How Annuities Work
Lately, I’ve been receiving a few questions regarding annuities. As I only have a basic understanding of annuities , I emailed Brian Poncelet (CFP and insurance specialist) to provide more details on on the types of annuities. For those of you fresh to the concept, investors who purchase an annuity would pay a lump sum to an insurance company and receive a cash flow stream for the rest of their lives.
The ancient Romans issued contracts called an “annua” that promised an individual a stream of income for life. Roman citizens would make a one-time payment to the annua, in exchange for lifetime payments made once a year.
In North America, annuities have been around for over 200 years. The average purchase age appears to be the mid sixties. Annuities are purchased for various reasons but most commonly for peace of mind and tax benefits. Others may look to buy an annuity when they receive a lump sum inheritance.
Annuity payments consists of both principal and interest. This interest is taxable but is spread over the life of the annuity, therefore the tax is deferred. While your other sources of income (GIC’s, stocks, mutual funds) may eventually be depleted, you cannot outlive your annuity income. Life annuities pay a lifetime of income.
Types of Annuities
- Term Certain Annuities
- Life Annuities
- Prescribed Annuities
Fixed payment for a fixed period. If annuitant dies during the guarantee period the beneficiaries(s) receive the income payments.
As the name suggests, life annuities offer guaranteed regular income for the rest of your life. The annuitant will not run out of money but if he/she dies early, there is no refund.
Joint Life Annuities
The annuity is purchased on 2 lives, issued with or without a guarantee period. They may be sold as Reducing or Non-Reducing annuities. At the first death (or death of the primary annuitant), the surviving annuitant receives a reduced periodic income. If the Reducing Annuity has a guarantee period, the reduction in periodic income would occur after both events have occurred (the death of one of the annuitants and the expiration of the guarantee period). The terms of the guarantee period are usually based on the age of the youngest annuitant.
With typical annuities, the periodic income paid to an annuitant is predetermined, consisting of principal and interest. The interest was determined at the time of purchase and does not change.
With variable annuities the payment can vary because the interest piece is based on the stock market. However most do offer a minimum rate of interest for every year that the annuity remains untouched.
This annuity is like the Manulife Income Plus. In a bear market this does not look so bad. However in a bull market this is expensive. A variable annuity should be bought and thought of as a pension purchased for the long term.
Therefore, it the purchaser is seeking immediate income payout, it is best to avoid variable annuities.
Prescribed vs Non-prescribed Annuities (non-reg only)
Non-prescribed Annuity: taxes payable on the income earned are higher in the early years of payments but gradually decrease to zero over time.
Prescribed Annuity: the taxes payable on the income earned are paid evenly throughout the term of the contract.
How is my annuity income determined?
- Current interest rates
- Male vs. Female: a female annuitant is expected to live longer than a male annuitant of the same age. She will received a smaller periodic payment because the insurance company assumes that they will have to pay the periodic income for a longer period than for the similar male life.
- Number of years you want payments guaranteed: the longer the payment period, the smaller the periodic payments.
A life income annuity (payable until death) is attractive because the insurance company has to pay for life, even if you live to 110. However if you die much earlier than you expect, the insurance company keeps all of the money. Rather than gamble with your family’s inheritance, consider purchasing an insured annuity. This is a 2 step process where the annuity is backed by a life insurance policy for the same amount. If you die early, the life insurance is paid to your beneficiary tax free.
Back to Back Annuity (insured annuity)
This example compares GIC vs a life annuity with a matching life insurance policy.
- Current GIC rate 3.25% (five year rate lock-in)
- 65 year old male purchases $100,000 non-reg annuity and $100,000 life insurance policy
- Tax bracket 31.41% ($40,970 up to $65,345) Ontario
After taxes are considered, a GIC of over 6% is needed to equal the annuity. At higher tax brackets, a GIC paying over 8% is needed! Also, under the annuity strategy, he pays less tax as he is showing less taxable income and is less susceptible to OAS claw backs and age amount (age 65) claw back. This could mean many hundreds or thousands of dollars saved every year.
Currently interest rates are low, but because the way annuities are taxed, they will always pay a higher income than GIC’s at higher rates.
Early Planning is Best
To lower the insurance premium required to cover the annuity and to get an even higher rate of return, permanent insurance should be considered at a much earlier age (and better health) if cash flow permits. Or to give more options in retirement, such as selling the house in retirement and living off the capital. Insurance fills the hole after the money is spent.
An individual who plans well for their future, could buy a 20 pay life (paid for 20 years) insurance policy at $2700 per year (age 40). The insurance coverage would start at $100,000 and would be worth $215,000 by age 65 and have a cash value of $108,000. Not only would this insurance more than cover the annuity purchase at 65, but the individual would have access to the cash value at age 65. This allows for more options for a comfortable retirement.
Brian Poncelet who is an insurance specialist and independent certified financial planner (CFP) working in the financial services industry since 1994. Along with insurance, Brian Poncelet focuses on mortgage and retirement planning.