Do you have pension envy? Are you one of those people who secretly or not-so-secretly covet a gold-plated defined benefit pension plan that promises a stable income for life, no matter how long you live or how poorly the stock markets perform? If so, funds permitting, you can take matters into your own hands and create one for yourself by purchasing a life annuity. Even better, unlike some pensions that only provide you with limited choices, a life annuity provides you with far more options on the features and guarantees that go with it so that you get the best fit for your situation. Even better, even inside most registered plan, you are not required to spend every last dollar on an annuity. As a result, you’re not stuck committing more of your retirement dollars towards monthly annuity cheques than makes sense, which means getting to keep the surplus invested for rainy days and emergencies. Sound enticing? Read on.
There are actually a surprising number of different types of annuities out there, such as those that are a lot like GICs, those whose payouts are influenced by stock market returns and some pay out only to a set date, whether or not you last that long or long past that date in time. I want to spend my time today talking the type of annuity that most resembles a defined benefit pension plan: a “life annuity.” Like a pension, it lasts as long as you do. Also like better pensions, payouts can be structured so payments continue until the last of you and your spouse passes on. If buying a life annuity, you may purchase one using either non-registered funds or money inside a registered account, such as inside an RRSP, RRIF, locked-in RRSP, or Life Income Fund.
In a nutshell, a life annuity is a life insurance product that you pay for with a single rather large cash payment from non-registered funds (such as from an insurance death benefit or perhaps your GIC portfolio) or those previously mentioned registered funds. In exchange, the benevolent folks at the insurance companies pay you a set amount each payment (usually monthly or yearly) for life. Unless you purchase inflation indexing (which you probably won’t if using non-registered cash for tax reasons I’ll explain later), your payment will stay fixed for life if you’re the only life insured under the annuity.
On the other hand, you can purchase annuities that pay out so long as either you or someone (usually your spouse) lives rather than just payments on your own lifespan. If you purchase such a “joint life annuity”, you might agree to a reduction in payments when one of you dies in order to boost how much you get while you’re both above ground. After such a reduction, unless you’ve purchased indexing, the survivor’s payments will then remain constant until he or she joins you in the grave.
How much you can receive each payment depends on your age, gender and which bells and whistles you add onto your annuity contract. In some ways, an annuity contract is the opposite of a life insurance policy: you get paid during life rather than death, the older you are, the better the rates, guys get preferred rates and you’re not required to provide any medical evidence in order to qualify. The only exception is if you are in less than optimal health at the time of applying and want higher payments as a result. In that case, proof of poor health will be essential. Contrast this to life insurance, where your poor health either means paying through the nose or not qualifying for coverage in the first place!
Circling back to basics, I often describe life annuities as a cross between a mortgage and a bet. Like a mortgage, you “loan” your money to the insurer and they repay it over time. Moreover, both annuities and fixed-rate mortgages determine payments based on expectations of future interest rates. On the other hand, mortgages generally focus on much shorter time frames, while annuity rates need to take into account both 5 year and longer term rates, since that’s the time period that covers the period of this “loan.”
Unlike most mortgages however, whose due date can be circled on a calendar the day of signing, it’s usually impossible to know the exact date when the last payment from an annuity comes due unless someone has plans involving rat poison. That’s where the bet component comes in; you’re betting that you’ll live to a ripe old age and while the insurance company is secretly hoping that you’re not as healthy as you believe, as the final payment (subject to those bells and whistles that I’ll talk about shortly) is determined by your or your spouse’s death. Since insurance companies make these sort of bets with many, many clients, they can play the averages, like a casino, and set rates in their favour so that they’ll probably make money in the long run even if they lose a few bets along the way, such as in the case of my grandfather who passed away at 101 after annuitizing a large chunk of money in the 80’s when interest rates were in the stratosphere.
- Minimum Guarantee Periods
I compared life annuities in part to betting. Let’s extend the analogy further. Like gambling, life annuities allow you to hedge your bets. Rather than taking the chance that an investment of potentially hundreds of thousands of dollars generates only a few small cheques if you don’t last out the hockey season, you can purchase a guarantee that the insurer will pay out for a minimum timeframe, even if you’re not around to get paid. Common guarantee periods are 5, 10, 15 and 20 years. Putting concepts into numbers, if you died in year 3 of a pension with a 10 year guarantee, your chosen beneficiaries would get 7 years’ worth of payment (although they are usually converted to their current value and paid out immediately). If you’re really worried about losing money to the insurers, some people like to crunch the numbers to determine how many years of guaranteed payments equals your original investment (although this calculation doesn’t usually take into account tax consequences) and purchase the corresponding guarantee.
Of course, as the saying goes, there is no free lunch. You pay for guarantee periods by accepting a smaller payment now. Moreover, as you’d expect, longer guarantee periods, particularly when you’re no spring chicken at purchase, can significantly reduce your current payout. All the same, it is usually a good idea to at least look into the cost of purchasing a guarantee period in most cases. Strangely enough, an annuity with a 5 year guarantee may even be cheaper for some age brackets than the same product without any such protection because this option is the most popular, which means that the insurance companies are more willing to compete on price to get your business. Along those lines, do shop around if you purchasing an annuity; like mortgage rates, there are often some deals to be had if you look hard enough.
- Joint Life Annuities
There is another way of hedging your bet and that’s by owning them jointly with your partner. Thus, rather than picking a set guarantee period and hoping the your spouse doesn’t outlive it, you can eliminate the guesswork and ensure that s/he will still receive payments for life no matter how long it’s been since you’ve played your last round of golf. The pricing on this option will take into account your spouse’s age and gender, as the insurers are now covering both of your lives. This means that this can be expensive protection if your spouse is significantly younger than you, particularly if your partner is a “she.”
In order to strike a balance between funding current needs and ensuring that the survivior isn’t left destitute if she lives to 100, some couples do select the joint life option but agree to a reduction in the size of payments at either the purchaser’s death if he dies first or at the first spouse’s death. For example, if you purchased a 60% joint and last survivor prescribed annuity that paid $2,500 per month while you both share a golf cart, your spouse would get $1,500 when driving alone.
If debating between single life annuities with guarantee periods and joint life products, get ready for a lot of number crunching. I’m often in favour of couples purchasing joint life annuities if the cash flow lets them live the life they desire with a substantial margin for error, and enough other assets to protect against inflation. Of course, each situation differs, so it’s important to look at the specific facts in play rather than merely relying on general rules of thumb. Admittedly, one of the biggest risks of a joint life annuity is both partners dying shortly after payments start, which means your heirs lose out. If you’ve not particularly worried about this, if you have other assets they’ll get instead or if you have life insurance in place to cover this contingency, then this won’t matter to you. If it does, then you may have to go back to crunching numbers or even investigating if you can get a minimum guarantee period on a joint life annuity (or buying multiple annuities with different features and guarantees).
- Inflation Indexing
Not only do the best pensions pay their members huge payments each month, they often also go up with inflation (or, at least they have so far). Fortunately, you can theoretically get this benefit as well if you’re willing to spend more or to accept a smaller cheque in the early years.
Unfortunately, things don’t always work out as well in the real world as they do in theory and this is one such scenario. Although full inflation protect or cost of living adjustments (“COLA”) sound incredible, it is hard to find companies that provide full COLA protection and, even if you do, the cost is usually a deal breaker. Instead, most people purchase a set increase per year generally ranging from 1 to 4% while both hoping that actual inflation is less than that or relying on other funds to cover the increased cost of Corn Flakes and Raison Bran.
In addition, there is a second reason why most pensions purchased with non-registered money don’t have any inflation indexing, and this is entirely tax-related. If you’re willing to forgo indexing, the government essentially allows you to defer paying a bunch of the taxes that would otherwise be due in the early years of your annuity. If you took indexing instead, like a mortgage, the first several years of your annuity would see most of your cheques taxed like interest and with only a small portion usually classified as principle payments. Accordingly, if you’re looking for inflation indexing, you may want to look inside your RRSP or RRIF unless you’re okay with most of your income being taxed in the early years even though it was purchased with after-tax dollars.
- Taxation of Annuities
As you’d expect, the conversation about how annuities owned with registered plans (other than a TFSA) is short and sweet: you’re taxed on the full amount of each payment just like you would on any other withdrawal. Moreover, the money qualifies for the pension income credit if the recipient is over 65 and for the same income-splitting rules that apply to RRIFs.
As for annuities owned in an open account, the conversation is not nearly so short although it still may be infused with a dash of sugar. To begin, I am going to ignore the special status for some annuities issued before either January of 1990 or December 2, 1982 and only talk about the rules that apply to products purchased after those dates. When looking at the tax consequences of one of these newer annuities, it boils down to one question: does your annuity qualifies for “prescribed” status. If it does (and most people set up their annuities so that this is the case), you’re in the middle of a good news story. If not, you may be in for some rather large tax bills in the early years of payments, which might mean that your story starts out with a touch of tragedy.
What is a prescribed annuity you may wonder? It is a personally owned annuity on either your own life or also on the life of your spouse or a sibling that doesn’t have a guarantee period extending past the younger person’s 91st birthday. As well, it can’t provide indexing in any form. In exchange, the government uses mortality tables to estimate how long you’re going to live and, as a result how much you will ultimately receive before you die. It then determines how much of this money exceeds the amount you paid for the annuity and averages how much of this profit or interest you’ll receive over the life of the annuity. When the dust settles, you not only get a cheque of the same size from your insurer every payment; you also get identical tax slips each year breaking down the portion of that year’s payments that are interest and return of principle. From a tax planning perspective, this is a wonderful thing. You get to defer a lot of the tax that would have otherwise be due in the early years of your annuity (as I will explain shortly). As well, by leveling out the tax hit over the life or your annuity rather than compressing most of it in the early years, there is hopefully a better chance that you’ll be able to stay clear of the higher tax brackets.
Do you have your heart set on indexing? Want to own an annuity inside your company rather than personally? If so, if you buy with non-registered funds, your tax bill on payments over time will resemble the blend of interest and principle associated with mortgage payments. The government will still use its preset mortality tables to estimate your lifespan and how much interest you’ll actually receive over time, but most of it will taxed early on before you’re been repaid much of your principle. On the bright side, even if you don’t purchase indexing, you’ll get this benefit indirectly, as more of each year’s payments will be tax-free over time until (if you live long enough), the entire cheque is yours to keep.
- Annuities Within RRIFs
Most RRSP owners know that they will eventually have to face a day of reckoning: unless they take action before the end of the year that they 71, they will be taxed on the entire value of the account at that time. For most of us, we avoid this humungous and premature tax bill by converting to a RRIF, withdrawing at least the minimum required amount each subsequent year and paying any applicable income tax on it as we go.
Although it isn’t discussed particularly frequently, there is another choice: converting all or some of the RRSP to either a life annuity based on your or both your and your spouse’s lives or something called a “term certain annuity” that I’ll put off discussing until another day. Before explaining why or why not you annuitize part of this nest egg, I’ll reiterate a point from the previous paragraph that deserves extra attention. Whether you buy an annuity or RRIF isn’t an either / or decision; it’s possible to hedge your bets by annuitizing only some of your RRSP and rolling the rest into a RRIF.
Moreover, even after you RRIF, your decision need not be carved in stone, as you can always buy another annuity or two along the way within your RRIF if the mood strikes. Interestingly (at least to me and perhaps 4 or 5 other people with similar personality disorders), until relatively recently, if you converted or “commuted” a pension into locked-in investment account, you actually had to purchase an annuity with the remaining balance before turning 80. While this requirement no longer applies in the Canadian jurisdiction I’ve previously researched (which is a welcome change as sometimes annuities aren’t the answer), you still may wish to do so anyway.
Annuity Strategies, Tips and Thoughts
If I’ve got your attention so far, here are a few ideas to consider if you want a life annuity to call your own:
- Some people use annuities as a replacement for some or all of their fixed income portfolio so that they have equities of some type to provide for future growth, inflation and emergencies;
- As a variation on the above theme, some people purchase a large enough annuity to fund their fixed expenses, again with other funds invested in the background for discretionary purposes;
- For most of us, it generally doesn’t make sense to look at a life annuity until we’re in our 60’s due to cost concerns. If you have annuities on your radar but are still a few years away, it’s likely time to start changing the allocation of the portion you’ll likely spend to a conservative allocation now so that a market correction doesn’t later scuttle your plans at the last minute.
- Since annuity payouts are based on a blend of the insurer’s expected costs, mortality assumptions and the expected investment yield of the money you’d pay your insurer now over your expected lifetime, short-term interest rates are only a small part of the story. Accordingly, don’t let current rates talk you out of doing your due diligence. One of my big fears are clients waiting for rates to rise only to watch their portfolios fall during the interim.
- Two of the major buzzwords these days in financial planning circles are “reverse dollar cost averaging,” followed closely by “longevity risk.” Life annuities guard against both of these dread conditions. The first term suggests that if you’re forced to start liquidating savings when the market is down to pay for your retirement lifestyle, the effects continue to multiply going forward to further reduce your retirement dollars. The second expression is just a fancy way of saying that if we live longer than expected we might outlive our money. In any event, a life annuity protects against subsequent market collapses and ensures that you’ll still get paid even if you eventually need 3 digits to express your age.
- Retirement income projections are, at their most, best guesses. Moreover, most returns assume a fixed rate of return, such as 5%, each year, which is extremely unlikely. Even scarier, even if your average rate lives up to your hopes, you could still be in trouble if the inevitable down years are early in your retirement. If that happens, you still may get an average rate of return of 5% but if the up years are after your portfolio already took a few good hits, after which you needed to sell off in order to meet current expenses, it won’t be a good news story.
- Ever heard of Monte Carlo simulations? They “stress test” your portfolio by randomly changing the rates of return around some variables you provide, such as by how much might things change per year and what is the average rate of return. A computer will crunch the numbers 100, 1,000 or 10,000 times and tell you how often you achieved your income goals. There is a school of thought (check out a guy called Jim Otar) that suggests that if your portfolio can’t get you to the promised land with very little chance of things going wrong, then you need to annuitize your income (perhaps in stages) in order to guarantee that you’ll never run out of cash. Sure, the market might outperform if the stars align, but can you afford to take that risk?
- Worried about your insurance company going belly up, even though they are closely supervised and regulated by the government? If so, investigate Assuris, which is an industry-funded not-for-profit organization designed to step in if your insurer falls down. They guarantee the higher of $2,000 per month or 85% of the promised payout. Accordingly, in order to get full protection if you want to purchase a larger cheque each month, consider buying a series of smaller annuities of $2,000 or less from different companies.
- Although annuities tackle longevity risk and reverse dollar cost averaging head on, there are trade-offs, such as inflation risk and liquidity problems. As discussed earlier, most people with non-registered annuities probably don’t have any indexing and people funding out of their registered plans can usually only obtain or afford to pay for a predetermined bump up each year. If there are periods of high inflation, not only does that quickly erode your purchasing power but, unless deflation follows, your annuities won’t catch up. According, for both these reasons, I recommend keeping some of your money in other investments, particularly your TFSA.
- The government mortality tables used to figure out your tax bill if you buy outside of a registered plans are significantly out-of-date and assume that the average Canuck is going to die years earlier than current stats suggest. This is a wonderful thing, since this means that the government underestimates both the average payout from a life annuity and, as a result, the appropriate tax bill. For example, if you are a male buying an annuity in your late 70’s with no guarantees, don’t be surprised if all or almost all of your annuity cheques are tax-free! This is because the government tables assume that you’re already dead and, thus, won’t be around to collect any income on this investment. Unfortunately, all good things must end and these tables are going to be updated in 2016. As a saving grace, any annuities already in place before that time, including those purchased between now and then, will get to use the old rates. Accordingly, if you’re serious about annuities, it’s probably time to start doing your homework before the rules change.
- Worried about leaving behind an estate for those left behind? Purchasing guarantee periods is one option but the insurance industry has another approach called “an insured” or a “back to back” annuity. This works particularly well if you’re in your late 60’s onward, are a relatively conservative investor in a higher tax bracket and are essentially living off the income rather than drawing down principle. This technique involves purchasing both a prescribed life annuity with no guarantees and a permanent life insurance policy equal to the cost of the annuity (although this need not be the case). Essentially, the life policy takes the place of the guarantees. Of course, you also need to be healthy enough to qualify for insurance at standard rates. Some people get around their concern of no longer being healthy enough to purchase insurance when they’re finally ready to annuitize by purchasing the insurance component a few years in advance while most of their major organs are still fully functional.
In any event, the interesting thing is that even after paying the life insurance premiums out of your non-registered annuity cheques, you generally get a rate of return that is substantially higher than generally available for conservative investments. Moreover, depending on your age when buying the annuity, you may be able to get more of your income tax-free compared to sinking your money into GICs or other interest-paying investments. I suspect at some point I’ll get around to putting together a few examples, although this will be the subject of a subsequent article.
- Worried about Will challenges, probate and similar headaches? Both life annuities and insurance policies allow you to name beneficiaries directly on these products so they can pass outside the estate. Moreover, if you name a qualifying family member as the beneficiary of your insurance, then you may also get creditor protection during your lifetime assuming that you’ve owned the policy for at least one year (although more than five is even better) before trouble starts brewing.
I love to use sports analogies when describing financial planning. My favourite is, “Why pull your goalie when you’re up 3 in the third period?” In other words, if you are on track for your retirement goals, why take unnecessary chances in pursuit of extra money that you don’t really need? That’s why I think that annuities are always a topic that merits discussion when reviewing retirement plans. Maybe they will fit into your retirement picture or maybe not but, if nothing else, I do think they’re worth a second glance. Studies suggest that people with pensions have happier retirements, presumably because they don’t have to worry so much when they read the financial news in the morning. Perhaps, armed with a life annuity, you too can join this happy throng.