Retirees taking pension benefits from a Personal Pension, a PRSA and a Defined Contribution pension scheme [since February 2011] have a choice of buying an annuity [pension for life] or investing in an Approved Retirement Fund [ARF].
The advantage of an ARF is that funds can be drawn down as required. On the death of the pensioner, any remaining funds will transfer to their Estate.
The taxation of the transfer benefits on death is generous. To prevent high net worth individuals from using their ARF for tax planning purposes and leaving the entire amount of the ARF to their spouses and children, the Revenue imposed a mandatory mechanism called imputed distribution.
This required the ARF provider to encash 3% of the ARF every year and the holder was obliged to pay Income Tax and USC on the imputed amount withdrawn.
In recent years, the Government raised the imputed distribution rate to 5% and to 6% for ARFs with €2 million or more.
The Government decision increases the risk of capital run down and declining retirement incomes which will force retirees into a high risk investment strategy just to have a chance of maintaining their income in retirement.
Tony Gilhawley of Technical Guidance Limited recently ran a number of simulations about capital preservation in ARFs.
Using the statutory disclosure rates that will apply to all new life and pensions illustrations from December 2013, he discovered that when draw down is 5%, a person with a low risk portfolio has only a 1% chance of maintaining capital after 10 years compared to a 34% chance when the draw down is 3%.
A retiree with a high risk portfolio would have a 28% chance of maintaining capital over the same period with a 5% draw down compared to a 58% chance when the draw down is 3%.
With 5% draw down after 20 years, the chance is zero for low risk portfolios and 21% for high risk. With 3% draw down it is 29% and 60% respectively.
This move from Government has made it inevitable that ARF retirees will not be able to preserve their capital and therefore their income in retirement.