If you’re on the cusp of retirement, you might be facing a cash conundrum: what to do when your RRSP or defined contribution pension plan matures? You’ll suddenly have a large lump sum of cash to deal with. Some choose to convert to a RRIF (for RRSPs) or a Life Income Fund or Locked-In Retirement Income Fund for the pension plan. An often forgotten third option – an annuity – can in fact provide a guaranteed income stream for life equivalent to the kind once provided by a defined benefit pension payout. Yet an “annuity” has become something to avoid for many retirees. And that could be a big mistake. Here’s why.
Many investors avoid annuities because of low current interest rates, believing that annuities are inflexible in terms of rates and payouts. But the idea that an annuity is a good retirement option only when interest rates are high just does not hold true. All investments are affected by today’s low interest rates to some degree. So, why apply this thinking only to annuities?
Dr. Moshe Milevsky, an associate professor of finance at the Schulich School of Business and a member of the graduate faculty in the Department of Mathematics and Statistics at York University in Toronto, has a completely different take. And his views are an eye-opener for those conditioned to look at annuities as a distant second-choice in retirement income planning. Dr. Milevsky also happens to be an annuity specialist, and has long held that life annuities are in fact an optimalproduct for retirement income.
Very basically, an annuity is a contract offered by an insurance company, which undertakes to invest the lump sum you provide in a way that will guarantee a payout for the term of the annuity contract. The policy owner and the annuitant (the person who receives the income) are usually the same person, but not necessarily so.
How an annuity works
There are two fundamental forms of annuity: an accumulation annuity and a payout annuity. The annuities most people think of when they hear “annuity” is the payout form. An accumulation annuity is a deposit product based on guaranteed interest rates and is less well-known. The more common payout annuity is based on the investment of a sum of capital by the investor at an annuity rate offered by the insurer, and a return of that capital, for a period of time. That period may be specified as a term (also called a term certain annuity) or for life (a life annuity).
Payments from the annuity are made regularly – a monthly payment is most common, and for this reason – and annuity income is like any other regular source of income. It is dependable, the payout amount is level and known in advance, and neither the annuitant nor policy owner has any ongoing decisions to make.
The amount received as the payment is based on the amount of capital deposited, the gender of the annuitant, the age of the annuitant, his or her medical history, the frequency of payments, and the annuity rate offered by the issuer. The annuity rate is primarily based on the interest rate in effect at the time of issue.
Investors can and should comparison shop for annuity rates online to find the best rate, since rates vary between insurers. However, when shopping online, investors should be careful not to inadvertently end up on websites that offer “variable annuities.” Most variable annuities offered online are U.S.-based products that have some similarities to Canadian segregated funds, but are not sold in Canada. A type of variable annuity in which returns are based on the performance of the stock market are sometimes sold in Canada, but these are not widely available.
Dealing with interest rate risk
One way to manage interest rate risk in an annuity is to consider a laddered annuity approach in which available funds are used for multiple annuity purchases. There is no out-of-pocket cost to the policy owner to buy an annuity, so transaction costs with this approach are nil. Here’s how it works.
Instead of buying a single annuity with the total lump sum in year one, commit about 55% of the total for an annuity. Keep the remaining funds earning returns in your investment accounts (registered or non-registered). Then, in two or three years, commit another 27% of the remaining amount available to a second annuity, and then use the remaining balance two years after that to purchase a third annuity contract.
If interest rates rise within the two- to three-year period between annuity purchases, so too will the annuity benefit of the new contracts. Laddering the annuity purchases also has the effect of increasing the annual benefit, because the annuitant will be older with each purchase.
Types of annuities
There may be as many as four parties to an annuity: the issuer of the annuity –either a financial institution such as a bank or an insurer; the policy owner who funds the annuity; an annuitant (the person on whose life the annuity is based and who receives the income); and - in some cases – a beneficiary.
Term annuity.This type of annuity is very straightforward. It is one of the options to continue tax deferral when an RRSP matures. Its term must be to age 90, but other terms are available. This product is available through financial institutions as well as insurance companies.
The annuitant receives the income for the term of the annuity. If the annuitant dies before the end of the term, the unpaid balance of the annuity is paid to the beneficiary or to the annuitant’s estate.
Life annuity. This annuity contract is offered only through insurers and their agents. At first blush it looks equally straightforward: An income is paid for life to the annuitant, and there is no beneficiary. This is the life straight annuity, and it makes the highest annuity payment per $1,000 invested. However, it poses considerable risk, because if the annuitant dies the day he or she receives the first annuity payment, the balance of the annuity capital is sacrificed.
The risk can be managed by adding a guarantee period to the annuity. If death occurs during the guarantee period, the balance of the sum covered by the guarantee is paid to the beneficiary. For example, if Ben has a life annuity with a 25-year guarantee and he dies after five years, an amount equivalent to 20 years of payments is paid to his beneficiary.
Joint-and-last-survivor.One popular form of life annuity is the joint-and-last survivor annuity. It guarantees an income over the course of two people’s lives. At the death of the first annuitant, the surviving annuitant receives the income. There is no beneficiary.
Taxation of annuity payments
Taxation of annuity payments is based on whether the annuity qualifies as a prescribed annuity. A prescribed annuity spreads the capital of the policy owner evenly over the benefit period. Therefore, each payment is a combination of a set amount of capital and a set amount of interest.
A non-prescribed annuity contract pays more interest in its early years.
There are a number of conditions that must be satisfied for an annuity to be issued in the prescribed form, and a licensed life insurance agent can explain these fully.
The peace-of-mind benefit
One of the greatest benefits of an annuity is the peace of mind it provides. The value of not having to make a decision should not be underestimated, especially as an investor ages and good decisions become harder to make. As well, annuity income is guaranteed and paid regularly. Annuities truly are an optimal product for those searching for a worry-free stream of retirement income.
Courtesy Fundata Canada Inc. © 2015.Susan Yates is president of the Centre for Life Insurance and Financial Education (CLIFE).This article is not intended as personalized advice.