Annuities

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Contents

Introduction

An annuity is a life insurance contract that provides a regular, usually monthly, income during the life of the purchaser, with the option of payments continuing for the life of the surviving spouse. There is also the option of a guaranteed minimum number of payments, but taking either or both the options would reduce the annuity's regular payment.

A (US-focused) discussion of the basics of annuities can be found on the Bogleheads discussion forum. In US terminology, the type of annuity discussed below is termed a fixed-payout annuity. US variable-payout annuities are not discussed.

How do annuities work?[1]

  1. What is an annuity?
  2. What affects how much income I can get from an annuity?
  3. What choices do I have when I buy an annuity?
  4. What does an annuity cost?
  5. What do I need to know about the risks of an annuity?
  6. Is an annuity a good choice for me?

How do I buy an annuity?[2]

  1. Where can I buy an annuity?
  2. How do I choose an annuity that is right for me?
  3. What steps do I take to buy an annuity?
  4. How can I protect my annuity income from rising prices?
  5. Should I buy an annuity when interest rates are low?

Types of Annuities

Immediate or Life Annuities

Canadians are generally familiar with immediate or life annuities, which provide a fixed payout for life. But they are disappointed with what those payouts are. Payouts are a function of two things: mortality tables and interest rates. As with life insurance policies, the annuities marketed by life insurance companies pool mortality risks, and payout rates are partially determined by actuarial calculations of the probabilities of some people dying before their average life expectancy and some people exceeding their life expectancy.

Interest rates determine payout schedules according to the (relatively) riskless investment policy life insurance companies adopted. While insurance companies dabble in many types of investments, their reserve requirements — the amount of money they have to set aside in safe investments such as government T-bills, for example — limits the capital they can invest.

Immediate or life annuities come in different versions. They can be term-certain, that is, they cease after a certain age. If you die before the end of the term, the payments will go to someone you name as your beneficiary, or to your estate. They can cover a single life, in which case payments cease on the death of the annuitant. They can be joint-life, in which case they stop after the second annuitant has died. They can be guaranteed for 5, 10, 15, 20 ,25 years. If you die before the guarantee period ends, the money goes to your estate. If you live on after the guarantee period, payments will continue until your death. There may also be circumstances in which a return of premiums is offered.

Variable Annuities and GMWBs

Variable annuities, widespread in the U.S. market in which Canadian annuity providers are also active, are probably unfamiliar to most Canadians. The Canadian equivalent, thanks in part to tax differences, is a segregated fund.

Segregated funds are akin to mutual funds. They offer a maturity guarantee of 75% to 100% on the initial investment on the 10th anniversary. They also offer death guarantees of 75% or 100% upon death of the annuitant. Finally, they offer a free pass through probate fees for an estate, and against creditors should a bankruptcy occur. That's because they are, in fact, life insurance policies, or rather, Individual Variable Insurance Contracts, so that the annuitant has no claim on the underlying assets (unlike a mutual fund) but only a claim on the insurance company's assets.

In the U.S., some variable annuities offer a menu of investment options, with some sort of fixed payout that could, potentially, be augmented by positive market gains (hence the term "variable"); in Canada, segregated funds usually track a single investment option.

Still, a number of Canadian lifecos have remodelled segregated funds to mimic American-style variable annuities. These are segregated funds marketed as having a guaranteed minimum withdrawal benefit (GMWB). They are still insurance products sold by an insurance agent, but, in some sense, they act as pension plans.

With a GMWB, an investor might, 15 years before needing the money, buy a policy that promises 5% annual withdrawals on the amount invested. By staying the course each year, with no withdrawals, the annuitant will receive annual bonuses that increase the underlying capital on which the 5% can be withdrawn. And, in favourable markets, the capital underlying the initial investment can be boosted, every three years, by market gains. Market losses are the lifeco's problem.

There is a price for this; the insurance company is offering a risk-transfer deal.

Taxation

RRIFs can be converted to annuities, or remain in existing investments, with no impact on the tax-free compounding within the registered account. Money withdrawn is subject to taxation as income, rather than capital gains or dividends treatment.

Prescribed Annuities

For non-registered accounts, income earned (with after-tax dollars) from an annuity is treated as a blend of ordinary income and return of capital. A prescribed annuity rearranges the taxable events by front-loading the return of capital so that, in the later years of the annuity, most of the annuitant's receipts will be taxable income. This is an example of age arbitrage.

Back-to-Back Annuities

Back-to-back annuities are a part of insurance jargon. The principle is to fund a prescribed annuity and to take the payments from the annuity to buy a life insurance policy. Upon death, the principal behind the annuity will pass on "tax-free" to the heirs. But it's not actually tax-free, since the annuity was paid for in after-tax dollars and lifecos paid premium and perhaps capital taxes; instead, it's a mortality arbitrage, since a healthy person might get a lower premium rate on the life insurance policy versus the general pool of annuity policy holders.

For more discussion on the taxation of annuities, see Annuity Taxation.

When to Annuitize

The retiree or prospective retiree may wish to consider an annuity purchase in the following circumstances: [3]

  • He/she or his/her spouse are relatively healthy and are likely to live longer than average.
  • Maximizing income in retirement is more important than leaving an estate.
  • A guaranteed monthly income stream is wanted regardless of how long you live.

The first two-thirds of How to Completely Avoid Outliving Your Money provides a good introduction to annuities.

Since their purchase is irreversible, always seek professional advice before purchasing an annuity. Many people talk to their life insurance company. Once you know what you want, what is appropriate to your needs, you can also ask an annuity broker or your financial adviser to find the best deal for you. A broker shops around for the best deal for you from different companies.

Current annuity rates for a single male, not guaranteed, non-registered, are listed at Canadian Business. Other annuity rates will generally be lower, and can be accessed from this page.

Insurance

Assuris is the life-insurance company insurance organization. It protects annuity payments in full up to a level of $2000/month for each member insurance company. [4]

References

  1. ↑ Investor Education Fund How do annuities work? Viewed August 17, 2009
  2. ↑ Investor Education Fund How do I buy an annuity? Viewed August 17, 2009
  3. ↑ Financial Planning - Retirement
  4. ↑ Assuris, Individual Payout Annuity, viewed Oct. 13, 2009.
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