Know what you're getting into
I am often asked to discuss annuities, so today I want to delve a little deeper into this strategy, often used to create a lifelong income in retirement. Life annuities are designed for clients who have insufficient savings and/or a very low risk tolerance to investing in the market. There are four main types of annuities: straight life, joint life, term-certain and deferred. We will discuss each one plus some of the added features you can opt for.
Straight life annuities are the simplest. This annuity guarantees a periodic income for life with payments starting immediately minus a premium. Be careful with this. It does pay the highest amount for life, but when you die the payments stop and there isn’t a payout to the estate. The benefit is that if you live longer than your life expectancy, you will benefit from the funds left in the pool by those who died earlier.
One thing I am not a fan of with this product is that the payments are fixed over time and do not compensate for inflation. Because of this, you can add an income protection option called an increasing life annuity. The plan will then increase by a defined pre-set percentage each year.
You can also choose an indexed annuity (often less expensive), which will increase the payments each year in line with inflation (measured only by the Canadian Consumer Price Index).
Joint life annuities last as long as either partner is alive. There are a couple of options with them. You can buy an income-reducing annuity, which is less costly, whereby the payment from the joint annuity declines when the first spouse dies. There is also an option to guarantee the payout of the premium if you choose a cash payment provision. When the annuitant dies, the difference between the premium and the payout can then be paid to the beneficiaries.
Term-certain annuities are usually the one I prefer. With them, payments are made for a specific period whether or not the annuitant dies. If you are using funds from your RRSP/RRIF in a term-certain annuity, payments usually only last until age 90. You can manipulate your term from three to 40 years and most are highly flexible. A cashable option is only available with this type of annuity since the convertible value can be easily calculated at any time. If needed, you could cash in your plan in the event of an emergency.
The last type of annuity is a deferred annuity and often purchased long before the income from the product is required in retirement. Clients can take advantage of a slightly higher rate of interest by purchasing the annuity years earlier than required. You will be encouraged to pay a higher premium during the deferral period, allowing interest to accumulate in the product and therefore increasing the overall value at the agreed-upon conversion date when it switches to a paying annuity.
With this product, it’s best to opt for a return of premium guarantee in the event that you die prematurely before the payments start. Remember: interest earned during the accumulation phase is taxable, so it is best to fund this product with your registered investments.
All annuities are insurance products and vary widely based on the provider. Some insurance companies offer variable pay annuities that can be linked in part to the return of a specified stock market index. These plans offer something for everyone. Clients can choose an index tailored to specific profiles, such as conservative, moderate, growth or aggressive. Depending on the insurance provider, you may even be able to choose a combination of indexes with variable payments. Basically, a person chooses an annuity product because they don’t want to be concerned with the ups and downs of the stock market, and they want a “set-it and leave-it” strategy with a guaranteed monthly income for life.
Before you run out to purchase an annuity, here are the disadvantages. Most annuities cannot be cashed or altered after income payments have commenced. Payments often cannot be adjusted to reflect changing needs, and the funds cannot be accessed in an emergency. Remember, you are giving up ownership of your investments and control of your capital to the annuity. It cannot be used as a loan guarantee or reassigned. Annuities help diversify a retirement portfolio, but it’s a good idea to use them with other investments that offer more flexibility, such as RRIFS and TFSAS.