Reforming the Irish pension system is normally a long and complex process of negotiation. Surprisingly, the most radical and successful reform in the Irish private pension regime happened without any consultation whatsoever in 1999 with the introduction of the Approved Retirement Fund commonly known as an ARF.
The ARF was devised by then Minister of Finance Charlie McCreevy seemingly on the back of an envelope. Despite the lack of fanfare, it proved a transformational innovation because it gave back control of the retirement fund to the pension holder after retirement.
The driving force behind McCreevy’s plan came from his experience of advising his clients on private pensions as a chartered accountant. At that time, you were obliged to use your private pension fund to buy an annuity when you retired. In effect, that meant renouncing your hard-earned pension fund to an insurance company in return for a fixed income for life. Charlie McCreevy sensed instinctively that pensions would appeal more to maverick spirit of the self-employed if they were allowed to retain control of their funds after retirement. The ARF was designed to do just that, and it allowed investors to invest their funds post-retirement, draw an income and pass on the residue of the fund to their family or other beneficiaries on their demise. The regulations were simple, and it led to a hugely increased take up of private pensions amongst the self-employed and business owners. So much so, that the option was extended to all members of defined-contribution, employer pensions soon afterwards. It was also subsequently copied in the UK.
When do I set up an ARF?
An ARF comes into play when you want to start drawing a lump-sum and/or an income from your pension funds. In general, this does not require you to formally retire, and there are slightly different rules applying depending on your employment status. For example:
- If you have a company pension, PRSA or Personal Retirement Bond from previous employment, you can generally access a lump-sum from age 50 and leave the balance to grow tax-free in an ARF until age 61 when you must start drawing an income typically of 4%-6% per annum
- If you have a personal pension or PRSA from self-employment, you can access the lump-sum from age 60 and transfer the balance to an ARF from which you must draw an income while retaining the option to continue working
- If you have a company pension, PRSA or Personal Retirement Bond from a current employment you can access the lump-sum from age 60 and transfer the balance to an ARF from which you must draw an income while retaining the option to continue working
- If you have multiple employments, it can be technically possible to access personal pensions from self-employment and/or company pensions from a current employment at age 50.
What an ARF can and cannot invest in
An ARF can invest in most asset classes. For example:
- Stockmarket funds and property funds
- Multi-asset funds including shares, bonds, property and other assets
- Alternatives such as currencies, renewable energy, commodities and cryptocurrency
- Direct share, bond and private equity portfolios
- Direct residential and commercial property
- In general, an ARF cannot invest in property or shares connected to the pension holder.
How much income you can draw from an ARF
The amount of income that you must draw from an ARF depends on your age and the size of the ARF as follows:
- If you have an ARF prior to age 61, you are not obliged to draw any income
- From the year you reach age 61, you are obliged to draw an income of 4% per annum
- From the year you reach age 71, you are obliged to draw an income of 5% per annum
- If you have a combined ARF value exceeding €2M, you must draw an income of 6% per annum from age 61 unless and until it falls below €2M.
How long your ARF should last
It is very important to bear in mind that the income you draw from an ARF is not necessarily aligned with the income produced by the investments in the ARF. Some of the income you draw from the ARF may come from the capital in your ARF, so the ARF value is likely to diminish gradually over time. Of course, it would be ideal if the ARF investments produced income and capital gains each year that were sufficient to cover the mandatory annual income from the ARF and the ARF management fees. However, a balanced portfolio might do well to produce net annual returns of 4% per annum on most actuarial assumptions. A medium-high risk growth portfolio might do well to produce the 5% net required to cover the 5% annual ARF income drawdowns from age 71 onwards.
It is also necessary to factor in inflation. Although most ARFs cannot automatically increase the income each year, it may be necessary to increase the income manually every few years to maintain your standard of living. Only a very high-risk investment strategy could generate the c. 8.25% per annum required to produce a 5% annual income, typical 1.25% annual management fees and 2% annual inflation while also maintaining your real capital value. It is very unusual and rarely sensible for anyone to adopt such a high-risk investment strategy in their retirement.
In short, an ARF is best thought of as a DIY annuity. In other words, it is designed to gradually diminish in value in real terms over your lifetime. Longevity is unpredictable as are investment returns and inflation. So, it is wise to conduct a professional cash-flow projection prior to starting your ARF to design the most suitable combination of investment strategy, income drawdowns and long-term capital projections. Here is an example for illustration:
- A client establishes a €1M ARF @ age 65
- They set a balanced investment strategy aiming for growth of 4% per annum after fees
- They start with the mandatory income of €40,000 (4%) per annum from age 65-71
- The income increases to 5% per annum of the ARF value (€50,000) from age 71
- The income is increased thereafter by 2% per annum to keep pace with inflation
- The projected residual value of the ARF is c. €700,000 @ age 85
- The ARF value will diminish to zero by c. age 98.
How is an ARF taxed?
The capital gains and income accruing on the assets held in the ARF are typically tax-free within the ARF. This is true for most Irish-based and domiciled assets. Foreign assets may encounter some withholding taxes. So, while you are not drawing an income from the ARF (for example from age 50-61), it grows largely tax-free.
The income that you receive from the ARF is taxed in a similar way to most other pension and investment income, i.e., it may be subject to income tax, PRSI and USC. You can offset your income tax credits against your ARF income. PRSI and USC typically reduce or cease from age 66-70 depending on your tax circumstances.
What happens to your ARF when you die?
The distinctive feature of the ARF is that the residual value can be passed to your family or other beneficiaries on your demise. The tax treatment depends on your relationship to the beneficiary and their age. For example:
- You can pass the value of an ARF tax-free to a spouse on your demise if they put the proceeds into an ARF in their own name
- You can pass the proceeds of an ARF to your children over 21 subject to tax @ 30%.
ARFs and residency
It is very difficult to convert an Irish pension to an ARF if you are not resident in Ireland at the time. It can also be surprisingly difficult to transfer an Irish pension to some popular foreign jurisdictions such as the USA before you ARF it and virtually impossible after you ARF it. Therefore, if you are leaving the country on a permanent basis, it is very important to consider your pension options before you leave.
The demise of the AMRF
Until 2021, it was necessary for many people to reserve €63,500 of their pension fund in an Approved Minimum Retirement Fund (AMRF) after retirement until age 75. The AMRF did not produce an automatic income or allow significant capital withdrawals. These have been phased out from 2022 so many clients are left with small secondary ARFs and it may be necessary to merge these with a primary ARF.