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ARFs: The ups and downs

26/10/2018 Posted by IAPF | Comments(0)

Since the 2011 Finance Act opened up approved retirement funds (ARFs) to people in defined-contribution pension schemes, they have become the preferred vehicle for growing numbers of people who want to manage their accumulated pension and provide an income throughout their retirement years.

The Irish Association of Pension Funds (IAPF), which represents pension savers, estimates the total market for ARFs is worth between €8-€10 billion. As a measure of their popularity, ARFs are growing at €1 billion per year. The IAPF found clients preferred these schemes to annuities because they could maximise the tax-free lump sum on retirement and invest the remainder in an ARF.

ARFs are a direct competitor to an annuity, where the retiree pays their lump sum to an insurance company in return for a fixed annual income during retirement. “The advantages of ARFs is that they’re really flexible vehicles. You can assume as much or as little control as you want. You can even acquire investment properties in your ARF and you have access to a whole host of asset classes,” says Richard Kearney, associate director with Davy.

The IAPF research also found ARF holders liked how the model let them pass savings on to family members in a tax-efficient way in the event of their death, whereas annuities usually don’t allow for this.

“If you have an ARF and you die, the full value of the ARF passes to your spouse. When she dies, the ARF crystallises and passes to your children, with only a 30 per cent tax payment if the children are over 21,” says Joe Hanrahan, head of retirement planning at Investec.

Planning for an ARF is the kind of decision people typically need to make as retirement approaches rather than when they start saving into a pension. “You should start planning for an ARF around seven to 10 years from your retirement age. Prior to that, you’re building up a pension fund and the benefit choice doesn’t impact on the decisions that you make. If you’re going to choose an ARF, you should hold investments that would broadly align with the ones you will hold in retirement. There’s no sense in fully de-risking your fund if you intend to reinvest it after you retire,” says Trevor Booth, head of financial planning at Mercer.

Less predictable

An ARF by nature is less predictable than an annuity. Its returns can depend on how long the holder lives and what types of investment it comprises. It also means that ARF holders need to manage their fund – or have someone do it for them – much more proactively than if they chose a ‘set-and-forget’ annuity that simply delivers the same fixed amount every year.

Part of the attraction for ARFs is that the returns are potentially higher than interest and inflation, giving retirees a crucial buffer in their living expenses. “Even if interest rates rise, the reality is, inflation will be higher than the nominal interest rate for some time to come, so you need to invest in a way to get more than your 4 per cent or 5 per cent annual return in a world where the traditional ‘safe haven’ assets of cash and bonds are giving you almost no return,” says Investec’s Joe Hanrahan.

The dilemma for many people is that they become more risk-averse as they get older, but in order to get an income to meet their needs for the rest of their life, they need to invest in risky assets because bond yields are so low. “Although the ARF is a tremendous option to have, it may not suit everybody to do it. I would argue that you have to look at the totality of the individual’s balance sheets and circumstances before making that decision,” says Hanrahan.

For example, someone with a large pension pot and no mortgage may be better able to absorb a small decline in income if the ARF loses some of its value in a given year. By contrast, someone who still has debts after retirement and whose pension pot is their only asset might be less comfortable with taking on the investment risk.

Income-producing assets

Richard Kearney of Davy says a good approach to mitigate any risk is to have a well-diversified multi-asset investment, possibly including some income-producing assets. “The flip side of the coin is that there’s no guarantee an ARF can go up; it can go down. You should avoid concentration of individual investments. You have to get back to first principles of spreading risk. Your financial adviser’s job will be to tilt towards those assets that are performing,” he says.

Another factor to weigh in deciding on an ARF is “bomb-out risk”. To put it crudely, that’s when your money dies before you do. “Having an ARF has loads of advantages, but should you outlive your money, that is a real problem. People have to legislate for that,” says Bernard Walsh, head of pensions and investments at Bank of Ireland.

Someone who lives until the age of 90, having retired at 60, could have another three decades of life they’ll need to pay for. “You can’t keep taking out of a fixed pot and expect it to last forever. Thirty years is a really long time, and if you’re not careful, that fund can whittle down quite quickly. You need to mitigate the risk by making sure that it’s working as hard for you as is possible without overstretching it on the risk side. That’s a very delicate balancing act for many people,” says Kearney.

Investing in an ARF has lots of upsides, but financial advisers emphasise the importance of understanding the nature of the investment. “If you have no experience of investing and you don’t understand it, then you either need to do lots of research or partner with a provider who can give you the service you need,” says Hanrahan.

Walsh agrees. “Outside your family home, your pension could be your biggest financial asset. The decision you make around your retirement is vital and in many cases it’s irreversible. Think long in advance about it and get good-quality advice when the decision has to be made,” he says.

Read the original article here.

Access all the IAPF research data here

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