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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.

Short history

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
  • Term Certain Annuities
  • Life Annuities
  • Prescribed Annuities
  • Indexing

Term Certain:

Fixed payment for a fixed period. If annuitant dies during the guarantee period the beneficiaries(s) receive the income payments.

Life Annuities

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.

Variable Annuity

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?

  1. Current interest rates
  2. 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.
  3. Number of years you want payments guaranteed: the longer the payment period, the smaller the periodic payments.

Insured Annuity

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
Insured annuity GIC
Gross income $8,165.28 $3,250
Taxes payable $742.90 $1,012.37
Life insurance $3,240 $0
Total net $4,182.38 $2,237.63

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.

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FrugalTrader About the author: FrugalTrader is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.

{ 68 comments… add one }

  • Brian Poncelet, CFP May 18, 2012, 12:11 am

    Hi FT,

    Since the market is going nowhere right now a number of people have expressed an interest in annuities.

    As you know interest rates are down and so is the payments. (annuity)

    Having said that, for people who believe rates will be higher in ten years and look to be in a position to consider annuities as a part of a strategy this may make sense if they consider the ” insured annuity”

    So for kicks I ‘d like to update the numbers based on today’s rates…which stinks! But after taxes it still beats any 4 – 5 percent GIC sold today!?

  • FrugalTrader FrugalTrader May 18, 2012, 8:37 am

    @Brian, maybe it’s an idea to update the rates within the comments so that readers can compare to the original.

  • Brian Poncelet, CFP May 18, 2012, 3:26 pm


    I will get you some new #’s shortly.

  • Brian Poncelet,CFP September 2, 2012, 6:05 pm

    Hi FT,

    Sorry I forgot about the rates. For a 65 year old male annuities are 6% and 70 year it is 8%.

    I believe GIC rates seem to be around 2% for a five year term.

    The question is will interest rates be this low for another ten years? If one plans ahead gets permanent coverage while they are still young they have choices.

  • Lou November 8, 2012, 12:18 am

    Personal hardship has drastically affected my ability to earn an income, so annuities seems like a good idea. Can I buy an annuity using RRSP’s and stocks investments combined? I will be 55 next year.

  • Brian Poncelet,CFP November 8, 2012, 2:42 pm

    Answer is yes.

    However the payout 55 vs 65 will be less. If you can wait til later you are better off.


  • Bernie December 9, 2012, 3:14 pm


    I’ve attached a link to an RBC payout calculator for annuities. In your opinion do you think this calculator is an accurate representation? NOTE: It doesn’t give you the option to have purchases from both non-registered and registered monies.



  • Brian Poncelet,CFP December 12, 2012, 5:52 pm

    Hi Bernie,

    The Calculator seems ok but with RBC but I am surprised at the low payout when say I use a 65 male. you can switch the non-registered or registered to see what is taxable.

    The best is to get a quote from a bunch of companies.


  • ed January 19, 2013, 2:14 pm

    Do all annuities “expire” at the annuitants death(s). In other words, are there annuities that have a cash value at death that can be willed to children?

    I ask because I’d like to try and decide between accepting a lump sum rather than a company pension. The pension benefits expire at death.

    I’ve also been told that I’d have a hard time beating the income I’d earn from the company pension in any annuity. Agree?

    Thank you.

  • Brian Poncelet,CFP January 19, 2013, 8:33 pm

    Hi Ed,

    Great question(s). The answer if you wanted a steady pay going to say your wife or children even if you died early would be something like a 20 year annuity, which means the insurance company has to pay out for 20 years.

    There is no cash value in an annuity.

    The pension vs. an annuity… it depends on your age who the pension is from…say Air Canada vs. Federal Government also you really need someone to review the numbers guarantees etc.

    If you want some money to go to your children/partner etc. Then the best is to consider permanent life insurance.

  • Mike @ Annuity Rates July 12, 2013, 12:02 pm

    Hello Ed,

    I think the best way to answer your question is to meet with a financial planner that has access to a retirement planning software. He can run multiple scenarios to compare investments in a regular portfolio, pension plan and annuities. You already know how much you will get from your defined pension plan, then you need to request a quote for an annuity to know how much you will earn from it.Then, with those simulation, you will know how much return your portfolio must generate to match your pension plan or your annuity.

    The main advantage of a regular portfolio is the liquidity of your asset (e.g. you can withdraw additional amount at any time). On the other side, the return is not guaranteed (as compared to a defined pension plan or an annuity). Keep in mind that your defined pension plan works like an annuity for your employer. Since he has a bigger purchase power than a single individual, chances are he will offer you a better pension payment than any other annuities.



  • charlie acton July 21, 2013, 10:29 pm

    Concerning that the question on commissions was side-stepped. I do think people will investigate more transparent options in order to know what potentially motivates an advisor.

  • Ready Retire April 18, 2014, 10:26 am

    Hi Brian,

    Can you explain how to use whole life insurance to purchase annuity?

  • Brian Poncelet,CFP April 19, 2014, 12:56 pm

    Ready Retire,

    You should have the insurance in place years before consider buying an annuity.

    See insured annuity.


  • Elis November 6, 2014, 10:50 am

    Hi Brian,

    This article gives new perspective on annuities. So I thought I’d like to try this for my kid (my background, I’m 40 and I have very limited knowledge in investment but I do have RRSP, bonds and TFSA – I simply contribute to those very conservatively). 2 agents have so far introduced this to me (2 years apart) but both have said everything is tax-free because the contributions are after tax.

    But from reading this post, your (afticle) example implies the annuity is tax-free but as I read through the comments and your replies to the comments, I’m seeing the words like “taxable or taxed” and the sample (from Mimi) worries me that my kid (and/or I) may prefer something else that is same with annuities but non-taxable. Can you explain further or am I getting confused?

  • Brian Poncelet,CFP November 8, 2014, 11:19 am

    Hello Elis,

    In a nutshell I do not recommend annuities for kids or young adults.

    That said if you read Mimi statement ” a annuity settlement ”
    This means there was a settlement probably is a structured settlement by the courts. This would suggest a guaranteed payout (monthly for a certain period of time)

    Only a annuity can do that. In her case the taxes would be payable in the child’s name. Since this is and would have to be non-registered investment.

    If you are conservative and in a high tax bracket then there is other options which are much better than an annuity at a young age.

    Unless the annuity is held in a RRSP the funds are taxable.

    Let me know if this helps.

  • John K December 25, 2014, 11:26 am

    An aspect of annuities which I have not seen discussed much is using an annuity for income splitting. I am 65, and my wife is younger.

    I currently have about 400,000 in RRSP’s and 150,000 in a LIF.
    Due to wishing to invest about 100,000 in real estate in 2015, I am considering the following manoevre, but don’t know if it is possible:
    For taxation year 2015 I want to purchase a one-year annuity for 150,000 from my RRSP. I have been told, that since I turned 65 in 2014, I can purchase an annuity in my name, and the payments made each month to me will count as PENSION payments, and will qualify for INCOME SPLITTING. So of the 150,000 the portion attributable to my wife would be 75,000.
    My 2 questions are:
    1. Am I correct about the income splitting aspect?
    2. What is the shortest annuity term I can purchase? I was hoping a 1-year annuity is possible. Are shorter terms possible? Which company issues the shortest term annuity?
    I am willing to take the tax hit for taking the money out quickly (via the annuity) but it would be softened significantly is income splitting applies.

  • Brian Poncelet, CFP December 28, 2014, 12:09 am


    I am not sure what you are looking for here but I will try to answer it.

    You can split your income through annuities.
    You will not be able to buy a one year annuity. (Once you buy the annuity, the money is with the insurance company)

    You may also be able to make a joint election with your spouse or common-law partner to split your pension, superannuation, annuity, PRPP, RRIF (including life income fund) and SPP payments you reported on line 115 if both of the following apply:

    •you were both residents of Canada on December 31, 2013 (or were residents of Canada on the date of death); and
    •you and your spouse or common-law partner were not, because of a breakdown in your marriage or common-law relationship, living separate and apart from each other at the end of the year and for a period of 90 days beginning in the year

    To make this election, you and your spouse or common law partner must complete Form T1032, Joint Election to Split Pension Income. **

    **CRA website

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