What is Life Annuity?

The following is a guest post from Brian So, financial advisor and blogger at AAFS 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 is an insurance advisor, future CFP and blogger at http://aafsinsurance.com. His areas of expertise include retirement planning, tax savings and insurance advice. If you want to hear his thoughts about the world of personal finance, follow him on Twitter.

Image courtesy of anankkml / FreeDigitalPhotos.net

The Best Way to Buy Annuities for Retirement

Securing your future financially can be an overwhelming task. Although saving is crucial for all of us, it is especially important for those us of getting ready for retirement. Buying an annuity is one way to make the saving process easier.

annuities

The best way to buy annuities is to know as much about them as you can to make an informed decision. Here is what you need to do before buying an annuity for your retirement:

Shop Around

Don’t commit to the first insurance company you contact about buying an annuity. Ask to speak to someone about the type of annuity they could offer you, what it would cost you and its advantages and disadvantages. Let the company know you will be in touch, and gather between three and five quotes from different companies and compare your options.

Compare interest rates, commission fees, surrender charges and other fees that would apply in the event that you need to withdraw from your annuity early or sell your annuity in the future.

In the event that you need to forgo the annuitized payments and you decide to cash in your annuity for a lump-sum payout, each company may penalize you differently. Make sure you know the terms and conditions of each contract and decide which one is the right one for you.

Know How Much You Need for Retirement

Look at your current lifestyle and project what you would need from retirement income. Factor in other sources of retirement income, such as Social Security, to determine what your long-term financial goals are for your annuity.

This will give the insurance company a better idea of what kind of annuity is right for you, and you can make a more informed decision if you know what you expect to invest in a certain amount of time.

Buy From a Reputable Company

Insurance companies that buy and sell annuities are not created equal. A referral from one of your friends may be a good place to start, but what works for your friend may not work for you. Make sure the insurance company you buy your annuity from is highly rated by a financial institution rating agency, such as Standard & Poor’s, Fitch, AM Best or Moody’s.

You can obtain a professional rating by calling the insurance company directly or by visiting a financial institution rating agency’s website.

Know the Terms and Conditions Before You Sign

This shouldn’t be a problem if you buy your annuity from a reputable company, which will go over the contract in detail with you, but it is always good to read the contract in its entirety and ask questions about anything you don’t fully understand. You can even have your contract reviewed by a financial adviser to make sure there are no hidden fees or fine print.

Annuity terms and conditions may vary depending on the insurance company you are working with, but here a few general things you should know:

  • All annuities grow tax-deferred.
  • You cannot withdraw from an annuity before you reach age 59½ without penalty.
  • All annuities provide options during the income phase based on how you want to receive your money.
  • There may be fees involved if you withdraw early or sell your annuity in whole or in part.

Purchasing an annuity should give you some financial relief for your future. To ensure you make the best decision for your retirement, be informed on your decision before you sign on the dotted line.

Kaitlyn Fusco is a content writer for Annuity.org. She combines her interests in writing and overcoming debt to inform the public about issues related to credit, debt, annuity and personal finance.

Getting Started – Asset Allocation

Diversification of assets is one of the major pillars of investing. If and when disaster strikes, you should be in a position to protect your assets. Diversification of assets has been proven to protect people’s portfolios time and again and something that should not be ignored.What do you diversify with?

  • Cash – Emergency funds, savings, GICs etc
  • Equity – an asset allocation of 25%-75% is recommended
    • Canadian equity
    • US equity
    • International (rest of the world) equity
  • Bonds – an asset allocation of 25%-75% is recommended
    • High grade bonds
    • Inflation protected bonds such as TIPS or real return bonds
    • Corporate bonds
  • Commodities – such as gold, oil etc can be a good way to hedge to protect against inflation
  • Real Estate – can be either your own home or via a REIT. Also acts as a great hedge to protect against inflation.

My Asset Allocation

I realize that my current portfolio goes against the recommended value of holding atleast 25% bonds. This is because of the extraordinary times that we are going through, with the bond yields being extremely low. In addition to that, once the interest rates start rising again, the bond funds lose value – so I am expecting some negative returns there. Nevertheless, I hold approximately 11% of my portfolio in bonds. I have increased my holdings in the next best thing to bonds with income producing equity sectors such as utilities and consumer staples.

Another way to looking at the diversification is to look at the geographical diversification – so that I am protected against disasters in one country. For e.g., if I was completely invested in the US market back in 2007-2008, I would have lost a lot more money than I did. With part of my portfolio in Canadian equity and international equity, I was able to protect my assets. My current geographical diversification looks as shown above.

What does your diversification look like? Are you diversified enough?

Disclaimer: The information provided here is for educational purposes only. All opinions here are my personal opinions and should not be taken as financial advice. I am not qualified to be a financial advisor. Always consult with your financial advisor before investing in any of the companies mentioned on this blog.

Getting Started – Where do I go from here

If you have gotten started with some investing and are comfortable with it, you are already on your way to financial freedom 🙂 In the first post of this Getting Started series What to invest in, I covered some basics on the advantages of index funds for people starting out. ETFs are comparatively better than mutual funds, but over the course of years, the fees do add up (click here for my post on fee comparison) and more often than not, you are better off picking quality companies to invest in.

Dividend Growers

There are multiple schools of thoughts on picking the companies to invest in – but my choice is to invest in dividend growing companies. These are generally companies that are mature and stable; have been paying dividends constantly over the years and growing their dividends on year-to-year basis. These companies almost always perform better than the index funds (when you pick the right combination and balance your portfolio with appropriate asset allocation) both in the bull and bear market.

It is important to keep in mind that you want to own these stocks and not rent them – i.e., invest for the long term and stay the course.

Choices

You can get ideas for stock picking by looking up lists such as the following:

Want more ideas for picking dividend stocks? Check out which stocks own by the big name ETFs such as
Disclaimer: The information provided here is for educational purposes only. All opinions here are my personal opinions and should not be taken as financial advice. I am not qualified to be a financial advisor. Always consult with your financial advisor before investing in any of the companies mentioned on this blog.

Getting Started – When to invest

The short answer is “Now”. A more careful detailed look at this would sound more to the tune of “Depends…”.
There have been countless studies and you can find various examples on the internet of how your nest egg can grow by a substantial amount depending on how many years you save. The bottom-line for every single calculator is Start Early. Your returns compound over the years and have a snowballing effect. As a simple example:

Lets say you invest $5,000 every year and manage to get a 8% return on your investments. If you start at the age of 25, you end up with $615,580 at the age of 60. If you start at the age of 35 instead, you end up with $431,754 at the age of 60. That amounts to a whopping $183,826.

That being said, here are a few considerations to keep in mind:

  1. Rank and pay down the high interest debt: It is highly unlikely you will be able to invest and get better returns than the interest rates charged by the credit card companies, which are normally at 18-20%. So, first things first – get rid of your bad debt.
  2. Analyze & Re-Analyze Goals: Each person’s investment goals are different. You need to analyze and annually re-analyze your goals to make sure your savings, debt payments (mortgage, car loan etc) and investments are matching your goals.
  3. Save consistently: Consistent monthly savings (using automatic transfer programs) is an important part of investing. Most people who say “I will to save and transfer whatever is left at the end of the month” seldom have a healthy financial future. The old adage of ‘Pay yourself first‘ is popular for a reason. If you treat your savings like a bill payment, where you periodically and automatically save, you can build on your nest egg.
  4. Invest consistently: It is a fools game to try and time the stock market. Consistently investing by finding the best available value at the time almost always provides better results. If you feel that one method of investing suits your needs and you are happy with the risk vs. reward balance, stick to it. If you ever feel the need to gamble and have some extra money, open a new account for it without taking anything out of your retirement fund.
< Getting Started

Disclaimer: The information provided here is for educational purposes only. All opinions here are my personal opinions and should not be taken as financial advice. I am not qualified to be a financial advisor. Always consult with your financial advisor before investing in any of the companies mentioned on this blog.