The aim of this post is to explain what exactly a pension annuity entails and lay out the upside and downside of ownership. In October’s post, I’ll provide an opinion on the viability of annuities and drill down on a few key characteristics.
In its simplest form (and for purposes of this post), 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.
The cash coming back is guaranteed so long as the insurance company doesn’t go under – which hasn’t happened in Canada in over 20 years (and even then the annuity holders suffered no financial loss).
Annuities can be put in place at any time but normally are done so at, or in the months leading up to retirement.
The use of annuities by the broad public pales in comparison to the traditional retirement investment channels of mutual funds, direct company ownership (stocks), bonds and GICs.
To peak behind the curtain for a moment, keep in mind insurance companies simply take the lump sum payment and invest it in the same traditional channels. If an annuity was a Twix bar it would be the wrapper not the deliciousness inside.
Let’s look at a specific situation to help put in perspective. From the Canadian website, lifeannuities.com, a 65 year old male making a $100,000 lump sum payment inside a registered account (i.e. using funds from his RRSP or work pension) can expect monthly income coming back of about $530. This scenario includes a 10 year guarantee period (i.e. payments continue for ten years even if the annuity holder dies prior to). The longer a guarantee period the lower the monthly income amount of course.
So how does the rate of return from an annuity stack up in comparison to the more traditional mix of mutual funds, stocks and bonds?
To come off a little morbid (which is impossible to avoid talking about this stuff), it all comes down to the annuity holder’s life span. To simplify a little, those living longer than the average life expectancy of the public at-large will earn a higher return than the traditional mix and vice-versa. This is because the longer one hangs around, the longer the monthly income keeps rolling in.
An idea I find useful in helping to demystify annuities is the comparison to a workplace defined benefit (DB) pension (known to many as the “gold-plated” pension). As a refresher for anyone in need, a DB pension pays the retiree a guaranteed fixed monthly amount until death – sound familiar? And we all love our guaranteed DB pensions don’t we?
- The monthly income is guaranteed, so no losing sleep over your retirement savings running out before you do (removes what the financial industry refers to as longevity risk).
- One knows exactly how much is coming in each month and predictable cash flow makes budgeting easier. We can draw a parallel here with the fixed vs. variable mortgage debate –many prefer the predictability of a fixed mortgage payment.
- The sheer simplicity of a guaranteed fixed monthly amount. Retirees need not worry over how the ups and downs of the market are impacting their retirement nest egg, or pouring over investment statements on a regular basis or which investments are best to sell to fund next month’s living expenses. For those in the “set it and forget it” retirement camp, an annuity is right in your wheelhouse.
- The monthly income payments cease on passing and nothing further is received. This is therefore a deal breaker for anyone looking to ensure something is left behind to loved ones, charitable causes etc. A teaser for next month’s advance class post – perhaps an annuity is appropriate only for a portion of retirement savings…
- As an extension of point one, should an annuity holder die shortly after purchase, they will have handed over a pile of cash for next to nothing in return – a raw deal indeed. As mentioned however, for a price (reduced monthly income) adding a guarantee period is an option to mitigate.
- The fixed monthly amount provides no protection against inflation (remember when a Twix bar was $0.50? OK, I’m done with the chocolate bars). Outside of annuities, retirees have the ability to increase their exposure to equities (mutual funds and stocks) which provide inflation protection. Just as the premature death dilemma, this downside can be eliminated or at least mitigated. Most annuities provide an option to index payments to inflation or as a close substitute increase by a percentage point or two annually. This of course comes at a price…you guessed it…lower monthly income.
- Once the lump sum is handed over, it’s gone and gone forever. This can become an issue in the event of an expensive non-insured medical expense or other emergency cash flow need. For balance, one may be able to borrow funds and use the annuity as collateral but even still interest will be charged until the funds are repaid. To broaden the point, while there is simplicity in the fixed monthly amount, a retiree’s need for cash is never consistent month to month. Fixed cash in and variable cash out can at times create headaches.
Keeping with the theme of most other posts, I’ve tried to lay out the basics of a far reaching personal finance topic. Hopefully I’ve left you more informed on a less publicize possible retirement solution.
Stay tuned for the “advanced class” annuity post next month. In the meantime, don’t hesitate to reach out with comments or questions. My insight is entirely academic and it would be great to hear from someone with real world annuity experience!
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