My September post introduced the basics of life annuities (and simply “annuities” from here forward) and some of the more talked about upside and downside to ownership. You can read the post here.
As a quick refresher, in its simplest form an annuity involves handing over a lump sum of cash to an insurance company in return for a recurring, usually monthly, fixed amount of cash coming back until one’s passing.
As promised, this post will build on the basics already introduced and provide advice in deciding whether annuities make sense in your own personal retirement income plan.
Annuities are less attractive for those with a defined benefit (DB) workplace pension. Remind yourself that a DB pension provides a fixed monthly payment until death – sound familiar? No need to double up with an annuity on top of the DB pension as your longevity risk (risk of running out of money) is already well managed. I say well managed and not completely eliminated as with a DB pension there is still reliance on the former employer to keep a fully funded pension pool – never a guarantee – just ask the former employees of Enron.
Flipping the idea on its head, annuities therefore make most sense for those without a workplace pension followed by those with a defined contribution workplace pension.
Annuities are even less attractive for the extremely wealthy with no real risk of running out of retirement savings. Not only is longevity risk a non-issue, too much wealth is put in jeopardy in the case of premature death.
As a final thought on suitability; those in very poor health should not be candidates for annuities. This is because in the “rate of return” battle between annuities and traditional investments of stocks, bonds and mutual funds, annuities will only come out ahead when the holder exceeds their average life expectancy.
No need for the “all or nothing” approach
As noted last month, two annuity downfalls are poor return in the case of premature death and leaving nothing behind to loved ones and charitable causes. As previously hinted, a possible solution is to put only a portion of retirement savings into an annuity. This preserves the balance of savings to be invested in traditional channels of stocks, bonds and mutual funds which don’t disappear when you do.
Here are two options for the mixed approach which I find intuitive: 1) convert enough savings into an annuity such that monthly annuity income approximates monthly fixed costs (housing, insurance, utilities, vehicle etc.), this provides comfort in that no matter one’s circumstances, the basics are always covered; and 2) convert the portion of savings otherwise pegged for fixed income investments into an annuity, there is some matching here as both are thought of as safe investments.
As a twist on the first option, the monthly annuity income could be combined with other forms of guaranteed income (i.e. CPP, OAS) to match monthly fixed costs. By bringing in the other guaranteed income, the monthly amount required from the annuity income declines and in-turn the initial lump sum handed over is less. This is perhaps the most intuitive option as fixed income matches fixed costs. Just make sure there is some variable income left in the fold to cover variable expenses or get used entertainment comprising a trip to the public library!
The second option is a tad simplistic in that as one ages, their fixed income holdings as a percentage of total saving should increase (bonus marks to anyone already thinking that). This dilemma is a nice segue into the notion of laddering annuity purchases. Laddering simply involves a series of investment purchases stretched out over a period of time (often five, ten or more years) rather than a big “all-in” purchase on day one.
Laddering annuity purchases has the following upside: 1) allows for more control over your other traditional investments such as fixed income. This is because you hold onto built up savings for a longer period; 2) reduces your interest rate risk. When interest rates decrease the cost of annuities increases and vice versa. If you purchase your annuity in one shot and interest rates increase, you’ve lost out to the market (keep in mind the opposite is true). By laddering out purchases, you mitigate this risk (win some, lose some sort of thing). This strategy is uber popular with other investments subject to interest rate risk such as bonds and GICs.
Let’s not forget the tax man
As stressed in many other posts, while most everything in the media touts gross investment return, what actually matters is net return – otherwise known as cash in your pocket. Net return is simply gross return less fees and taxes. Let’s remove fees from this discussion because they are in effect set in stone on signing of the annuity contract and your hands are tied from there. This leaves us with taxes.
The taxation of annuity income payments depends on the nature of the funds that were used to setup the annuity. There are two possibilities: funds in an RRSP and everything else (non-registered investments, TFSAs, cash in a bank account, cash in a mattress, etc.).
If the annuity was setup with funds from an RRSP, each and every dollar of the monthly income is fully taxable. This make sense because when funds are withdrawn from an RRSP directly they are fully taxable.
If the annuity was setup with “everything else” then normally there is a taxable and non-taxable portion of the monthly income. The portion attributable to income earned on the initial lump sum is taxable whereas the portion attributable to the return of the initial lump sum itself is non-taxable. This makes sense because you already paid tax on the initial lump sum so you’re not getting hit up twice.
How the split is determine is beyond the scope of today. More important is recognizing that annuities are not all taxed the same and that financial decisions should be based on after tax-dollars.
A final thought to address the downfall of annuity holders leaving nothing behind to loved ones and charitable causes. Let’s hope most people aren’t living annuity cheque to annuity cheque – in other words that there is something left over at the end of the month. We can put these “left-overs” to work by first investing in a TFSA and baring no contribution room, investing in a taxable account. This will start (or add to) a nest egg that can be left behind or alternatively for an emergency situation.
While annuities are not heavily promoted in the investment world (some wonder whether this is because they don’t offer an ongoing stream of income to advisors as do mutual funds), as I’ve illustrated above, annuities do fit a purpose of many retirees – in particular those without a workplace pension looking for a guaranteed stream of income.
As always I welcome your comments and would be delighted to respond to questions.
The author, Pat Kenney, is a Certified Professional Accountant. He has worked in public practice at a local boutique CPA firm in Mississauga for 9 years. He currently holds a senior management position.by