Annuity

An annuity is a financial product that provides you with a guaranteed regular income. Typically, it is used during your retirement years and sold by an annuity provider, such as a life insurance company. They help individuals address the risk of outliving their savings. Upon annuitization, the holding institution will issue a stream of payments at a later point in time. Annuities were designed to be a reliable means of securing steady cash flow for an individual during their retirement years and to alleviate fears of longevity risk of outliving one's assets.

Annuities are generally purchased as a lump sum payment or through multiple payments over a time period. Annuities 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.

The received income payments are a combination of interest earned, a return of capital and a transfer of capital from annuity holders who die earlier than statistically expected to those who live longer than expected.

The typical use of annuities is to provide retirement income. Given a certain amount accumulated for retirement, when it is time to generate income, you can either manage it yourself, for example in a Registered Retirement Income Fund ((RRIF), buy an annuity, or do a combination of both (known as partial annuitization).

Annuity basics

 * Annuities are purchased from insurance life companies
 * You pay a lump sum, which is typically transferred from a RRSP, RRIF, or a non-registered account
 * The money is returned to you, with interest, in regular payments
 * You can choose to receive payments for a set number of years or for the rest of your life
 * You can receive monthly, quarterly, semi-annual or annual payments
 * For a given lump sum, annuity income depends on current interest rates, your age, your gender, and any guarantees or options

Important changes
On January 1, 2020, new tax rules related to advanced life deferred annuities came into effect. These include a new maximum age at which an annuitant can defer payments and a new amount limit.

Immediate or life annuities
Canadians are generally familiar with immediate or life annuities, which provide a fixed payout for life. 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 invest in many types of investment vehicles, 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:

Life annuities come in two different forms, single or joint. Single Life annuities pay a periodic income as long as the sole annuitant is alive. Joint Life annuities pay a periodic income as long as one of the two joint annuitants is alive. Annuities can be purchased with registered funds from individual RRSPs, locked-in RRSPs, Pension Plans or Deferred Profit Sharing Plans. Annuities can also be purchased with "after-tax" or "non-registered" funds.

A single premium immediate annuity (SPIA) is like life insurance in reverse. The purchaser provides a lump sum of money to an insurance company which in turn guarantees a regular periodic payment. These periodic payments are made monthly, quarterly, semi-annually or annually. The payments usually cease upon death of the owner.

The similarity to life insurance in reverse continues when we consider that male life insurance rates are higher than female life insurance rates for persons of the same age because mortality tables show that females on an average live longer than males. When the same male and female of the same age purchase individual life annuities, the male will receive a higher periodic payment than the female because the male's life expectancy is shorter. The best life insurance rates are based on good health of the applicants, while poor health raises the likelihood of increased life annuity payments because of shortened life expectancy. If you have a health concern, make certain that you reveal it when investigating annuity payouts.

Some of the benefits of being male or female are lost when locked-in pension funds are used to purchase a life annuity because it is mandatory that unisex rates be used to calculate periodic payments.

Single or Joint Life annuities may include a guarantee period which ensures that the periodic income continues for a specified minimum length of time or number of payments whether or not the annuitant(s) is/are alive. Thereafter, payments continue as long as the Single Life annuitant, or one of the Joint Life annuitants, is alive. If the annuitant (Single) or both annuitants (Joint) die prior to the expiration of the guarantee period, the remaining guaranteed periodic payments may be paid as scheduled or as a lump sum (that is, payment is commuted).

Joint Life annuities may be sold as Reducing or Non-Reducing. A reducing annuity would see the surviving annuitant receive a reduced periodic income in the event of the designated primary annuitant's death or the first death. In the case of a Joint Life Reducing Annuity with a guarantee period, the reduction in periodic income would occur only after the death of one of the joint annuitants and the expiration of the guarantee period. (The guarantee period guarantees the number and amount of the payments.)

Single or Joint Annuities are described as being Deferred if payments commence on a date which is more than one payment period after the purchase date. If an annuitant or annuitants dies prior to the first periodic income payment, the premium may be refunded at a specific rate of interest or with no interest.

Annuities purchased with non-registered funds are described as being either Prescribed or Non-Prescribed. Prescribed annuities generally qualify for a more favourable income tax treatment than do non-prescribed annuities. The income from an annuity purchased with non-registered funds is the same for both prescribed and non-prescribed status. It is the tax treatment of the income that is different.

Term certain or fixed term annuities
These annuities annuities pay a periodic income for a specific predetermined length of time or number of payments. If you die before the end of the term, the payments will go to someone you name as your beneficiary, or to your estate.

Term-certain annuities bought with money from an RRSP or RRIF must extend to age 90.

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.

Deferred annuities
With a deferred annuity, you pay a lump sum today and get a stream of regular monthly payments in the future, starting after a specified delay. One purpose of this product is longevity insurance. For example, you could set up a ladder of bonds (nominal or real return bonds) to cover retirement income needs for the first 20 years, and use a deferred annuity to provide income afterwards. This strategy avoids the loss of liquidity associated with immediate annuities, yet covers the longevity risk. In U.S. examples provided in the linked journal articles, the proportion of capital used to buy the deferred annuity is about 10%, and the rest goes into the bond ladder.

Advanced-life deferred annuities (ALDAs) were previously problematic in Canada because of the tax treatment. However, the 2019 federal budget amended the tax rules to allow them starting January 2020. If insurance companies decide to offer them, they will be purchased using plans such as RRSPs and RRIFs, with a limit of 25% of the plan value or $150k; payments will have to start no later than the end of the year when the annuitant attains an age of 85.

Benefits of annuitization

 * Sustained income for life
 * Protection against longevity risk, investment risk, and inflation risk (if the annuity is inflation-protected)
 * Benefit from mortality risk pooling, if the annuitant lives long
 * Stable income facilitates financial planning
 * In the case of partial annuitization, the retiree can worry less about the performance of the remaining portfolio
 * Peace of mind: "no need to take further investment decisions about the money you’ve deposited"

Drawbacks of annuitization

 * Loss of liquidity (the decision is not reversible)
 * Loss of bequest (except if the annuitant dies within a guarantee period)
 * Income needs may vary over time, including unforeseen expenses
 * Not favored for people with short life expectancies
 * The market for inflation indexed annuities is "nearly nonexistent in Canada"

Other reasons for the lack of popularity

 * Behavioral biases including decision framing, mental accounting, regret aversion, and misinformation
 * Financial advisors paid a percentage of assets every year will not typically recommend them

When to annuitize
The retiree or prospective retiree may wish to consider an annuity purchase in the following circumstances:


 * 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 five sections of How to Completely Avoid Outliving Your Money by M.A. Milevsky provide a good introduction to fixed payout annuities.

Age at annuitization has a large effect on the income received. The cash flow one receives from an annuity is comprised of three streams. Return of principal, interest on principal, and mortality credits. Mortality credits are the result of living longer than the others in the annuity pool. When one annutizes in one's sixties, interest on principal is the main influence on the income stream. By the time one is in their late seventies, mortality credits comprise the main income stream. As Jonathan Chevreau noted, the swing is from about 80% interest-rate influence in one’s early 70s to about 80% mortality credits by one’s late 70s."

How much to annuitize
An annuity is an insurance product, and, like all such products, is designed to provide a profit to the issuing insurance company. Accordingly, the purchaser should buy an annuity for reasons of safety, not return, and should not purchase more than is necessary to provide a basic lifestyle (if other sources of pension income are not sufficient). Nonetheless, as has been discussed by Milevsky, partial annuitization can significantly reduce the risk of running out of money. A calculator allowing the "Retirement Sustainability Quotient" (i.e. risk of running out of money) to be estimated for various asset mixes and annuity combinations is available at Qwema.

Annuities purchased with registered funds
If you buy an annuity with money from a pension plan, RRSP, or RRIF, your annuity payments will be fully taxed (i.e. taxed as regular income).

Annuities purchased with non-registered funds
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.

Income from the early years is considered mostly interest for tax purposes, and that portion will be fully taxed. Income from the late years is mostly return of capital. Since you have already paid tax on that money, your taxes go down over time.

Prescribed annuities
A prescribed annuity, also purchased with non-registered funds, rearranges the taxable events leveling the blend of ordinary income and return of capital. This reduces the tax due in earlier years and increases it in later years if the purchaser lives that long. This is an example of age arbitrage.

Under current regulations in place in January 2015, the taxable income portion of a prescribed annuity is determined using the 1971 Individual Mortality table. Under draft legislation for the 2014 Federal Budget, starting January 1, 2017 the new regulations would require that insurers use the Annuity 2000 Basic Mortality table. This will effectively increase the amount of tax due for newly purchased annuities.

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. The annuity and life insurance should be bought from different companies. 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.

Charitable gift annuities
Charitable gift annuities involve giving a donation (which can be "in kind"; such as a stock) to a registered charity which then purchases an annuity for the donor with a part of the proceeds. The donor receives a tax write-off for the entire gift.

In essence, the donor forgoes taxes in order to make a roughly similar payment to a registered charity.

Are prices fair?
There is a perception that annuity prices are not actuarially fair, since insurance companies want to make profits, they have administrative costs, and there is the problem of adverse selection. Nielson (2012) calculated the "money’s worth ratio" of annuities in Canada in 2009. She found the ratio was close to or above 1, "implying that Canadian purchasers were getting attractive prices in the marketplace at that time". Her explanation was that "the sale of annuities offers a natural hedge to the mortality risk posed by the sale of life insurance products. In other words, most annuities are sold by insurers that have a large portfolio of life insurance policies also tied to mortality – but in the opposite direction. The sale of an annuity reduces the overall risk faced by the firm".

Current payout rates
Current payout rates for annuities can be found at Cannex and LifeAnnuties.com.

Cost of options
Options and guarantees reduce monthly payments. The Ontario Securities Commission gives the following examples for a 65 year old male buying $100k of annuity with non-registered funds:
 * Straight life (no options) = $536 per month
 * Life plus 5-year guarantee = $531
 * Life plus 10-year guarantee = $515
 * Life plus joint-and-last-survivor = $435

Historical data
Ten years worth of yearly historical annuity rates are available here.

Historical weekly data from 2000 to 2013 can be found at Ifid. The Ifid data also include the Implied Longevity Yield (ILY), which is a calculated internal rate of return that can be compared to current bond yields. For 2014 onward, similar data is available to CANNEX subscribers (for a fee).

Buying an annuity
There are three ways to buy an annuity:
 * 1) In person from a licensed insurance agent or broker
 * 2) Online or by phone from a broker or insurance company
 * 3) A financial advisor who is licensed to sell insurance

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 advisor to find the best deal for you. A broker shops around for the best deal for you from different companies.

Sales commission
According to the Ontario Securities Commission, the one-time sales commission "can be up to 3% of the lump sum you’re depositing". A typical commission might be in the 1.5-2% range.

All other costs should be included in the quoted price.

Six steps
The OSC recommends you take the following six steps if you purchase an annuity:
 * 1) Decide how long you want to receive payments for (fixed term or life)
 * 2) Decide what options you need
 * 3) Compare prices (shop around), including any up-front commissions, and "buy only from a strong life insurance company with a high credit rating"
 * 4) Decide on how often you want to receive payments
 * 5) Choose a beneficiary, if applicable
 * 6) Review and sign the contract

Consumer protection
Assuris is the life-insurance company insurance organization. It protects annuity payments, for each member insurance company, up to $2,000 per month or 85% of the promised Monthly Income benefit, whichever is higher.

Alternatives to annuities
The classic dilemma is should the retiree continue to self-manage wealth (e.g. in a RRIF) or buy an annuity from a lifeco.

But if greater guaranteed inflation-indexed income is desired, an alternative to private market annuities is to deffer Old Age Security and/or Canada Pension Plan/Québec Pension Plan. These income streams can be viewed as inflation-indexed annuities, which you can increase significantly by delaying them up to age 70. See Delaying OAS and CPP/QPP.