The shift by employers to “over to you” defined-contribution pension plans from traditional defined-benefit arrangements — the latter of which typically guarantee income for life — has put more responsibility on employees for making their savings last through an unknown number of retirement years.

However, with most employees lacking the knowledge or ability to choose from the investment strategies available to them, the manner in which plan participants ultimately create income becomes an important consideration as they approach retirement.

For this reason, many new retirees would be better off converting a significant portion of their retirement savings into an annuity, according to a recent U.S. Gov-ernment Accountability Office report entitled Retirement Income: Ensuring Income Through-out Retirement Requires Difficult Choices.

Annuities are often described as “life insurance in reverse.” A client buys an annuity policy with a lump-sum payment and, in return, the life insurance company pays the annuitant a guaranteed amount for a certain period of time — or for the rest of his or her life.

Despite this surety, relatively few DC plan members opt for an annuity at retirement, according to the most recent GAO data — and the Canadian experience is quite similar. According to a recent report from Toronto-based Bank of Montreal’s BMO Retirement Institute, only a small portion of those planning to retire in five years are willing to give up control over some of their retirement savings in order to receive guaranteed income for life.

Moreover, although annuities are useful for addressing a longer than anticipated life, matching fixed expenses with income and preventing the annuitant from compounding any previous poor decisions, these products do little for those who need some liquidity or want to leave a substantial estate.

But don’t rule out annuities too quickly, says Moshe Milevsky, associate professor of finance at York University’s Schulich School of Business and author of Pensionize Your Nest Egg: How to Use Product Allocation to Create a Guaranteed Income for Life.

Although the amounts vary, it’s important that your clients understand that their monthly annuity cheque is made up of three things: their savings, interest and some other people’s money.

Because annuity payments are based on mortality tables, annuitants are implicitly making a bet that they will outlive the average Canadian. If your clients lose the longevity bet, the balance of their savings will go to the winners — the insurance company and, to a certain extent, its other annuity holders — instead of their heirs.

But there is an upside, Milevsky’s report argues, highlighting the two main variables that affect life annuities: interest rates and mortality credits. Although your clients may be cool to the idea of annuities because interest rates are so low right now, the report explains clearly how mortality credits — the “other people dying” factor — can work to your clients’ benefit the longer they live.

The report also illustrates what portion of your clients’ retirement savings might be devoted to such an annuity, and under what circumstances, to obtain the optimal mix of security and income.

Arguing that most retirees want stability as they age, Milevsky’s report reinforces the GAO’s stance, making a compelling argument for why annuities could form the foundation of many a home-grown pension plan.   IE