresee no circumstances where your assets will not see you through this mortal coil then there is no reason for securing a lifetime income with an annuity. If on the other hand you see circumstances where your assets might run out or you might need to curb your lifestyle then there is an argument for taking out some longevity protection by purchasing an annuity. As I say this should usually be safely deferred without too much surrender of the mortality cross subsidy until say age 75.

Put another way, an annuity is an insurance policy against outliving your assets and insurance involves intermediation costs. So if there is in effect no risk of excess longevity either because you have an abundance of assets or maybe even if you are in bad health then insurance makes no sense.

 

[Bluefin]

if you are comfortable enough that you foresee no circumstances where your assets will not see you through this mortal coil then there is no reason for securing a lifetime income with an annuity.

Critical point... A statement I'll quote in the future when advising /chatting about pensions.

 

[MaloneFinancial]

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

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.

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

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

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.

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.

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.

Appreciate the response and I'm glad you liked the video clip! I'll leave a follow up below to your response. Again, more than happy to be proven wrong on my assumptions so let me know if I'm off the mark here.

1. Yes, I'm aware of how mortality cross subsidy operates. Perhaps I should have called this out in the video so that viewers could understand the inner workings of annuities. However, I would still contest that for the deceased annuitant and their family, there is little comfort in knowing that their death is funding the annuity of those who live longer. But for those who don't wish to leave their pension to their estate, fair enough, a case could be made that this isn't relevant (similar to how lifetime mortgages are suitable for those who don't have the need nor desire to leave home equity to their children).

2. Regarding the tax treatment, yes there is no difference. I wasn't suggesting there was. I was getting at the point that within the ARF, the funds are growing tax free which can enable higher drawdowns in the future. "The investment income backing an annuity within the life company is totally tax free and will compound" - would you mind explaining how this benefits the annuitant? My understanding is that with standard annuities the payment is fixed. I get that the performance of the underlying investments is good news for the life company's liquidity and for meeting current and future annuity obligations. But does it have any monetary benefit to the annuitant?

Cheers! Great thread!

 

[GSheehy]

As a financial novice who is always keen to educate myself in these matters, I was interested in the last point discussed above by DOM, concerning annuity fees. One of the learning points for me from this thread is that the process of setting up the annuity results in a fee (or commission) for someone, be it an IFA or other. That’s only fair I’m sure, the worker is entitled to his wage, but here is my potential learning....perhaps this fee is negotiable from a customer’s perspective....? In other words maybe the IFA (or other) can offer an enhanced annuity rate in return for a lower fee?

Absolutely, yes.

The benefit to you (as a 61 year old, single life, guaranteed 10 year, 0% escalation, on €400K - currently) of a 0.5% commission contract Vs a 3% commission contract would be circa €45 pm.

Annnuity quotes only hold for 2 weeks.

Gerard

www.PensionAnnuity.ie

 

[Duke of Marmalade]

1. Yes, I'm aware of how mortality cross subsidy operates. Perhaps I should have called this out in the video so that viewers could understand the inner workings of annuities.

Yes, and I know it's Ireland but maybe any remake of the video would go easy on the "life companies profiteering by their annuitants' deaths" motif.

2. Regarding the tax treatment, yes there is no difference. I wasn't suggesting there was. I was getting at the point that within the ARF, the funds are growing tax free which can enable higher drawdowns in the future. "The investment income backing an annuity within the life company is totally tax free and will compound" - would you mind explaining how this benefits the annuitant?

It's in the pricing and there lies another advantage of annuities; after the initial transaction ordinary folk can forget about the markets. Maybe the remake (in the interests of balance) could describe (for ordinary folk) the excessive costs and the anxieties of having your old age so dependent on the vagaries of the stockmarkets.

Cheers!

 

[Kev1964]

There’s another angle that just occurred to me ....as we age our cognitive abilities diminish sometimes into dementia or similar. The process can be slow but relentless ...at what stage are we still sufficiently competent at understanding and acting upon investment advice associated with having an ARF?

 

[Marc]

There’s another angle that just occurred to me ....as we age our cognitive abilities diminish sometimes into dementia or similar. The process can be slow but relentless ...at what stage are we still sufficiently competent at understanding and acting upon investment advice associated with having an ARF?

This is in my view the most important issue around an ARF and for a DIY investor with an ARF it’s a potential train wreck waiting to happen.

Our view is that in addition to having a power of attorney for all ARF accounts as an absolute essential we also believe that the most efficient option for ARF management is a discretionary service rather than an advisory one since it removes the need for constant client sign off of all transactions.

 

[Kilkenny06]

The Bogleheads (largely a US group) have an interesting pension withdrawal strategy called "variable percentage withdrawal", and they advocate for the equivalent of social welfare, DB pensions and annuities to provide a "base income", i.e. minimum living expenses, and a variable element through their equivalent of an ARF. The advantage here is you get the stability of an annuity if things go wrong, but you have part of your assets at work in the markets with the potential for greater returns in the future.

The same strategy advocates moving almost everything into annuities at 80 to hedge against longevity & cognitive risk. There's very little estate planning.

 

[Colm Fagan]

There’s another angle that just occurred to me ....as we age our cognitive abilities diminish sometimes into dementia or similar. The process can be slow but relentless ...at what stage are we still sufficiently competent at understanding and acting upon investment advice associated with having an ARF?

Good question. I am one of those DIY investors who @Marc thinks is

a potential train wreck waiting to happen.

Thankfully, I'm not yet (I hope) at the stage of my cognitive abilities declining towards dementia, as @Kev1964 fears, but it could and probably will happen at some stage. As I noted in an earlier post (#12 above) my investment strategy, though nominally "active", has become quite passive in the last few years, partly because of my advancing age, more because I'm putting a lot of effort into promoting a smoothed equity approach to auto-enrolment, which I'm sure most contributors on this site are well aware of.
There were only three transactions in my ARF account in 2022 (two sales, one purchase) and none so far in 2023. I have no plans to buy or sell anything this year. I'm confident that dividends on existing holdings (plus the small amount of cash in the account) will be more than sufficient for "income" needs. Neither am I concerned that I'll have to sell much over the next couple of years, because dividends on existing holdings will cover a high proportion of my income needs.
Looking to the longer term, I may eventually move everything to a passive world equity fund (to get the lowest possible fees), and give enduring power of attorney to one of my children.
Contrary to the advice from @Duke of Marmalade (whose opinion I respect) and others, I have no intention of annuitizing - never. The equity risk premium has served me well. I am confident that it will continue to serve me well in future, maybe not quite as well as in the past, but I'll be surprised if I don't earn bond returns plus at least 3% a year on average. I'm still hoping for possibly another 15 years or so of retirement, on top of the 12 I've already enjoyed. I've no intention of turning up my nose at an average extra 3% a year on my savings for those 15 years.

 

[Duke of Marmalade]

I'm confident that dividends on existing holdings (plus the small amount of cash in the account) will be more than sufficient for "income" needs. Neither am I concerned that I'll have to sell much over the next couple of years, because dividends on existing holdings will cover a high proportion of my income needs.

Colm sounds like you might fit the first person described in my post #42.

One thing is for sure is that if you are comfortable enough that you foresee no circumstances where your assets will not see you through this mortal coil then there is no reason for securing a lifetime income with an annuity. If on the other hand you see circumstances where your assets might run out or you might need to curb your lifestyle then there is an argument for taking out some longevity protection by purchasing an annuity.

But this whole thread has convinced me of the serious inadequacies of either option for the sort of people that AE is targeted at. Society has not yet twigged to the fact that DC pensions are just horribly inappropriate for the woman on the 46a. If AE was being launched 20 years ago I am sure it would be a supplementary DB state pension.
But I believe that you are proposing a Messiah for DC with your smoothed proposal and from what I understand of it, if it works it could be a real game changer - no need for that Hobson's choice between ARF and Annuity.

 

[Colm Fagan]

Thanks Duke.
I agree that it's horrifically difficult to manage an ARF. Even I, supposedly someone who knows my way around investments, find the prospect of deriving an income for life from my ARF daunting.
On the other hand, I would be terrified altogether to be locked into a fixed annuity for the rest of my days. Maybe it's because I have such horrid memories of high inflation in the 70's and 80's, something that is probably just a folk memory to youngsters like yourself. And I suspect that governments around the world will eventually resort to inflation to address all the problems they'll face in future - climate change, mass immigration, etc.
BTW, I wouldn't agree that I have no worries for the future adequacy of my ARF. If either I or my other half - or both of us - live well into our 90's, then my spreadsheet could have us running low. I take comfort from the fact, however, that if we live that long, we'll probably have vacated our house and can use some of the equity in it to support us in our extreme old age.

 

[AJAM]

I have to say this thread has changed my mind.
My plan (in the faraway future) was always to go the ARF route.
However, now I believe I will still ARF at retirement, but at 75+ (as suggested by Duke) opportunistically buy a small annuity if/when interest rates are attractive. Or at least consider the possibility.

The fact that the risks of the 2 products do not seem to overlap is the main reason I will consider this route.

 

[Marc]

Today we were quoted a rate of 6.51% level for a 75 year old man with 10 year guarantee and 100% spouses pension.

A typical ARF would need to be averaging around 8%pa just to keep up.

 

[knockshe]

Good point Marc. Unlikely to get 4.5% interest if left on deposit somewhere.

But if you put the cash on deposit it will still be there at the end of your life.

 

[ClubMan]

But if you put the cash on deposit it will still be there at the end of your life.

Having almost certainly lost real value due to deposit rates lagging behind inflation.

 

[Kev1964]

Zurich.ie has a site which allows you to calculate annuity rates and I've been regularly doing personal quotes. Rates are on upward trend as we know and to illustrate that here are some figures (age 61, no escalation, single). Usually the Zurich rates that I've seen are better than the equivalent IL.

4th May 2023: 4.79209%
21st Aug 2023: 5.01280%

 

[fayf]

Zurich.ie has a site which allows you to calculate annuity rates and I've been regularly doing personal quotes. Rates are on upward trend as we know and to illustrate that here are some figures (age 61, no escalation, single). Usually Zurich rates are better than IL.

4th May 2023: 4.79209%
21st Aug 2023: 5.01280%

Thanks for sharing, very interesting, they have been creeping up for a while now.

Do you have a link to the zurich annuity calculator, i could only find the Irish Life one

 

[Kev1964]

Thanks for sharing, very interesting, they have been creeping up for a while now.

Do you have a link to the zurich annuity calculator, i could only find the Irish Life one

Here it is - very useful comparison tool comparing an annuity with drawing down an ARF.
Great to see this type of insight being available in the public domain.

Retirement Drawdown Calculator

Retirement Drawdown Calculator

www.zurichlife.ie

 

[Cameo]

A point to bear in mind too, is that by purchasing an annuity you are potentially getting the investment return of assets not as easily accessible via an ARF, E.g. infrastructure assets, commercial mortgages, equity release, residential mortgages etc.

This enhanced returns on offer will partially offset the life insurance company's cost of the guarantee which will be passed onto the customer in any case

There are also various mechanisms the regulator provides life insurance companies to make it more attractive for life for Them to offer annuities (volatility adjustment and matching adjustments) which annuitants get the benefit of.

personally, assuming I’ve a big enough pension pot for an ARF and/or income from other sources, I‘m a fan of an ARF invested in equities/property. I’m probably biased because I’m assuming I will have other income sources, various fixed pensions and rental income

For many, I think an indexed annuity makes a lot of sense though, particularly if limited sources of other income and a modest pension pot

Of course, a 50/50 approach is almost always a reasonable compromise too.

lastly whilst equities should provide some Inflation protection over the long term, returns are unlikely to match inflation in the short term; an insurance company is far more likely to use inflation swaps to match any annuity payments linked to inflation. In any case there will always be some basis risk, as pointed out by someone earlier, not much you can buy to match medical cost insurance, food inflation or medical costs

only thing you can say for sure about annuities, is that the rates on offer now are higher than they’ve been for many years but this doesn’t mean that buying annuity now will workout, particularly if a high prolonged inflation scenario ensues over the payment period

iMO it’s a pity the NTMA doesn’t offer more bonds with inflation linked payments to allow insurance companies provide more options to customers Which might better meet their needs