What is Life Annuity?

The following is a guest post from Brian So from Brian So Insurance

When asked about their plan for their RRSP at the end of the year in which they reach age 71, most people’s response would be to simply transfer their assets into a RRIF. But did you know there is another option? An option that provides guaranteed income for life and removes all investment risk? I am talking of course about life annuities. This post will explain the basics of life annuities to help you decide if they fit into your portfolio.

Life Annuity Basics

You can think of a life annuity as the opposite of a life insurance policy. With life insurance, you pay a premium every year and in return, the insurance company pays your beneficiary a lump sum amount when you pass away. With a life annuity contract, you give a lump sum amount to the insurance company, which promises to pay you an annual income until you pass away. The longer you live, the more money you’ll receive. If your family has a history of long life and you’re in good health, you’ll benefit from more payments than someone who isn’t blessed with longevity.

The amount of income you receive is based on several factors, including the lump sum amount deposited, interest rate, your age and sex. A younger person is expected to live longer than an older individual and females also have longer life expectancies than their male counterparts. What this means is that a young woman will receive a lower income than an older man, since they are expected to collect payments for a longer time period.

Annuity payouts are also based on the prevailing interest rate. The higher the interest rate, the higher the payment and vice versa. This may be a turnoff to most dividend investors given that the yields of long-term risk-free fixed income assets pale in comparison to many dividend stocks. But in exchange for a lower return, annuities provide income that is guaranteed for life while also eliminating investment risk. And the amount of income generated by an annuity isn’t something to scoff at either. For a $100,000 lump sum amount, Sun Life is currently paying $6,497 annually on a straight life annuity for a 65 year old male. Not bad considering an equivalent amount deposited into a 5 year GIC currently only pay $2,000 annually.

Taxation of Annuities

An annuity purchased with registered money pays out income that is fully taxable, like any other type of withdrawal from a RRSP or RRIF. Taxation of non-registered annuities is treated differently. It’s important to understand that payments are comprised of interest and return of capital. Interest is fully taxable while return of capital is received tax-free. When you purchase a non-registered annuity, you have a choice between reporting tax with the prescribed or non-prescribed method. With a prescribed annuity, the interest component remains level throughout the life of the contract. But a non-prescribed annuity begins with a higher proportion of interest, which gradually lowers over time.

Using the example above, the amount of interest reported via the prescribed method is $682, which remains level for the life of the contract. The amount of interest reported using the non-prescribed method is just under $3,500 in the first year, and gradually decreases over time.

How to further lower your risk

Some people avoid annuities because they think that payments stop immediately after death and are worried that they will ‘lose’ to the insurance company if they pass away soon after purchasing it. While this is true with a straight life annuity, a guarantee period can be chosen to reduce the risk. For example, with a guarantee period of ten years, payments must be made to you or your beneficiary for at least ten years. If you pass away before the expiry of the guarantee, the income stream will continue to your beneficiary until the guarantee period ends.

Another way to ensure income continues after your death is to purchase a joint life annuity as a couple. This allows for payments to continue to the surviving spouse at a reduced rate. Both of these methods transfer risk from the annuitant to the insurance company. As a result of the guarantees, the insurance company will reduce the amount of income paid out compared to a straight life annuity.

Drawbacks of life annuities

Since this is an investing blog, I should discuss some of the risks involved with owning a life annuity. Like other fixed income investments, annuities are not immune to inflation risk. With a planned retirement time frame of 25-30 years for most people, receiving steady but unchanging income means your purchasing power will gradually diminish over time. This can be offset by purchasing an annuity with an indexing option, but in return your initial income will decrease dramatically.

Another disadvantage is the loss of control over your money. Once you give the insurance company your money, there’s no way to withdraw the entire amount. All you’re entitled to is the regular stream of income. If an investment opportunity or emergency comes up, you’re out of luck. This is another reason why diversification is key and you shouldn’t put your entire retirement savings in an annuity.

In summary, although they are not considered fixed income, annuities display the similar feature of smoothing out your portfolio’s overall performance. As you enter the drawdown phase of life, you can consider annuities as an investment alternative capable of balancing your portfolio.

Brian So, CFP, CHS, is an insurance broker and blogger at briansoinsurance.com. Follow him on Twitter for his musings on life insurance and why the Vancouver Canucks will win the Stanley Cup next season (Seriously).

Image courtesy of anankkml / FreeDigitalPhotos.net

6 thoughts on “What is Life Annuity?

  1. Great info especially retirees. If one is unable to manage their finances or their mental ability lowers with aging an annuity is a great option. Helps self budget yourself and also a layer of protection against people defrauding seniors.

    • It is, A-G. I am unfamiliar with annuities and havent really looked into them closely. Hence the guest post from Brian on some of the basics of annuities for people to consider as a an option.

      regards

    • Thanks for the comment A-G. It does make sense for seniors with cognitive impairments to take all investment decisions out of their hands with an annuity.

      Before this step though, they should make sure they have power of attorneys for property and personal care so that a trusted family member can handle their finances for them in case they become unable to do it themselves.

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