Essay: 'Annuity Purchase Rather than ARF should be the default option for Retirees'

Introduction
This paper aims to assess some of the central aspects which should be evaluated when assessing what type of default solution is appropriate ‘ taking into account the current situation in Ireland, comparative analysis with some of the most progressive economies globally, the inherent risks associated with pension solutions worldwide, to the framework and guidance which we have recommended as part of our summary conclusion.
While it is evident that when it comes to retirement that no one solution is perfect, it should also be noted that solutions exist and these solutions are quite varied as part of our interpretation of the essay title we have examined a number of privately funded post retirement options available in Ireland and a select number of other countries. We have not looked at the scope of state provision, the so called first pillar of pension provision at this time as it is not within the terms of reference as we see them.
In addition to examining privately funded post retirement provisions internationally we have also studied the Irish system under a variety of headings to help us present our conclusions at this time.
For the sake of clarity we have taken the Irish Pension Board definitions of ARF and Annuity :
‘Approved retirement fund (ARF)
An ARF is an investment contract for the proceeds of any AVCs, or in the case of a 5% Director, RAC or PRSA holder other retirement benefits that are not taken in the form of a lump sum or pension on retirement. Certain qualifying conditions must be met to be eligible to take out an ARF. Money is invested with a qualified fund manager and may be invested in any manner you wish and will accumulate tax-free. Income tax is payable on any withdrawals from the fund.’
‘Annuity
A guaranteed retirement income for life paid at stated intervals until a particular event (usually the death of the person receiving the Annuity). Annuities are normally purchased from a life assurance company at retirement in return for a lump-sum payment (from your pension fund)’.
We have contrasted both these options in Table 1.
Implications of funding your retirement with an Annuity versus an ARF
BENEFITS ANNUITY ARF
Guaranteed Payment Yes-monthly payments are
guaranteed for life
During periods of low interest
rates, the payments offered
maybe much less attractive No-stocks/bonds are volatile so
the value of your investment
& eventual pay-outs are not
Known with certainty
Inflation Protection It depends-Most Annuities offer
equal monthly payments with
no inflation protection. If you’re
willing to accept lower initial
payments, then you can purchase
an inflation protected Annuity It depends on your choice of
Investment. A well diversified
portfolio will give you the
opportunity to keep pace with
or beat inflation but it will
depend on your investments
and their performance
Withdrawal Flexibility No-once the Annuity is purchased
and the monthly benefits are set,
It does not change Yes-you can withdraw funds,
subject to your needs and minimum
imputed distribution of 5% pa.
Conversion No-not allowed. Yes-can convert to an Annuity at any time.
Tax Implications The income from your Annuity
forms part of your overall income
and taxed at your marginal rate Investment earnings/withdrawals are
treated as income and subject to income
tax at your marginal rate
Could I outlive my retirement savings? No-with a life Annuity, payments
are guaranteed as long as you live Yes-depending on how your assets
perform and how much you withdraw
each year, you could run out of money
Spousal Protection It depends-a joint life Annuity
must be specified at the time the
Annuity is purchased and it will
reduce your monthly payment The value of the ARF can be
transferred to your surviving spouse or
estate
On Death Once you die your Annuity for life
dies with you, unless you buy
a guaranteed period, an investment
protection option or joint life Annuity Value of ARF can be transferred to your
surviving Spouse or estate
Table 1
Selected Countries
We have looked at four other Nations in conjunction with Ireland’s post retirement provisions as part of this assignment to assess whether the Irish system is robust enough at this time, it is our intent through this comparison to determine if there are other more efficient systems of providing for Retirement that the current system in Ireland. These countries were selected as they provide a diverse range of Post Retirement options.
.
Country Tax Free Lump Sums Taxable Lump Sums Fixed Term Annuities Life Time PW’s/ARF Lifetime Annuities Market Linked Annuities Allocated Annuities Phased Retirement State Pension
Australia Yes Yes Yes Yes Yes Yes Yes Yes Yes
Canada No Yes No Yes Yes Yes Yes Yes Yes
Ireland Yes Yes No Yes Yes No No Yes (PRSA) Yes
New Zealand Yes No No No No No No No Yes
United Kingdom Yes Yes Yes Yes Yes Yes No Yes Yes
Table 2
We have examined these countries under the above headings and where a country does not provide a substantially different benefit, we have not closely examined that benefit, we have only focused on benefits that are in variance with our own current system so as to examine if there are options available elsewhere that may enhance offerings in Ireland.
Australia
Tax Free Lump Sums Taxable Lump Sums Fixed Term Annuities Life Time PW’s/ARF Lifetime Annuities Market Linked Annuities Allocated Annuities Phased Retirement State Pension
Yes Yes Yes Yes Yes Yes Yes Yes Yes
Table 3
Tax Free and Taxable Lump Sum
There is generally no tax payable on Superannuation payments or Lump sums made in retirement once contributions were taxed at the point of investment. Employees receive a concessional tax rate of 15% on contributions made. This differs for public sector superannuation funds where contributions are not taxed on the way in.
You can take your super as a retirement income stream
Type Of income Stream Category Common Product names used
Pension Account Based (investment Fund) – Allocated Pensions
– Market Linked Pensions
( also called term allocation pension)
Pension Non Account Based – Lifetime pensions
– Fixed Term Pensions
Annuities Account Based (Investment Fund) – Allocated Annuities
– Market linked Annuities
Annuities Non Account Based – Lifetime Annuities
– Fixed Term Annuities
Table 4
Account Based income Streams
Allocated Pension Option (Life Time PW’s/ARF)
The most popular option within the Account Based Income Stream is the Allocated Pension Option. It consists of an investment account where a regular income is drawn from each year. This is known as the percentage factor (PF). It is similar to the Irish Approved Retirement Fund with two notable differences. There is no requirement for a guaranteed income to access this fund and an increasing income percentage over time.
Age at 1 July Percentage Factor (PF)
Under 65 4%
65 to 74 5%
75 to 79 6%
80 to 84 7%
85 to 89 9%
90 to 94 11%
95 and over 14%
Table 5
Account Based Market Linked Annuities
Referred to as term allocation pensions or (TAPS).Instead of locking yourself into a fixed Annuity rate it depends on underlying performance of your investment account. You need to choose a minimum term which is your retirement age and a maximum term of 100. Different payment factors apply dependant on your chosen age. You have 10% flexibility on each side of the pricing arrangement. If you choose a reversionary market linked pension it can be commuted by your next of kin on your death.
Non Account (Fixed) Based Income Streams
This pays for a set period of time. Only use Superannuation money to invest in a fixed term pension whereas a fixed term Annuity can be purchased either using superannuation or ordinary savings. At the end capital can be paid back if a short term decision or no capital returned if a long term option.
Death Treatment
Income stream will be payable for a fixed period. If you die within the fixed period the payments can continue to a beneficiary or your estate or a lump sum may be payable. You can set up a fixed term income stream so that on your death, the income may continue to your spouse. The income referred to is reversionary income. The reversionary income would then be payable for the remaining original term. Alternatively the income can be cashed in and a lump sum paid to a beneficiary or your estate.
Canada
Tax Free Lump Sums Taxable Lump Sums Fixed Term Annuities Life Time PW’s/ARF Lifetime Annuities Market Linked Annuities Allocated Annuities Phased Retirement State Pension
Yes Yes No Yes Yes Yes Yes Yes Yes
Table 6
Canadians do not have access to a tax free lump sum as part of their options at retirement. They can however cash-in their benefits fully as a taxable lump sum at retirement between age 60 and 72.
Tax-Free Savings Account (TFSA)
The Canadian Government introduced the tax-free savings account in January 2009. This enables Canadian’s to earn tax free investment income to help meet lifetime savings needs. Their annual contributions are capped at $5,500 per annum. This works on a TEE bases, their contributions are not tax deductible but the funds are allowed to grow tax free and withdrawals are tax exempt. There is no limit to the number of contributions or duration of investment and the funds can be accessed at any time. The TFSA does not have any effect on your pension or funding limits and was introduced to complement the current retirement savings plans.
Three Options at retirement:
Cash in your Registered Retirement Savings Plan (RRSP). The full withdrawal amount will be added to your income for that year and most of the savings will be taxed at higher rate.
1. Purchase a registered Annuity from an Insurance company. The ideal solution if you are looking to cover your fixed expenses or concerned about outliving your retirement capital and you don’t want to make on-going investment decisions.
2. Transfer to Registered Retirement Income Fund (RRIF). This is the most popular choice as you continue to manage your investment. It is similar to the ARF.
Retirement Benefit Options
ANNUITY BENEFITS RRIF BENEFITS
Single Life Lifetime Provides the highest guaranteed starting, fixed regular income from retirement but no death benefits are included. Income Drawdown Withdraw income from your pension, while remainder stays invested to benefit from future growth.
Joint Life Lifetime Choose to have part or all of your pension income transferred to spouse on death; they will then receive the benefit for the remainder of their lives. Phased Retirement You are allowed to take benefits from your pension, while you continue to work in your current employment and contributing to the same pension.
Guaranteed Period Weaker protection for dependants than joint life Annuity as your pension is only guaranteed for a specific period, usually 10 years. If you were to die within this period your pension will continue to be paid to the deceased estate for the remainder of the term.
Equity Indexed Annuity These Annuities offer a minimum guaranteed interest rate combined with an interest rate linked to a market index. They are more risky than fixed Annuity as Annuity income can drop while not as much as variable Annuities. These usually come with a guaranteed minimum return of 87.5 % of the premium paid and 1-3% interest
Principle Protected This Annuity option provides a guarantee on the capital value of your Annuity; if you were to die prematurely the remaining balance of your fund will be paid to the deceased estate.
Prescribed Annuity These Annuities are purchased from non-registered funds, as the Annuity would be subject to high tax rate applied on the benefits if a prescribed Annuity is not chosen. Each payment includes both interest income and a return of the capital.
Variable Annuity This is an invested Annuity where by your contributions are invested in a variety of sub-accounts, which you control. These funds are tax-deferred so you do not pay any tax on the growth of the funds until you draw upon them as an income. These Annuities allow you to include additional benefits, such as a death benefit or guaranteed minimum withdrawal amount.
Enhanced or Impaired Medical underwritten Annuity offers better income levels for poor health or lifestyle i.e. Smokers can receive higher Annuity rates
Term Certain Provides investor with the maximum regular income for a fixed period, usually 5 or 10 years. Once the Annuity is purchased, it cannot be altered or ceased. The payments must continue as the contract originally stipulated.
Table 7
Registered Retirement Income Fund (RRIF) Canada’s ARF option
Canada’s RRIF option at retirement is similar to the Irish ARF option but has no AMRF facility. This means that withdrawals are calculated from the full fund value each year, provided there is no Annuity held within the fund. The RRIF is the most common method of retirement provision used in Canada due to its flexibility, the different options available and the ability to maintain control of your investment.
Once you meet the relevant criteria, you can select from the following types of RRIF’s:
Type Definition
Minimum Income RRIF Provides a minimum level of income, usually suitable for people who do not require a high level of income from their pension and want to defer taxable income for as long as possible.
Capital Preservation RRIF The goal is to preserve the capital element by paying out a fixed level of income and to withdraw only your investment returns each year, subject to minimum withdrawals.
Level Income RRIF
This allows you determine the amount of income required to be paid each year so that you can deplete your fund by the time you reach a certain age.
Lock-In RRIF
The plan allows you to take the minimum withdrawal amount each year from your RRIF, while any funds above this limit cannot be accessed.
Table 8
Each State in Canada has differing drawdown requirements on an RRIF. Some of these rates start at between 3.33% and 7% rising each year to 20% or above by age 94, while some other States force a compulsory purchase of Annuity by a certain age.
All individuals must withdraw the minimum amount every year, which is tax exempt and all withdrawals above an exempt limit are taxable at the following rates:
‘ 10% on amounts up to $5,000
‘ 20% on amounts over $5,000
‘ 30% on amounts over $15,000
The Minimum withdrawals amounts are dependent on age and value of the fund, they are graphed as follows:
Graph a
New Zealand
Tax Free Lump Sums Taxable Lump Sums Fixed Term Annuities Life Time PW’s/ARF Lifetime Annuities Market Linked Annuities Allocated Annuities Phased Retirement State Pension
Yes No No No No No No No Yes
Table 9
Overview
New Zealand is poorly served regarding post retirement income options, in all reality aside from some legacy DB schemes that pay Annuity from DB fund there is no ability to take either a phased withdrawal or annuitised income. Currently there are no Assurance companies providing Annuities in the New Zealand market (source direct email from NZ financial regulator). All benefits accrued through what is known as Kiwi-Saver and these benefits entitle members to a lump sum, not a pension, on withdrawal at age 65 or over.
Regular income is provided for through a state funded pension.
UK
Tax Free Lump Sums Taxable Lump Sums Fixed Term Annuities Life Time PW’s/ARF Lifetime Annuities Market Linked Annuities Allocated Annuities Phased Retirement State Pension
Yes Yes Yes Yes Yes Yes No Yes Yes
Table 10
Options on Retirement
Individuals have a 25% Tax Free Lump Sum lifetime allowance (based around the normal ??1.5 million lifetime allowance unless you have fixed protection in which case use ??1.8 million) and can purchase an Annuity (guaranteed income for life) with the balance. The level of Annuity payment will depend on what options or type of Annuity that the individual chooses i.e. level/indexed/joint life/investment linked or impaired life.
Alternatively, you can opt for one of the following 4 drawdowns:
‘ Drawdown Income – leave your money invested and manage it yourself with a drawdown income
‘ Capped Drawdown – there is a maximum amount you can draw each year but no minimum.
‘ Flexible Drawdown – No limit to the amount that you can draw but you must have at least ??20,000 each year from ‘secure pensions’
‘ Phased Retirement – Take out only a small amount of money every year for now (and maybe keep working) through a phased retirement
A further option is to avail of the Value Protection which is like a guaranteed period, except a lump sum is paid to a person of your choice. The lump sum is how much you gave the insurance company to begin with, minus what the insurance company paid out to you and the point you die and taxed at 55%.
All of the above information on UK retirement options is based on our understanding of the UK system prior to Budget 2014, the reform of the system proposed in that Budget are impossible for us to ascertain at this time.
Ireland
Tax Free Lump Sums Taxable Lump Sums Fixed Term Annuities Life Time PW’s/ARF Lifetime Annuities Market Linked Annuities Allocated Annuities Phased Retirement State Pension
Yes Yes No Yes Yes No No Yes Yes
Table 11
Tax Free and Taxable Lump Sums
Both are available within Revenue Rules
Options for Balance
‘ Purchase an Annuity (see restricted range available on chart 1.3);
‘ Depending on the type of plan you have, you may be able to take the rest of your fund, after the retirement lump sum, in one go. You will need to pay income tax on this
‘ Structure an income drawdown (ARF & AMRF options) and utilise the various investment solutions to try and make the remaining pension funds work for them over the longer term
‘ There is currently a 5% PA deemed distribution requirement from the ARF only, and again this distribution is taxed at one’s marginal rate of tax.
Benefit Implications of an ARF or Annuity Option at Retirement
This has been presented in table form in Table 1, page 5.
It is apparent from our analysis of the data we assembled from four other OECD member states and Ireland that there is quite a significant differential in the provision of retirement options available to retirees in each of the countries evaluated. Some systems such as Australia, UK and Canada are very progressive and others like New Zealand have a very underdeveloped Private Post Retirement system at this time.
We will now proceed to consider the Irish market in further detail, specifically by analysing the:
‘ Risks
‘ Variations of ARF options on Irish Market
‘ Sales Commission
‘ Current Annuity Rates
‘ Sovereign Annuity/ European Bond Market
‘ Lack of Awareness/ Financial Illiteracy
Risk
Longevity & Mortality
Method Period LE at 65 Cohort LE at 65
CSO (Updated 17.6 years 19.9 (years)
GAD (1%) 17.6 20.9
GAD (2) 17.6 21.8
Table 12
”The purchase of an Annuity with at least part of the accumulated balance would also offer a minimum degree of protection against longevity risk. The default option at retirement that could be appealing for low-income workers is a combination of an income drawdown plan and a deferred Annuity that starts paying benefits at an old age (say 85), with the possibility of recovering at least part of the Annuity premia in case of early death”.
OECD 2013 ‘Review of the Irish Pension System.
Encourage Annuitisation as a protection against longevity risk
Irish Annuities are inflexible and the income provided is just that an income. One of the major downsides of an Annuity is that current Annuity rates are out of kilter with longevity. Using current Annuity rates the current projected payback age is 92 and the probability of a 65 year old reaching this age is 39% . This implies that 61% of people who invest in an Annuity will not receive their initial investment back.
However if you accept the concept of an Annuity being protection from longevity risk (Risk of outliving your resources) it fulfils an insurance rather than an investment requirement and the original mandate of a pension ‘to provide an income in retirement’.
The downside of this is lifetime Annuities are illiquid and inflexible, and do not allow for funds to passed on to an estate. The key policy question to address, therefore, is which arrangement for the pay-out phase policymakers and regulators should promote or recommend.
OECD research suggests that a certain level of Annuitisation of pension balances should be set as the default mechanism for the pay-out phase, unless Pay As You Go public pensions or the old-age safety net already provide for sufficient regular pension payments.
How this would be facilitated currently is uncertain.
Bomb Out Risk
One of the major potential dangers to an ARF is what is know as Bomb out risk: there are various descriptions of Bomb out risk but the most prevalent description is that an investor who takes regular withdrawals and/or imputed distributions over the life of their potentially run the risk that the income needs of a retiree may no longer be met by the value of their ARF. The below table compares an indexed linked Annuity and an ARF taking a hypothetical initial drawdown of ‘10,000 per annum, indexed at 3%.
Annuity with payments increasing at 3% p.a. ARF growing at 3%p.a. (before fund charges) ARF growing at 6% p.a. (before fund charges)
Age Cash-in value Annual income Cash-in value Annual income Cash-in value Annual income
65 0 10,000 187,132 10,000 192,731 10,000
66 0 10,300 179,480 10,300 190,705 10,300
67 0 10,609 171,406 10,609 188,275 10,609
68 0 10,927 162,893 10,927 185,412 10,927
69 0 11,255 153,927 11,255 182,088 11,255
70 0 11,593 144,490 11,593 178,273 11,593
71 0 11,941 134,565 11,941 173,934 11,941
72 0 12,299 124,135 12,299 169,037 12,299
73 0 12,668 113,182 12,668 163,548 12,668
74 0 13,048 101,686 13,048 157,428 13,048
75 0 13,439 89,629 13,439 150,638 13,439
76 0 13,842 76,991 13,842 143,137 13,842
77 0 14,258 63,750 14,258 134,881 14,258
78 0 14,685 49,886 14,685 125,823 14,685
79 0 15,126 35,376 15,126 115,916 15,126
80 0 15,580 20,198 15,580 105,109 15,580
81 0 16,047 4,328 16,047 93,347 16,047
82 0 16,528 0 4,360 80,575 16,528
83 0 17,024 0 0 66,732 17,024
84 0 17,535 0 0 51,758 17,535
85 0 18,061 0 0 35,585 18,061
86 0 18,603 0 0 18,146 18,603
87 0 19,161 0 0 0 18,541
88 0 19,736 0 0 0 0
89 0 20,328 0 0 0 0
Table 13 Quantitative Comparison between an Annuity and an ARF for a 65 Year-Old Male
What can be seen from the above is that using a conservative growth rate of 3% gross on an ARF, the bomb out risk is somewhat high and is a real and concrete consideration for retirees and advisors alike to plan for in so much as can be structured at the outset of retirement. Given the volatility of then global markets over the last decade, in particular the equity markets in 2008, it is our belief that a gross rate of 6% is more difficult to achieve and that the 3% rate is a more compelling and pragmatic target at this time. This last opinion with respect to ‘realistic’ investment returns of 3% needs to be measured in-light of the 5% deemed distribution currently applying to ARF portfolios.
Longevity and Bomb Out Risk
When we take the Bomb out period in the previous example of approx. 16.5 years and compare them to the CSO report commissioned for the Central Bank on Mortality Trends in Ireland (see table 14), then by implication the average male will outlive an ARF in all three statistical projections
Method Period LE at 65 Cohort LE at 65
CSO (Updated 17.6 years 19.9 (years)
GAD (1%) 17.6 20.9
GAD (2) 17.6 21.8
Table 14
However if we look at a level based ARF drawdown the picture becomes a little less stark with a Bomb Out term of approx. 29 years, well above average life expectancy (Table 15):
Age Initial Sum Assuming 3% Growth Income
65 200000.00 196000.00 10000
66 196000.00 191880.00 10000
67 191880.00 187636.40 10000
68 187636.40 183265.49 10000
69 183265.49 178763.46 10000
70 178763.46 174126.36 10000
71 174126.36 169350.15 10000
72 169350.15 164430.66 10000
73 164430.66 159363.58 10000
74 159363.58 154144.48 10000
75 154144.48 148768.82 10000
76 148768.82 143231.88 10000
77 143231.88 137528.84 10000
78 137528.84 131654.70 10000
79 131654.70 125604.34 10000
80 125604.34 119372.47 10000
81 119372.47 112953.65 10000
82 112953.65 106342.26 10000
83 106342.26 99532.53 10000
84 99532.53 92518.50 10000
85 92518.50 85294.06 10000
86 85294.06 77852.88 10000
87 77852.88 70188.47 10000
88 70188.47 62294.12 10000
89 62294.12 54162.94 10000
90 54162.94 45787.83 10000
91 45787.83 37161.47 10000
92 37161.47 28276.31 10000
93 28276.31 19124.60 10000
94 19124.60 9698.34 9698.34
Table15
What we conclude from this Bomb Out risk is a very real concern for retirees and advisors alike, conversely with prudent drawdown and even with a conservative investment strategy an ARF should exist for longer than its investor.
Other Risks
Risk Annuity Approved Retirement Fund
Investment None Yes-it depends on the choice of fund(s) chosen. You could potentially lose a portion/all of your money
Inflation It depends:-most Annuities offer equal monthly payments with no inflation protection. However, if you are willing to accept lower initial payments, you can purchase an inflation protected Annuity It depends on your choice of investment. A well diversified portfolio will give you the opportunity to keep pace with or beat inflation but it will depend on your investments and their performance
Counter Party Yes-if the company that you purchase your Annuity with becomes insolvent and unable to meet their obligations, then your Annuity will be lost (Equitable Life) Yes-if the company that you invest your ARF with becomes insolvent. However, you may have recourse to an Investor Compensation Act.
However, certain Self Directed ARFs may not have recourse to any compensation
Table 16
Variations of ARF Option in the Irish Market
Irish Life’s Protected Annuity
In the Irish market at this time as far as we can ascertain Irish Life is the only provider to provide an investment protected Annuity. The benefit of this is that unlike with traditional Annuities that die with you, an investment protected Annuity pays the balance on your death to your estate. However there is a significant additional cost with the Annuity rate being reduced by between 12 to 18 per cent on average. There is no guarantee period with this Annuity and is only available where an ARF option can be provided for.
Canada Life’s Approved Retirement Fund
The Lifelong Income Benefit (LIB) ARF with lifelong income benefit represented a major new direction in the provision of Annuity products blended with the benefits of an ARF option for Irish retirees.
Age at first income payment date Income Withdrawal Percentage
60-64 4.00%
65-69 4.25%
70-74 4.50%
75-80 4.75%
Table 17
The amount that was paid was the higher of:
1. 1/12th of the guaranteed lifelong income amount and
2. 1/12th of the 5% of the fund value of the policy at the date the payment was calculated.
The benefit of the LIB/ARF consisted of though the underlying payment was guaranteed (subject to counterparty), the fund governing that payment was invested and was not locked in to Annuity rates. Thus the client had the opportunity to obtain a higher lock in value if investment markets performed favourably. If the fund was higher than the lifelong income withdrawal base on that date, the fund would be rebalanced to reflect the new rate. Alternatively if markets performed poorly the client had the guarantee that they would receive the guaranteed rate applicable to their age. Consumer had 3 choices in terms of the default investment options ranging from Conservative to Advanced. There was an Annual Guarantee Charge to provide the guarantee.
However the increased lock in values did not reflect in values for surrender of the policy or for minimum payment on death.
A major benefit of the LIB/ARF was option of taking discretionary withdrawals from the fund that gave the client access to funds in times of emergency or if the client needed access. Though this was an innovative step it did reduce or nullify the lifelong income benefit as it reduced the underlying fund.
In conclusion, the key point for the Canada Life LIB/ARF is that it represented a significant change in the approach to providing guaranteed income for a client in retirement and at the same time addressing many of the concerns often attributed to ARF’s. The Bomb Out risk was addressed through the guaranteed income; the concern over low Annuity rates was mitigated through the possibility of higher returns with the underlying funds being invested. The death treatment was addressed through the minimum payment on death. Though the discretionary withdrawals reduced both the fund and the lifelong income benefit, it allowed clients a combination of both the benefits of an Annuity and the flexibility of an ARF.
This Product has been withdrawn since amalgamation of Canada Life and Irish Life at this time we are unable to ascertain if it will be re-launched.
Sales Commission
”Single premium investment products (including ARFs) typically pay commission of 3.5% of the premium plus 0.5% of the fund value each year, which clearly has the potential to amount to considerably more than 2% over the life of the ARF”.
It is extremely difficult, if not impossible, to ascertain whether varying commission levels payable on the various retirement options available affects the types of underlying assets held within retirees’ pension portfolios. It is clear that advisors can potentially receive more commission from placing investments into ARF options, even so if the ARF contains risky underlying assets then regular review of the underlying portfolio would be required and advisors should be remunerated for their advice and service.
As we know, providing professional advice and services are not without their risks (hence, reason for professional indemnity insurance and the threat of the law of tort, duty of care and negligence) and as such why advisors should be remunerated for their services accordingly. It is imperative to note that a reasonable level of fee income should be proportionate to the time and effort in providing the advice to the client. This is a key consideration in our opinion.
Table 18 shows the levels of ARF and Annuity business placed in Ireland from 2007 ‘ 2012. We are not suggesting that the increase in ARF business over that of Annuity business is directly as a result of the obvious commission bias towards ARF business, nevertheless the irregularity does exist. We would recommend that the Central Bank and the appropriate pension providers review this matter in further detail and complete research into whether there is a prejudice towards one option over another due to potential higher remuneration available:
Table 18
Annuity Rates
Annuity rates are at their lowest in about 40 years. If you retired in the early 1960’s at age 65 you might have been expected to live for 12 years. Currently if you retire you are likely to live for another 22 years. On this simple measure it can be argued that Annuities are somewhat better value than 40 years ago, even though rates are similar, because you will receive your Annuity income over a much longer period:
Graph b: Falling Annuity Rates in Ireland
A Case for Sovereign Annuities
Due to historically low government bond yields, currently a 10-year German Bond will yield 1.54% PA versus for example 4.62% PA in June 2008 (Source: Bloomberg.com), providers of Annuities are finding it increasingly difficult to offer realistically attractive Annuity rates to Irish retirees.
Consequently, pensioners may have to consider alternative underlying investment strategies / asset classes to meet their long-term pension requirements. Does this mean they have to take on undue equity risk? Possibly not. Sovereign Annuities could also be considered should they be available for purchase individually by retirees, as opposed to merely being available currently to trustees of pension schemes alone (Table 19 for Current 10 Year Bond Yields.)
Sovereign Annuities ‘ what are they and can consumers currently purchase them in Ireland?
A Sovereign Annuity is an Annuity contract issued by insurance companies where the annual income payment is linked directly to payments under bonds issued by Ireland or any other EU Member State (known as reference bonds). Sovereign Annuities can currently only be purchased by the trustees of occupational pension schemes (both defined benefit and defined contribution schemes)
Risk and Analysis of the European Bond Market
It is crucial to note that whilst some government yields maybe attractive at a point in time, and consequently look to supply a retiree with a higher than ‘normal’ annual income level, bonds are not without their inherent risks.
Governments may default of their debt by various means, chiefly if they are not in a financial position to service their debt and meet their obligations. Default examples may include issuers:
‘ Not being in a position to pay the bond holder (in this case, the retiree who holds the debt) the annual return as agreed at the outset of the bond purchase;
‘ Not being in a position to return the bond holder with the agreed par maturity value (usually ‘100) at the end of the term
‘ And in some cases, even paying back a reduced, partial amount upon maturity. A prime example of this form of ‘haircut’ is Greece and their debt, after they asked the private sector holders of Greek debt to take a 20% haircut and then later a 50% haircut.
Access to sovereign debt could potentially increase the annual yield on their savings, potentially reduce transaction and handling costs, and at the same time increase diversification across their retirement portfolio.
Country Credit Ratings ( Moody’s & Fitch) Yield
Germany AAA/Aaa 1.54%
Ireland BBB+/Baa3 2.93%
Britain AAA/Aa1 2.66%
France AA-/Aa2 2.04%
Greece CCC/Caa1 6.05%
Portugal BB+/Ba3 3.85%
Table 19 Current 10-Year European Sovereign Bond Yields
Lack of Awareness/ Financial Illiteracy
Consumer Knowledge & Education
There is a perception that Annuities are bad value at this time. It can be argued that this perception is in part down to confusion on behalf of the retiree regarding the options available to them on retirement. This confusion can be partially addressed through a concerted marketing campaign to increase financial literacy both by the central bank and pension providers.
This campaign should be designed to help people understand the different Annuity options available and benefits of having a guaranteed life-time income stream. Most people are not aware of the longevity risks involving the ARF option and the fact that they could well outlive their own pensions.
The OECD has published many articles on how consumers lack an understanding of Annuities. They are unfamiliar with different types of Annuities on offer and what benefits Annuity payments provide, such as offering security and removing risks associated with investments. They have highlighted how Annuity payments can offer certainty and the ability to pay for long term care and medical expenses, etc in old age. These are topics that most people overlook in choosing a suitable retirement option. The OECD have also described how this is an international problem and not just specific to Ireland.
The Association of British Insurers (ABI) has been working with its member insurance companies, the UK government and consumer groups to improve customer experiences at retirement. Their main objective is to ensure consumers are provided with all the information they need in choosing an Annuity at retirement.
Graph c
The ABI carried out a survey, published in May 2013. In this they interviewed 500 pre-retirement customers who were in the process of selecting their retirement date and 1,000 at post-retirement who had purchased an Annuity in autumn 2012. The research has found among other things, that the majority of people in the UK do not understand their retirement options. The chart above shows the results obtained when sample size were questioned on their understanding of Annuities.
In November 2008, Hibernian life and pensions surveyed approx. 1000 people on the topic ‘clueless about money ‘ Irish consumers demand more advice on dealing with pensions and finance’.
The findings for pension knowledge make for stark reading.
‘ 72% said they need independent and unbiased financial advice.
‘ 31% have no interest in Pensions and Investments.
‘ 40% do little or no planning for retirement.
‘ 31% find pensions and investments boring.
‘ 42% find pensions and retirement too complicated.
Graph d: Consumer view of pensions
Websites such as http://www.pensionsboard.ie/en/LifeCycle/Welcome.html are attempting to increase consumer awareness but consumers are a long way from being prepared for retirement at this time.
Conclusion ‘ Researched Alternatives
Taking into account the data in the tables which we have gathered and our research one can simply concur that the options available on retirement choice to the Irish consumer are noticeably lagging behind that of the Canada, UK and Australia. We need to ensure that Irish retirees have all the necessary tools available to them at retirement to make informed decisions on retirement
There are other more effective Retirement Options available, we will detail them below:
Deferred Annuities
A combination of programmed withdrawals with a deferred lifetime Annuity (e.g. starting payments at the age of 85) that offers protection against inflation could be seen as an appropriate default. The demand for Annuities could be also promoted by financial education initiatives stressing that they are insurance products designed to protect people from outliving their resources. Lump-sum payments may have to be discouraged as a form of benefit pay-out, except for small account balances.
Fixed Term Annuities
A fixed-term Annuity provides a regular stream of retirement income for a number of years (usually up to, 5, 10 or at times, 20 years) as well as a maturity amount (or ‘bullet’ repayment) at the end of the specific period. Retirees can then utilise the matured return to invest in another retirement product, such as another fixed term Annuity or a lifetime Annuity or income drawdown (in Ireland’s case, the ARF structure).
This type of Annuity is commonly available in Canada, Australia and the United Kingdom; however they are not available in Ireland currently.
The main benefit of this type of fixed term Annuity is that it allows you to keep your options open at a fixed, defined date in the future. You avoid locking in to a lifetime Annuity contract at the outset by merely setting the term, at say 10 years, and when this term ends, you can assess the market conditions at that time to see which type of follow-on solution would best meet your aims and objectives at that time.
The introduction of this type of Annuity to the Irish market would provide the retiree with more choice in terms of
‘ The term of 5, 10, 15 yr might be more appropriate than a standard lifetime Annuity
‘ a matured amount at the end of the term which can be used to invest into the most appropriate structure at that time
‘ diversity and choice in respect of the Annuity options available in the Irish pensions market.
Market/Investment-Linked Annuities
Historically, the traditional Annuity solutions were more popular than investment-linked Annuities as the rates they paid were higher. However, this is not the case currently with Annuity rates at historic lows.
In the UK and Australia, if investors opt for an investment/unit-linked Annuity, they can usually choose from a range of different funds containing different investment assets. As we have seen with the recent global financial crisis, diversification is imperative when it comes to the prudent and wise management of your assets, whether they are direct investment assets and/or pension assets.
Investment-linked Annuities provide underlying access to asset classes as diverse as:
‘ Equities
‘ Bonds
‘ Cash
‘ Property
Underlying diversity is encouraged in order to try and provide investors with additional returns over and above the usual minimum income return from the Annuity element. There is therefore a ‘market-related premium’ to be returned to investors should the underlying assets perform well over time. This has been described by one author as ‘the third way’
Conclusion
Further detailed research and due diligence by the Pensions Board and the relevant pension providers should be completed to ensure that all alternative retirement solutions such as those describe above are robust, durable and effective strategies for Irish consumers to employ.
These must recognise the impact of Mortality, Bond yields, Cost of on-going advice, the risks detailed above at minimum.
It should be achieved through a combination of new product development/adaptation and a rigorous consumer education program.
It is our contention that the ideal product is an Annuity based income that will allow a lump sum withdrawal and return of balance of fund on death such as the Australian Account Based Allocated Pension Option would be the benchmark to aim for.
Such a product ‘An Aruity’ as it were would enhance existing options and this in conjunction with early and on-going education of the consumer is essential to ensure a that the options chosen at retirement are as a result of retirement planning and not product purchase as seems to be partially the case on retirement at this time.
Bibliography:
Books and Reports
Antolin, P., C. Pugh and F. Stewart (2008), “Forms of Benefit Payment at Retirement”, OECD Working Papers on Insurance and Private Pensions, No. 26, OECD publishing, ?? OECD. doi:10.1787/238013082545
Berthold, T. (2013). Assuring retirement income. Working paper 01/13. Wellington, NZ: Ministry of Social Development.
Crouch, K; Allen, G; Whitehead, F; Carter, A; Levy, R (2013). ‘Retirement Choices: Baseline to Measure Effectiveness of the Code of Conduct’,
Department of Finance, Finance Act, 1999
Gilhawley, Tony, Are Annuities a good investment, Volume 2, Issue 2, The Financial Professional Magazine
Life Strategies, Review of the Irish Annuities Market. Indecon July, 2007
Mercer, Securing Retirement Incomes ‘ Time to Act, Risks Challenges and opportunities with New Zealand’s Retirement Income System, July 2009
Finance Magazine December 2000-Pension industry expecting shake up from predicted Approved Retirement Funds extensions article, McGarry, Des
OECD Publishing Pensions at a Glance 2011: Retirement-income Systems in OECD and G20 Countries, . http://dx.doi.org/10.1787/pension_glance-2011-en
OECD, IOPS Working Papers on Effective Pensions Supervision, No.18
OECD,Review of the Irish Pensions System, April, 2013
OECD, Design and Delivery of Defined Contribution (DC) Pension Schemes,Policy challenges and recommendations. Cass Business School, London, March 2013.
Roberto Rocha, Dimitri Vittas, Heinz P. Rudolph, Annuities and Other Retirement Products, Designing the Payout Phase, World Bank Publications 0821385739 ISBN-13: 9780821385739
Dr Susan St John, Associate Professor Economics Co-director Retirement Policy and Research Centre The Annuities Market in New Zealand October 2009
Revenue Practise Manual, Chapter 23, ARF
New Ireland , Pension Technical Manual, , Jan 2014
Pension Country Profile: New Zealand (Extract from the OECD Private Pensions Outlook 2008)
Pension Country Profile: Ireland (Extract from the OECD Private Pensions Outlook 2008)
Notes for Guidance ‘ Taxes Consolidation Act 1997 ‘ Finance (No. 2) Act 2013 Edition – Part 30 OCCUPATIONAL PENSION SCHEMES, RETIREMENT ANNUITIES, PURCHASED LIFE ANNUITIES AND CERTAIN PENSIONS
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The Social Welfare and Pensions Act 2011
Web Sources
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Bateman Hazel 2010 ‘Retirement Income Provision In Australia (7 )Australian Prudential Regulation Authority (2013).
Retirement Income Streams/ Australian Government Department Of Social Services.
Superannuation In Australia Wikipedia The Free Encyclopaedia
Money Smart Australia
Challenger Australia http://www.ehow.com/list_6115334_canada-pension-plan-death-benefits.html#ixzz2xClyquIa
Phased Retirement http://www.osfi-bsif.gc.ca/Eng/pp-rr/faq/Pages/pr-rp.aspx
Variable Annuity http://www.lifeAnnuities.com/variable-Annuities.html
Equity index Annuity http://www.utstat.utoronto.ca/~sheldon/lin0108d.pdf
https://www.finra.org/Investors/ProtectYourself/InvestorAlerts/AnnuitiesAndInsurance/p010614
fixed term Annuity https://www.edwardjones.ca/en_CA/products/investments/Annuities/term_certain/index.html
Annuity Knowledge and understanding http://www.oecd.org/daf/fin/private-pensions/37977188.pdf
http://www.oecd.org/site/iops/principlesandguidelines/48269620.pdf
http://www.nestpensions.org.uk/schemeweb/NestWeb/includes/public/docs/ABI-Customer-engagement,PDF.pdf
http://www.centralbank.ie/regulation/industry-sectors/insurance-companies/Documents/Mortality%20trends%20in%20Ireland.pdf
http://www.pensionsboard.ie/en/regulation/Sovereign_Annuities
http://wwwblog.irishlife.ie/infocus-market-updates/review-of-2011/
http://www.bloomberg.com/markets/rates-bonds
http://www.pensionsboard.ie/en/LifeCycle/Welcome.html
http://www.pensionsboard.ie/en/LifeCycle/Welcome.html
http://www.aviva.ie/group/mediacentre/latestnews/pensionsmadesimple/ Tyrrell, A. (2008) Clueless about money – Irish consumers demand more advice on dealing with pensions and finances
http://www.employeebenefits.co.uk/Journals/2013/06/05/m/e/h/Retirement-Choices-research-May-2013.pdf http://www.nestpensions.org.uk/schemeweb/NestWeb/includes/public/docs/ABI-Customer-engagement,PDF.pdf -Association of British Insurers, (2013). Customer engagement in the annuity market in 2013
http://www.osfi-bsif.gc.ca/Eng/pp-rr/faq/Pages/pr-rp.aspx Government of Canada, Office of Superintendent of Financial Institutions,(2013). Phased Retirement
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Other Sources
Canada Life Lib ARF Brochure
Millman via Standard Life, comparison between ARF’s and Annuities Sold by Insurance Companies
Association of British Insurers Consumer Research
The Telegraph 4th April 2014, ”A ‘third way’ between Annuities and drawdown”