Annuities Get A Bad Rap, But Is It Time To Look More Closely?

By Marc Westlake

Published on: November 1, 2022

Retirement Planning includes pension planning throughout your working life and assessing your options as you approach retirement age.

Purchasing an annuity at the point of retirement is rarely considered in 2022. Advisors often dismiss the idea of an annuity at the point of retirement or fail to give the option any consideration whatsoever. Instead the Approved Retirement Fund (ARF) has become the default retirement option.

Here, we look at a case study that demonstrates why all options should be laid out and considered at the point of retirement. Creating a bespoke pension plan for your requirements and circumstances can open up more options in the future and lead to significant tax savings.

Annuity Advice for Joe & Mary

Joe is 66 and just retired. He and his wife Mary are now in receipt of their State Pensions which come to about €24,000 pa combined.

He has a private pension worth €1.5m and, in common with most people in Ireland today, he is thinking about setting up an Approved Retirement Fund (ARF). His understanding is that the alternative, an annuity, is bad value and means that all of the pension fund is lost in the event of his death. His adviser hasn’t done anything to challenge this belief.

When we look more closely at Joe’s needs:

  • He is looking for an after-tax income of about €4,000 per month, which he anticipates will decline as he gets older by around 1 or 2% pa.
  • He is risk averse.
  • He is concerned about inflation reducing the value of his investments over time.
  • He is concerned that he needs to make provision for Mary in the event of his death, as she only has the basic State Pension.

He has been advised to take his lump sum of 25% of the value of his pension and to put the rest into an ARF with a low-risk investment strategy.

Establishing a Benchmark

Typically an ARF investor and their adviser will look to protect their original investment or seek to meet the 4% withdrawal.

This is a huge mistake. The most relevant benchmark for an investor in an ARF is the annuity that they didn’t purchase at outset.

This helps us to establish a “critical yield”, that is to say the level of return the ARF needs to achieve on average just to keep up with the income payments that would have been guaranteed by the annuity most suited to the client’s circumstances.

In this case we need inflation protection and a spouses pension.

An inflation protected annuity (with annual increases of 2%) and a 50% spouses’ pension (which will be paid to Mary in the event of Joe’s death) is currently paying €37,582 pa (3.346%).  When added to his State Pension income of €24,000, this annuity would provide a total annual income of around €61,500 pa gross.

An estimated critical yield can therefore be established as follows:

Annuity Rate (increasing by 2% pa compound) + charges differential + plus allowance for mortality cross-subsidy of annuity

3.346% + 2% + 1% = 6.346% pa (increasing by about 0.067% pa to match the inflation protection).

This means that the ARF would need to have a very significant equity bias in order to keep up with the annuity that could have been purchased at the outset.

As annuity rates improve with increases in interest rates, it should be clear that the relative attractiveness of an annuity also increases.

Equally, we need to consider what the realistic prospects for investment returns might be.  The ARF will be comprised of large positions in cash and Bonds for a conservative investor. Putting this into context, the yield on the Vanguard Global Bond Index fund is currently 3.6%.

If an ARF with a suitable risk profile for Joe sought to match this annuity, the projected benefits in real terms would look like this.

Since the income is fixed in real terms there is some possibility of the value of the ARF bombing out in this scenario.

Estimated Tax 2022 for Indexed Annuity

  • Net Annual Income       €50,721
  • Total deductions            €10,861
  • Average Tax in 2022      17.63%

Of course, an ARF investor can’t just take an income of 3.346%. The minimum deemed distribution is 4%, rising to 5% when Joe is 70 years of age, so the actual profile of the ARF income looks like this.

We can see that as the withdrawals reduce as the capital balance drops there is little practical chance of running the account down to zero.

Estimated Tax 2022 for an ARF

  • Annual net income €54,838
  • Total Deductions €14,162
  • Average tax in 2022 20.52%

So, we can see that the ARF income isn’t particularly tax efficient.

Mary isn’t using her €13,000 exemption from USC as her State Pension isn’t subject to USC.

Our Advice to Joe and Mary

Joe & Mary need to structure their income so that it is

  • tax efficient
  • has some potential to offset inflation
  • makes provision for Mary in the event of Joe’s death
  • seeks to provide a legacy for their children/grandchildren

A Possible Strategy

Transfer the pension into a PRSA and split into 2 parts.

Use €800,000 to provide tax free lump sum of €200,000 and use €600,000 to purchase an annuity.

A level annuity with a 10-year guarantee and 100% spouses’ pension is currently paying €24,090 pa (4.025%pa with Irish Life).

The €200,000 tax free lump sum should be invested in a dividend portfolio in Mary’s sole name to make use of her tax exemptions and reliefs. This will currently generate a gross income of approx. €4,000 pa.

Estimated Tax 2022 for Hybrid Option

  • Annual net income €47,235
  • Total deductions €4859
  • Average tax in 2022 9.32%

The hybrid plan is almost exactly in line with the income target of €4,000 pm net, but is only using €800,000 of the pension fund to achieve it, since the tax payable is so much less.

The balance of €700,000 is to remain in the PRSA as “unvested” benefits to be deferred up to age 75 (9 years).

Having locked in and guaranteed Joe’s income requirements, arguably he has the capacity to take more investment risk with his unvested pension.

Taken to it’s logical conclusion, Joe has theoretically no need for the remaining pension fund and therefore could consider a full equity strategy.

For example:


With the following projected results:

Benefits of Hybrid Approach to Retirement Planning

The benefits of this approach are as follows:

  • Part of the pension remains invested to grow in a tax efficient environment. This capital growth can be used to offset the effects of inflation and provide additional financial security for Mary in the event of Joe’s death
  • Because there is no immediate need to take an income from the deferred element of the pension, we can have more of an equity bias and we don’t need to be so concerned about sequence of return risks.
  • While the PRSA is deferred, Joe and Mary are not paying 40% income tax plus USC on the income payments (which would be the case in the event of imputed distributions from an ARF). This is therefore effectively an interest free loan from Revenue for up to 9 years.
  • 25% of this unvested pension is available as a lump sum, taxable at 20% (tax year 2022). Therefore, until the unvested part has grown by at least €500,000 (to take the total pension value up to €2m), Joe can increase his entitlement to additional taxable lump sums. This is significant because Joe has a marginal rate of income tax of 40% plus USC. Therefore, being able to take some of the extra pension at a rate of just 20% is an attractive option.
  • If Joe dies before vesting the unvested PRSA, the whole value of the PRSA is payable to Mary as a tax-free lump sum.
  • The PRSA can be further split into a vested and an unvested part (known as phased retirement) making additional lump sums and possibly additional annuity purchases or ARFs available to Joe in the future.
  • The pension payable to Mary in the event of Joe’s death is 100% of Joe’s unvested pension.
  • The proposed annuity is payable for at least 10 years in any event and therefore the minimum value to the estate is 10 x €24,094 = €240,094, plus the balance of the PRSA €700,000 and the balance of the tax-free lump sum €200,000. In practical terms €1,140,094 (76%) of the original €1.5m pension is available for distribution to the estate, even though 40% of the pension was used to purchase an annuity.


Further Insights on Retirement Planning

Read one of our latest guides:

Retirement Planning for Gen X, Y (millennials) & Z

If you are 55+ and closer to your retirement date, then our Guide to Approaching Retirement is for you