Ten Questions on Annuities – Answered Here!

Ten Questions on Annuities – Answered Here!

I tell ya…I get no respect.

That could be an old, popular Rodney Dangerfield tagline or it could be how annuities feel from time to time:  disrespected, unloved, and generally misunderstood.

Thankfully, I have someone here to help demystify annuities – to see if these products could be right for you or someone you know at some point.

Alexandra Macqueen is a fee-for-service financial planner, author and faculty member at the Schulich School of Business.  She has also been kind enough to share her expertise on my site, why you should consider pensionizing your nest egg at some point, along with countless other personal finance and investing sites.

Here are ten questions and ten answers about annuities – in plain language – in the hopes of helping you learn more and become better educated about what these financial products actually do.

1. Alexandra – thanks for this!  Let’s get down to basics – what is an annuity?  

At the most basic level, an annuity is a contract under which you (the annuitant) provide a sum of money to an annuity issuer — a life insurance company — who, in exchange, provides you with monthly income for as long as you are alive, no matter how long that is.

Annuities come in many different “flavours” (indexed? deferred? joint? variable? prescribed?), but all of them incorporate this basic exchange: a sum provided to an insurance company for cash flow in your bank account over time.

2. Why should older Canadians consider annuities? Who are they designed for?

While I would in no way argue that every Canadian should consider an annuity no matter their financial situation, the reasons that a retiree might consider incorporating an annuity into part of their retirement income strategies include:

• If you are worried about living a long time, potentially outliving the funds from your portfolio, and want to ensure you have some cash flow that cannot “expire”.
• If you are reluctant to leave all of your assets exposed to some form of investment market risk and would prefer to have income that’s protected from market-based fluctuations.
• Depending on factors primarily including the age at which you purchase the annuities and the source of funds used for the purchase, if you are interested in cash flow that has a higher yield than products with similar guarantees (think Guaranteed Investment Certificates (GICs)), while producing lower taxable income to preserve income-tested retirement benefits (think GIS).

3. OK, so great benefits. Why do annuities get no respect? Do you think it’s because Canadians have a huge bias – they just think advisors or planners are (as a reader actually wrote on my site) just “circling the sky” on these products?

In my view Mark, there are many potential reasons why annuities “get no love.”

Think about the asset management industry today, compared to a few decades ago: we now have relatively abundant, cheap, and transparent DIY choices that allow individual investors to take their financial management directly into their own hands.

(Mark:  I’ve written about some of these choices here:

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In comparison, the annuity purchase cannot be a “self-serve” choice but must involve an advisor who holds a life insurance license. The product, too, is priced to take into account interest rates at the time of purchase, actuarial factors predicting how long someone might live, and how much the company wants to attract or forego that particular kind of annuity sale at the time you’re looking to buy.

None of these elements are transparently visible to the purchaser, or even the salesperson. In other words: although the concept is simple — the exchange of cash for income — the details are not.

Other factors include the reluctance of purchasers to hand over assets to the annuity issuer, the fact that many people really underestimate just how long they might live in retirement, and the belief that a portfolio invested in markets can “beat” the implied return of the annuity while potentially leaving estate value.

4. So you touched on transparency – a bigger issue now and rightly so. What are the typical commissions paid to advisors for annuities they sell?  Is it a one-time commission (vs. a mutual fund that typically charges for every year the asset is owned)?

Commissions on annuities are paid once (at the time of purchase), with no ongoing trailers or commissions paid to the advisor — which may explain why these products are perhaps less popular than they might be.

Typically, the commission is “tiered” based on the size of the annuity purchase, and might be, for example, 2 or 3 percent on the initial $100,000 deposit, and scaling downwards as the deposit amount goes up.

Certainly, there are other insurance products, and other asset management transactions, that pay higher commissions than an annuity purchase.

5. Are there certain annuities that more popular than others?  Which ones?  Why?
   

Without a doubt the most popular annuities in Canada are group annuities sold to fulfill pension plan obligations. Many people will have some portion of their retirement income provided from an annuity even if they never go out and buy an annuity directly. The size of the individual annuity market pales in comparison to the group annuity market.

For “annuity nerds,” however, the federal government’s 2019 budget announced some new annuity initiatives that may mean we will see innovation in the Canadian annuity market, and increased take-up of annuity options by individual Canadians in the coming years.

6. I’ve read that indexed-linked annuities may not be a good product.  Do you agree?
   

Particularly in the United States, there are lots and lots of products that use the word “annuity” in their name and are much, much more complicated than the basic income or payout annuity we’ve been discussing here. That’s because of the way that annuities are taxed in the U.S., which is quite different from the situation in Canada.

Indexed-linked annuities are a type of tax-deferred annuity sold in the U.S., whose credited interest is linked to an equity index—typically the S&P 500 or an international index. They guarantee a minimum interest rate (typically between 1% and 3%) if held to the end of the surrender term and protect against a loss of principal.

You can see from that description that an indexed-linked annuity (sometimes also called an equity-indexed annuity) is a complicated product. Fortunately, as they aren’t sold in Canada, I don’t (and can’t) provide an opinion about whether these products are “good” or not!

7. Very fair. So, some Canadians are under the impression you should wait until your 70s or even 80s to buy an annuity – is there any case to be made to buy these products in your 60s?

Because of the way they are designed, annuities purchased later in life pay more (and cost less) than annuities purchased earlier in life, even if interest rates change. As a result, for many people “dollar-cost-averaging” into annuities (buying a bit at a time, over a period of years) will likely be an optimal strategy to in retirement.

But the optimal age to purchase an annuity will depend on many factors that are individual to each buyer, ranging from how much of their portfolio they want to annuitize, how much of their retirement income they want to obtain from an annuity, how much of their portfolio they want to manage “on their own” and potentially leave exposed to market volatility, and how worried they are about living to a very old age.

8. Do joint & survivor annuities make sense for most couples and if so, why?  Any fine print prospective buyers should be wary of?
   

I just wrote a piece on this for MoneySense on this topic. In a nutshell, if you’re considering an annuity purchase and you have a partner, the use of a joint and survivor annuity (that will continue to pay even after the primary purchaser’s death) is a way to “take risk off your personal balance sheet.”

Whether a joint and survivor option makes sense for you or not depends on how much risk you have in your personal financial situation, and how much of that risk you want to retain or, alternately, transfer away from your balance sheet and, in this case, over to an annuity issuer.

9. What are the tax advantages of using non-registered assets vs. registered assets (e.g., from RRSP or RRIF) to buy an annuity?

The tax treatment of the annuity depends on the source of funds used to buy the annuity. If the funds are from a registered account (RRSP, RRIF), the payments are taxed as “ordinary income” (just like interest income or employment income).

On the other hand, if the payments are from a non-registered account, they are taxed partly as return of capital (i.e., no tax) and partly as interest; and the purchaser can choose two different forms of taxation for their annuity with non-registered funds: one that spreads tax over the expected lifetime of the purchaser, and one that “front-loads” the tax (like the interest on a mortgage is “front-loaded”).

The first option, that spreads tax over the expected lifetime, is called a “prescribed” annuity while the second is called a “non-prescribed” annuity. The option to opt for the level taxation of the payments means that the payments can be very tax-effective, with potentially little or even no taxable income coming out of the annuity.

This option not only reduces the income tax you pay, but also helps preserve other taxable-income-tested beneficiaries, such as OAS and GIS.

10. Any closing thoughts on annuities – who they could really apply for?

Annuities are conceptually very similar to defined-benefit pensions, which is why my co-author Dr. Moshe Milevsky and I wrote two editions of a book suggesting that people could “pensionize” their retirement savings using annuities.

The group of people that annuities might really appeal to are those who don’t have guaranteed income in retirement, and who would like some.

I’ve worked in personal finance for quite a while now, and I teach personal finance courses and write personal finance books. I deeply enjoy thinking about, learning about, talking about, and exploring many different aspects of personal finance and finance generally.

But some people don’t want to think much about markets, money, tax efficiency, investment statements, actuarial tables, “beating the odds,” and how long they’re going to live. For those people, an annuity can provide a way to get regular income in retirement without the need to manage how that income is generated, month by month. If you’re in that boat, an annuity might be worth considering.

Summary

Great stuff here to lean on folks.  I especially liked the point that annuities might appeal to those who want or need guaranteed income in retirement and may not understand nor wish to worry about how to generate it.

I want to thank Alexandra for coming back to the site to share her expertise and passion for personal finance and investing with my readers.  I hope you learned something!

Alexandra Macqueen is a fee-for-service financial planner, author and teaching professional. You can find her as part of this team, at the head of a class at York University’s Schulich School of Business, and on financial articles abound including those in MoneySense and The Globe and Mail.  She is also an entertaining follow on Twitter @MoneyGal.