A life annuity? What is its role in pension income planning? The aim of this post is to explain what exactly a life annuity entails and lay out some pros and cons to ownership. I’ll close with a few key considerations should ownership pique an interest.
In its simplest form, a life annuity (annuity from here forward) 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 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, keep in mind insurance companies simply take the lump sum payment and invest it in those same traditional channels. To draw an analogy using your favourite chocolate bar, the annuity would simply be the wrapper, and the underlying investments in the annuity (selected by the insurance company) would be the fun stuff inside.
Let’s look at a specific situation to help put it 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 workplace pension) can expect a monthly income 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.
An idea I find useful in demystifying annuities is the comparison to a workplace defined benefit (DB) pension – thought of by many as the “gold-plated” pension. As a refresher, a DB pension pays a retiree a guaranteed fixed monthly income until death…sound familiar?
The upside of an Annuity
- Monthly income is guaranteed. No losing sleep over retirement savings running out before you do. As life expectancies continue to rise, this longevity risk becomes more prevalent.
- Cash flow is predictable. One knows exactly how much is coming in each month making budgeting easier. We can draw a parallel here with the fixed vs. variable mortgage debate –many prefer the predictability of a fixed mortgage payment.
- Simplicity in guaranteed fixed monthly income. Retirees need not worry over how the ups and downs of the stock 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 may be right in your wheelhouse.
The downside of an Annuity
- Monthly income payments cease on passing. 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. This is deal breaker for anyone looking to ensure something is left behind to loved ones, charitable causes, etc. As mentioned however, for a price (reduced monthly income) adding a guarantee period is an option to mitigate.
- Fixed monthly income provides no inflation protection. Outside of annuities, retirees have the ability to increase their exposure to equities (mutual funds and stocks) which over longer periods 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 for good. 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.
Other considerations before jumping in an Annuity
- 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 in, the longer the monthly income keeps rolling in.
- To address the downside of an annuity leaving nothing after one’s passing, a possible solution is to allocate only a portion of retirement savings into an annuity. Two options I find intuitive:
- Convert enough savings into an annuity such that monthly income equals monthly fixed costs (housing, insurance, utilities, vehicle etc.), this provides comfort in that no matter one’s circumstances, the basics are always covered.
- 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.
- Annuities are less attractive for those with a DB pension as their longevity risk is much lower and often remote.
- Annuities are even less attractive for those with no 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.
Is it time to re-evaluate your retirement income strategy? parker simone and our network of expert financial planners assist clients with all aspects of retirement planning.
Pat, CPA, CA, is a senior manager with parker simone LLP and a ten year veteran of the public accounting space. He is a self-described student of all things business, accounting, taxation, personal finance and current events (thank you Steve Paikin and John Moore). Pat’s interest in sports and local organized runs was the driving force behind his existing stance as a fitness and wellness enthusiast at-large. Pat is active in community based volunteer work focused on financial literacy and societal integration of new immigrants.
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