May 5, 2022 0 comments
Dear Money Lady: A friend of mine put all his retirement savings into an annuity and said we should too. What exactly is an annuity? –Janice
Janice, I often get asked about annuities, so let’s talk about this strategy that is often recommended as a way to create lifetime income in retirement. Life annuities are designed for clients who have insufficient savings and/or very low risk tolerance to invest in the market. There are four main types of annuities: single life, joint life, fixed term and deferred. We’ll discuss each as well as some of the additional features you can opt into.
Straight life annuities are the simplest. This annuity guarantees periodic income for life with payments beginning immediately minus a premium. Be careful with this one. This annuity pays the highest amount for life, but when you die, payments stop and there are no estate payments. The advantage of this plan is that if you live longer than your life expectancy, you will benefit from the funds left in the pool by those who died earlier. One thing I’m not a fan of with this product is that the payments are fixed over time and don’t compensate for inflation. Because of this, you can add an income protection option called an increasing life annuity. The plan will then increase by a predefined percentage each year. You can also choose an indexed annuity (often less expensive) which will increase the payments each year according to inflation (measured only by the Canadian consumer price index).
Joint and survivor annuities last as long as either partner is alive. There are a few options with this one. You can buy a less expensive income reduction annuity, in which the joint annuity payment decreases on the death of the first spouse. There is also an option in this plan to guarantee payment of the premium if you choose a cash payment provision. On the death of the annuitants, the difference between the premium and the payment can then be paid to the beneficiaries.
Term annuities are generally the ones I prefer. In this annuity, payments are made for a fixed period whether the annuitant dies or not. If you use your RRSP/RRIF funds in a fixed term annuity, payments generally only last until age 90. You can change your term from 3 to 40 years and most are very flexible. A cashable option is only available with this type of annuity since the convertible value can be easily calculated at any time. If necessary, you could cash out your plan in the event of a serious medical problem or financial emergency.
The final type of annuity is called a deferred annuity and is often purchased long before income from the product is required in retirement. With this plan, customers can take advantage of a slightly higher interest rate by purchasing the annuity years earlier than needed. You will be encouraged to pay a higher premium during the deferral period, allowing interest to accumulate in the product and therefore increase the overall value on the agreed conversion date when it transitions to a paying annuity. With this product, it is preferable to opt for a premium refund guarantee in the event of premature death before the start of the payments. One thing to remember with this one: interest earned during the accumulation phase is taxable, so it’s best to fund this product with your registered investments.
All annuities are insurance products and vary widely depending on the provider. Some insurance companies offer variable compensation annuities that may be linked in part to the performance of a given stock market index. These plans offer something for everyone. Clients can choose an index suited to specific profiles, such as conservative, moderate, growth or aggressive. Depending on the insurance provider, you may even be able to choose a combination of indices with varying payouts. Basically, a person chooses an annuity product because they don’t want to be concerned about the ups and downs of the stock market and they want a “take it and leave it” strategy with guaranteed monthly income for life. Now, before you all rush out to buy an annuity, let me go over some of the downsides. Most annuities cannot be cashed or changed after income payments begin. Payments often cannot be adjusted to reflect changing needs, and funds are not accessible in emergencies. Remember that you are giving ownership of your investments and control of your capital to the annuity. It can never be used as loan collateral or reallocated. Annuities are great for helping diversify a retirement portfolio, but it’s always a good idea to use them with other investments that offer more flexibility, like RRIFs and TFSAs.
