I'm an annuity and it's all about me - baby !
Well, assuming we're talking about pensions. Now, don't stop reading just because I said the p word ! Bear with me. It will be worth it.
People talk so much stuff about pensions. Save as much as you can, reduce your tax bill, legitimately keep money from the tax man, invest also in a tax free way and in the end you have a lump of cash for when you retire. But what does that lump of cash really mean? It is very hard for people to get their head around how long a lump of cash will keep them going.
Get to the point please !
Think of retirement as a cliff edge. Like in the Road Runner movies. You are earning your salary right until your retirement age. Let's say this is €80,000. Then it stops ! Yes, there is a State Pension but that's only €12,950 per year - so if you aren't already, you need to start saving for your retirement !
So, how do I make up the other €70,000?
Well, the first thing to realise is that you may not need to earn at the same level. Your mortgage will be paid off. Hopefully your kids are standing on their own two feet by then and their needs for support are not as great. But you do need to shop, eat, run a car or two, eat out, have holidays and enjoy your retirement. So the first stage is to figure out how much you do need to make up. So let's say this amount is not €70,000 per year but is €50,000 per year.
Yes, but I have a pension through work so I'm all good, right ?
And to answer that question, we need to use an annuity. So, like I said at the start, it is all about annuities! Well, at least retirement planning is all about annuities. An annuity uses a lump sum to buy you an income stream that lasts until the day that you die. So it basically tells you whether the amount you have saved in your pension pot is enough.
So, for every €100,000 in my pension, how much juice do I get?
At the time of this posting, €100,000 will buy a 65 year old about €3,780 in annual income from an annuity.
Let us be very clear on what an annuity is. An annuity will pay this income as long as you are alive. So, if you live to 100, you get 35 years of payments - about €132,300. Not too bad a return from your €100,000 investment. But if you only live for 5 years, your €18,900 will not be a good return from your €100,000. (For the moment we are ignoring annuities which have a guaranteed period or which make payments to your other half after you die.)
I've got to live about 26 years (to 91) to break even on this annuity !
Yes, that's right.
€3,780 per annum for a €100,000 investment really does not sound great.
Yep, that's right. Very, very little.
Even the much storied €1,000,000 pension pot will get you €37,800 in annual income. Not to be sneezed at but we're not talking Beverley Hills here. €2,000,000 is the maximum size a pension fund can be before it starts attracting negative tax treatment (the "Standard Fund Threshold"). Before the Celtic tiger bubble burst, this pot could have been as high as €5,000,000.
But these days, your maximum €2,000,000 fund would buy an annual annuity income of about €75,000.
Has it always been thus?
Back in the 1980's a €1,000,000 pension pot would have got you €120,000 per year. Since then we have been steadily falling. Broadly speaking, annuity rates movement will track long-term interest rates on governments bonds. Insurance companies will cover their payments to you by investing in bonds similar to these. So when long-term interest rates fall, so will annuity rates.
Even back in 2000, a €1,000,000 pension pot would have got you nearly €60,000 per annum.
In 2007, you would have been talking about €44,000 per annum. And the advice would have been don't purchase an annuity. Wait ! Annuity rates will go back up ! But - along came the financial crisis and interest rates fell to the floor. Nearly 15 years later and annuity rates are as low as ever.
Wait a second: if retirees are not purchasing an annuity, you can't say it's all about annuities !!
Well, you do have other options at retirement. Pretty much everyone will elect to take their €200,000 tax free lump sum at retirement if their pension savings allow it. Others may elect to take up to a further €300,000 at the 20% tax level. However, after that, it is decision time. It is either buy an annuity or hold the money in a fund (like an ARF). And I would argue that decision is all about annuity rates !
If the rates were high, then we would buy an annuity. If they are low, then we may elect to hold in a fund and maybe buy an annuity at a later date. This is the classic kicking the can down the road strategy. It has not really worked in the past 15 years as interest rates have remained low. Arguably - post-Covid, we will see an economic rebound and higher rates. But the prediction of higher rates has been out there a long time !
So, what does all this mean for me ?
Think about how much you might need in retirement. Hint : you will need a lot more than the State Pension of €12,950 per year. Use annuity rates to figure out how big your pension pot should be to get you the income you need in retirement. Then figure out the amount of savings you need to make now to make that happen. Good news : it is likely that all those savings you need to make will mean you saving on your tax bill. Saving money away for retirement that would otherwise go to the tax-man.
That sounds like hard work !
Ok, fair enough. Come and speak to us at AM Financial. We give pension advice to clients in North Dublin and we can answer these questions with you. We will help and we will make it easy to understand.