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PETER DOLEZAL: Annuities: a retirement income option
An annuity is an insurance product which guarantees the holder a prescribed income stream for a specified length of time. Annuities can have a single-person lifetime payment guarantee, or for couples, a joint-life guarantee. Other options provide payment for a specified minimum period such as 10 years. Although most annuities typically offer an assured flat payment amount, indexed annuities are also available.
The longer the time frame of the selected payment stream — with joint benefit payments, indexing or other costly features — the less the monthly income received.
The older one’s age when purchasing an annuity, the higher the monthly payment will be. For some retirees, annuities are worth considering but only in certain unique circumstances.
There are several key disadvantages to annuities. The greatest of these is that the funds invested in an annuity are generally lost to the annuitant on death. If you happen to have a life annuity and live to 100, you win. On the other hand, should you die shortly after purchasing the annuity, the insurance company is the big winner. Although insured annuities exist, which preserve the invested capital, the extra cost of insurance drastically erodes the monthly income.
Another major disadvantage is today’s interest rate environment, used by the insurance company in determining the level of payments.
With historically-low interest rates, current annuity payments per $100,000 invested, regardless of the options chosen, are also historically low. With the projected rise in interest rates, this may begin to turn around in favor of the future annuitant.
If an annuity is purchased with RRSP or RRIF funds, all of the income received is taxed as ordinary income, exactly as if drawn from the registered account. However, if the annuity were purchased with Non-Registered funds, major tax advantages would exist, since a significant portion of the payments would be classified as a return-of-capital, which is not taxable.
Generally, annuities do not become a viable option until at least age 65. The longer the projected retirement, the lower the monthly payment will be. Let’s look at four couples, aged 65, 70, 75, and 80. Each is considering the purchase of a joint-life annuity which guarantees specified monthly payments until the death of the second spouse. The capital is not insured; it will be lost on the death of the last partner. Each couple is considering a $100,000 annuity purchase.
As expected (based on a July, 2013 quotation), the youngest couple will receive the lowest guaranteed monthly payment of 5.9% ($492/month). The 70-year old couple’s return rises to 6.6%; the 75-year old’s to 7.4%; and the 80-year old’s to a sizzling 8.9%. Obviously, the insurance company relies on the actuarially-determined probability that the greater the age of a couple purchasing an annuity, the shorter the length of time the insurer will be making payments. Thus the higher monthly payout to the older couples.
For some retirees, the total predictability of monthly income from an annuity provides the peace of mind that makes the downsides of an annuity worthwhile. No general rule of thumb can be applied to everyone, to determine whether or not a particular annuity should be purchased. Each individual’s, or couple’s, net worth, degree of risk-aversion, desire to leave a significant estate for family, tax position, and other personal factors need to be considered.
Is there an optimum time when one might at least consider whether the purchase of an annuity is a good idea in specific circumstances? Generally, an annuity might be best considered if the individual or couple is at least age 70; and aside from an employer pension or RRIF income, also has a significant Non-Registered portfolio. In this case, the attractive payment percentage, combined with the tax advantages, might favor the purchase of an annuity, using a portion of the Non-Registered funds. This would be akin to purchasing a lifetime GIC paying 6 or 7% - which many would jump at, were it available. However, unlike a GIC, purchasing the annuity eventually results in the invested capital being lost to the estate. This latter concern becomes less of an issue for those with no heirs.
Clearly, with the multitude of options and tax considerations, the decision to purchase an annuity is a complex one. If considering an annuity, do your homework before committing. Confer with an independent expert on annuities, and with your accountant. Obtain competitive quotes on the option you are considering, and don’t rely solely on advice from the individual trying to sell you an annuity. That salesperson stands to make a hefty commission for signing you up – hence can not be considered to be totally objective. You need to ensure that the decision you make is best only for you.
A retired corporate executive, enjoying post-retirement as an independent financial consultant, Peter Dolezal is the author of three books, including his most recent - The SMART CANADIAN WEALTH-BUILDER.