Why annuities are gaining respect

In the ’80s, when interest rates were around 16 per cent, my father-in-law purchased an annuity. Today, that annuity is still paying income to my mother-in-law. Although the interest rates you can negotiate for an annuity today are much lower than they were back then, there’s still a lot to be said for the stable, guaranteed income for life that’s the hallmark of these income vehicles. And when you add in the uncertainty of financial markets, no wonder many people are taking a fresh look at annuities lately.

Primarily because of the steady income they offer, annuities can play an important role in any retirement income plan. Once you’ve determined your retirement income needs and looked at the various sources of retirement income available, you should assess how much of that income is guaranteed (CPP, OAS, pension, annuity) and how much will fluctuate from month to month or year to year (RRIF, dividend, interest).

If you find you’re more comfortable with a larger portion of your income guaranteed, you should definitely look into an annuity as a complement to your current investment strategy, as well as considering the other types of fixed-iome investments available. Also, bear in mind that annuity rates are tied to the going interest rate. One way to reduce the risk of locking in all your money at a low rate is to stagger your annuity purchases; for instance, you might use a portion of your capital to buy an annuity now, another two to three years from now, and still another in three to five years.

Types of annuities
An annuity is an insurance contract with a financial institution that guarantees a regular income — monthly, quarterly, semi-annually or annually — in exchange for your cash. For tax purposes, annuities can be classified as one of the following:

• Registered annuity, in which cash originates from a registered plan, such as a pension plan, RRSP or RRIF, and all the income received from the annuity is taxed as regular income in the year it is received.
• Regular annuity, in which the money comes from a source other than an RRSP or RRIF. In the early years, most of the income you receive from a regular annuity is considered interest, and a smaller portion is considered return of capital. In later years, the income becomes primarily return of the original capital. This is important because the interest portion is taxed in the year you received it, and you don’t pay tax on the portion that’s considered a return of your capital. 
• Prescribed annuity, a special type of regular annuity in which the same amount of interest is taxed each and every year. In the early years, a prescribed annuity may give the annuitant a tax advantage — remember that, on a regular annuity, taxable interest income represents the bulk of income received in the early years.

Next page: Annuity features

Annuity features
Tax treatment should not be the only consideration when considering an annuity. In general, there are three key features that make up an annuity: the guarantee period, the level of payouts and indexing of payouts.

Guarantee period. There are term-certain annuities, which pay a guaranteed income for a specified period of time (such as 10 or 20 years), and life annuities, which make regular payments for the life of the annuitant(s), or if the annuity is based on two lives, continues to pay the established amount of regular income until the death of the surviving spouse. For example, an annuity with a 60 per cent joint-and-survivor benefit would pay 60 per cent of the original income after the death of the annuitant.

Investors concerned they may die after receiving only a few annuity payments, leaving the financial institution the big winner, could add a minimum guarantee period. The annuity contract could state the contract is a “life annuity guaranteed 15 years” or a “joint-and-last-survivor annuity guaranteed 10 years.”

Level of payouts. Some newspapers publish annuity tables regularly, and you can use these to get an idea of how much income your money can buy at a given time. As well, using your personal situation as a guide, your financial adviser or planner can provide you with current quotes. In general, how much income you can buy depends on many factors including:

• Long-term interest rates at the time of purchase. The higher they are, the higher the monthly income.
• What the company you are dealing with charges.
• The number of features or guarantees, such as minimum payment period or indexing, included in the contract. The more features, the lower the monthly income, although some guarantees may cost less than you may think and can give additional peace of mind.
• Gender and life expectancy. Since women generally live longer than men, male annuitants tend to receive slightly higher monthly income, in consideration of the fact that women will likely receive income longer. If you have a health condition that’s expected to shorten your life and are looking for an annuity based on your life only, you may qualify for an “impaired annuity” with a higher monthly income.
• The number of lives covered by the annuity. If it is a joint annuity, the age and sex of the second annuitant — often the spouse or partner — are factored into the calculation.

Indexing. By indexing annuity payouts, you can protect the purchasing power of your income. The annuity contract will specify the formula that’s used to determine the annual increase; for example, the level of payments may be linked to changes in the consumer price index (CPI), which is a common measure of inflation.

Next page: Advantages and disadvantages

Advantages

1. You receive predictable, guaranteed income for life.
2. You don’t have to make investment decisions as you would with assets you hold in your RRIF.
3. Annuity payments of up to $2,000 monthly are covered by CompCorp, a life insurance-industry protection fund, for annuities issued by member companies.

Disadvantages

1. There is little or no flexibility once the annuity is set up. You get what was agreed to in the contract. This is a good reason not to put all your money into annuities, just as the basic rules of diversification say you shouldn’t put all your money into any single type of investment.
2. You lock in your income at today’s rates, which could work against you if you purchase when rates are low. It’s important to compare the amount of annuity income on an after-tax basis with what you would obtain from other guaranteed investments.
3. You could leave less for your heirs. If you consider spending your own money a disadvantage, consider buying life insurance to replace the capital.

Regular, predictable income can provide peace of mind in retirement — much like the security you get from a company pension that’s designed to provide a stream of income for life. Individuals can create more pension-like income by purchasing their own annuity at almost any age. My family has longer-than-average lifespans — my grandmother is now in her 90s (she doesn’t want me to reveal her true age). Personally, I’m a fan of any investment that can help ensure my income lasts as long as I do.

Sandra Foster is the author of three financial books, includingYou Can’t Take It With You: The Common-Sense Guide to Estate Planning (John Wiley, 2002).