For many clients, annuities present an attractive way of establishing a predictable stream of income in retirement. Over the course of a client’s retirement, however, the purchasing power of that income potentially could be eroded considerably by inflation – especially as people live longer. Financial advisors can use different tools to help their clients manage that risk.
“Inflation is certainly a risk. But it’s a risk that can be mitigated, either within an annuity structure or outside of the annuity structure,” says Rocco Taglioni, senior vice president, distribution and marketing, individual insurance and wealth, with Waterloo, Ont.-based Sun Life Financial (Canada) Inc. in Toronto.
To offset the impact of inflation within an annuity structure, some insurers offer an indexing option, in which the payments that a client receives increase over time. Clients can choose the rate at which their payments increase each year, typically up to 4% or 6%.
“[Clients] can customize it,” says Taglioni, “depending on the amount of inflation risk that the advisor and client want to offset.”
Over many years, even a conservative 2% index rate could increase a client’s income significantly. For example, a 65-year-old male who buys a $100,000 annuity indexed at 2%, with payments starting in a year, would see his annual payments climb to almost $9,000 after 25 years from about $5,500 in the first year. At an index rate of 4%, annual payments would grow to $11,700 after 25 years from about $4,400 in the first year.
Although the prospect of steadily rising annuity payments may be attractive to clients, it’s important to keep in mind that the feature comes at the cost of considerably lower payments in the first few years after the annuity is purchased compared with traditional level-payment annuities.
For example, the same 65-year-old male who buys a $100,000 annuity with level payments would receive annual income of slightly more than $7,000 for the rest of his life.
“There’s a premium you’re paying to have that index feature,” says Taglioni. “So, you’re creating a lower income stream at the beginning, for the same dollars.”
Some advisors consider the reduction in payments in the early years too steep to justify the prospect of higher income down the road – especially as there’s no guarantee that the client will live long enough to reap the benefits down the road.
“It’s expensive,” says Bruce Cumming, executive director, private client group, and senior investment advisor with HollisWealth Inc. in Oakville, Ont., adding that it would take about 16 years for the 65-year-old client who buys a $100,000 annuity indexed at 3% to catch up with the level annuity in terms of total income earned.
There also are tax implications associated with indexed annuities in cases in which the annuity is purchased with non-registered funds. Unlike level-payment annuities, indexed annuities do not qualify for prescribed taxation, which levels the taxable portion of annuity income over the duration of the contract. Rather, indexed annuities are subject to accrual taxation rules, which result in less predictable after-tax income.
Given these considerations, Cumming urges his clients to opt for traditional annuities rather than the indexed type, and to pursue growth in other parts of their portfolios to offset inflation.
“I don’t believe [the annuity is] the place where you want your inflation protection,” he says. “This income should be fixed, flat and pegged. And you can use your other assets to protect against inflation – not the annuity.”
Specifically, equities holdings can provide an effective buffer against inflation because the value of stocks tends to rise as prices increase, Cumming says. Thus, he typically recommends that clients purchase an annuity with the fixed-income portion of their portfolio, and keep the rest in equities, which will grow with inflation over time.
In addition, he notes, clients who live in urban centres such as Toronto, Vancouver and Calgary can benefit from rising real estate prices, which can further offset inflation.
Taglioni says many advisors take a similar approach of mitigating inflation through investments outside of the annuity structure. As a result, he says, Sun Life has not seen a huge uptake of indexed annuities.
“Most Canadians and, I think, most advisors are choosing to opt for the higher income stream that a regular annuity creates from the get-go,” Taglioni says.
Annuities should be viewed as one component of a client’s portfolio, not necessarily as a silver bullet for managing all of the risks that will emerge in retirement, according to Taglioni.
“You need a combination of products,” he says. “You can think of an annuity as your base income stream, and then you layer in other products to help you on the growth side and the inflation side.”
For many clients who are preparing to retire, inflation simply is not a major concern, says John Dargie, insurance broker and president and chairman of Mississauga, Ont.-based Independent Financial Brokers of Canada. He points out that most retirees’ spending declines as they age and, as a result, the prospect of having less purchasing power later in retirement is not considered to be a key risk.
“[Retirees] make some allowances as they grow older: they do less, they drive less, they downsize their home,” Dargie says. “They get by on less.”
As well, inflation has been very low in recent years, so it’s generally not a risk that is top of mind for Canadians. Even if it does begin to gain pace again, Cumming says, it won’t present a problem for most retirees.
“[Inflation] hurts people who are trying to acquire assets,” he says. “But most people who are considering an annuity already have the ‘big frill’ items – their furniture, their cars. They have an asset base that is growing with inflation.”
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