Q: I’m due to retire in the next few months and while the recent stock market volatility has eased, I’m worried about what might happen to my pension if there’s a second wave of Covid-19. If that comes in the winter, I will have retired by then. What would be the biggest risks of any stock market volatility prompted by a second wave of the virus to those who have retired and are in receipt of their pensions? Can I do anything to protect my pension in retirement? Eddie, Dublin
: You don’t say if you are a member of a defined benefit (DB) scheme or a defined contribution (DC) scheme -and if DC, whether or not you are planning to opt for an annuity (a guaranteed pension for life) or an Approved Retirement Fund (ARF – a personal retirement fund where you keep your money invested after retirement and you retain ownership) when you retire.
If you are a member of a DB pension scheme or are in receipt of a guaranteed pension annuity, your pension income is normally guaranteed by the pension scheme or annuity provider – so you are unlikely to be impacted by any stock market volatility.
If however, you are invested in an ARF or a vested Personal Retirement Savings Account (PRSA) – which is another type of post-retirement fund – you could be susceptible to stock market volatility. This is because ARFs and vested PRSAs are usually invested in the stock market. From the age of 61 onwards, you must draw down a certain percentage of those funds each year as income (known as the imputed distribution) – even if you are still working. (Remember, once you withdraw your 25pc tax-free lump sum from a pension, the balance must move to an ARF or a vested PRSA or an annuity.)
With the imputed distribution, the minimum withdrawal is normally 4pc of the fund value per annum and you must pay income tax, PRSI and the Universal Social Charge (USC) on the income you draw down each year. For this reason, you will be impacted by stock market volatility if the value of your pension fund has fallen around the time that you make your imputed distribution.
If the value of your fund has fallen by 10pc since your last annual withdrawal for example, then your 4pc annual withdrawal will be based on a pension fund worth 10pc less than it was previously – and so the amount of income you get from your 4pc withdrawal will be smaller than would have been the case if the fund had not got a 10pc knock. You can of course defer the income payment to later in the year – which may give your pension fund time to recover its value if it has fallen.
For most people, it is likely that part of their post-retirement pension fund is invested in the stock market. ARFs are long-term investments designed to provide a pension income for the lifetime of the retiree so it is important to be invested in assets you can rely on to deliver such an income. If invested wisely and reviewed regularly, the money in an ARF should last for the member’s lifetime and any residual value (money left in the fund when the member dies) can be passed to their estate on death.
You can of course reduce the investment risk in post-retirement funds in the short term – however for most people, this invariably means they will reduce risk when their pension has lost value and this is never a good strategy due to the long-term nature of ARFs and vested PRSAs.
Defined benefit pension worries
Q: I’m a member of a defined benefit (DB) pension scheme. What are the biggest risks posed by stock market volatility – such as that which marked the beginning of the Covid-19 crisis and any volatility which might follow any second wave of the virus – to members of DB schemes? Is there anything I can do to protect myself against those risks? Roseleen, Co Kildare
As a member of a DB scheme, you have no control of the scheme itself. In general, a DB scheme normally comprises of one large fund for all the members. This fund pays a retirement income (that is, a pension) to the members after they retire. The benefits are typically based on a multiple of a member’s salary and their length of service. Members would usually have the option to exchange a portion of their retirement income for a tax-free retirement lump sum at retirement.
Whilst Covid-19 may have affected the investment performance of a DB scheme, the investment risk is more of a concern for the scheme and for the employer providing the scheme than it is for a member. This is because member benefits are generally not affected – even if the fund performs poorly.
Defined contribution pension risks
Q: I have a defined contribution (DC) pension scheme through work. Am I more vulnerable to stock market volatility than a member of a defined benefit (DB) scheme is? Bernadette, Co Westmeath
Yes – individuals who are in DC pension funds are more vulnerable to stock market volatility than those in DB schemes. With DB schemes, the pension is typically based on a multiple of a member’s salary and their length of service. With DC schemes, the retirement benefits will depend on the performance of each individual’s pension fund. As a result, the biggest risks posed by stock market volatility to members of DC schemes are timing, investment risk and poor investor behaviour. Timing is important because the more time a member has until retirement, the more risk they can afford to take and the more time their investment has to recover after an event that causes stock markets to fall in value.
It is common for DC schemes to reduce risk in their members’ pensions – within between 10 and five years from a members’ retirement. In very simple terms, investment risk is normally divided into low, medium and high risk. The higher the risk, the more a member’s pension fund is invested in the stock market (typically shares in large companies) and the higher the potential returns. The lower the risk, the lower the potential returns because there is a smaller investment in stock markets.
Investor behaviour and how people react when their pension funds fall is also a huge factor in the performance of a DC pension. For example, many people will look at a fall in stock market values as a fall in the value of their pension and some will panic and sell at the wrong time. Some will look at the same fall in stock market values as an opportunity to acquire assets at a lower price. Remember, stock market declines are temporary so if you are not due to withdraw benefits during a time of stock market volatility, then you should have no long-term concerns.
Remember too, while DB pensions have traditionally been viewed as more attractive than DC schemes, the benefits paid under a DB scheme are not always guaranteed. If a DB scheme’s assets are not sufficient to pay member retirement benefits, and the employer is not in a position to meet the shortfall, promised pensions may have to be reduced.
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