[February 2007]

As more Canadians cross the threshold into retirement, one of their main concerns is preserving an income for the rest of their lives. They must plan for fluctuating financial markets, unpredictable health and an unknown number of years left ahead.

One option for advisors to consider — for a portion of clients’ income, at least — is a life annuity. While a term annuity is designed to provide income and return of the original capital over a specified period, a life annuity provides a guaranteed income for life — whether the holder dies next Tuesday or lives for another 40 years. However, holders of life annuities are locked in forever; there is no maturity date at which point they would get back their original principal.

With at least a part of their income stream secured for life, many retirees then feel more comfortable investing a portion of their wealth in other assets such as equities, which may fluctuate in value but historically have offered superior long-term growth and a hedge against inflation.

Typically, an annuity can be purchased with a lump sum of $10,000 or more.

“Annuities take away the fear of outliving your money,” says Bill Bell, president of Bell Financial Inc. in Aurora, Ont. “They’re most appropriate for clients whose focus is income rather than liquidity, capital preservation or the desire to leave an estate to heirs.”

In some ways, an annuity is like a mortgage in reverse. Instead of borrowing money, people invest a sum with an insurance company, which will then make regular income payments to the investors. As the payments are a mix of principal repayment and interest, they have the potential to offer tax advantages relative to the straight interest income that is paid by a guaranteed investment certificate or a bond.

The amount of income provided by an annuity is determined at the time of purchase and is influenced largely by prevailing interest rates. Other factors determining the annuity’s income stream include the amount invested, the age and gender of the purchaser and the type of annuity chosen.

The more bells and whistles on the annuity, the bigger the lump sum required to produce the desired income, which can usually be received monthly, quarterly, semi-annually or annually. For example, some annuities pay an income that is indexed to inflation; others are “joint and survivor annuities” designed to pay a percentage of the original income to a surviving spouse after the first spouse dies. There is also an “impaired annuity” for people with a reduced life expectancy, which pays out a significantly higher income than a regular annuity.

The big drawback to life annuities is the inability to cash out or withdraw lump-sum amounts beyond the predetermined income stream. Clients have no access to capital, as they do when a GIC matures. Once they invest in an annuity, they are locked in for life, no matter what happens to interest rates or inflation, or what financial emergencies crop up. The inflexibility often means annuities can be more appropriate for people in the later stages of life with less time left and fewer changes to negotiate.

“People who don’t have a meaningful retirement income from a defined-benefit pension might consider using some of their funds to purchase a life annuity in order to hedge against longevity risk,” says Moshe Milevsky, associate professor of finance at York University’s Schulich School of Business in Toronto. “There is a certain amount of risk that cannot be removed by asset allocation in an investment portfolio, and an annuity can be viewed as a form of longevity insurance.”

It’s important to distinguish between retirees who buy a life annuity when they roll over the proceeds of an RRSP and those who use non-registered funds to purchase one, says Milevsky. If the annuity is purchased with registered money, all the income it pays to the holder is fully taxable, the same as it is if income is withdrawn from an RRSP, RRIF or LIRA. If the annuity is purchased with non-registered funds, however, only the interest portion is taxable, while any return of capital is tax-free. Typically, the proportion of interest income is higher in the early years and declines with time.

Another option for non-registered funds is the “prescribed annuity,” which spreads the expected interest income out evenly over the life of the annuity so that all payments to the purchaser have the same mix of interest and return of capital, and the purchaser receives a more tax-friendly income stream in the early years.

@page_break@“The great thing about a life annuity is that a client will never outlive his or her income,” says Jim Yih, retirement income specialist with Core Financial Advisors in Edmonton. “It’s true long-term security. Often, annuities make the most sense for single people or couples with no children, who are less concerned about eroding the value of their estate.

“An annuity is a vehicle that will not benefit children, and that’s a tough decision for some people.”

As interest rates are relatively low nowadays, annuities are not as good a deal as they would be in a higher interest rate environment.

Currently, a 70-year-old female looking for $40,000 in annual income would need to invest about $525,000 in a regular life annuity, Yih says. Her investment would give her a yield of 7.6% for life, which beats five-year GIC rates (currently about 4%), and offers tax advantages as well.

A $525,000 GIC investment would pay the same woman $21,000 a year, fully taxable. But it would also give her the principal back at maturity, and if interest rates rose during the term of the GIC, the funds could be reinvested at higher rates.

“An annuity can provide an attractive yield for life, no matter what financial markets are doing. But, once purchased, the mon-ey is gone,” says Bev Moir, financial advisor with ScotiaMcLeod Inc. in Toronto. “For that reason, I wouldn’t advocate using more than one-quarter to one-third of a client’s investment assets for an annuity. Annuities can be a nice component of an income stream, but it makes sense to have more than one investment pool, and to use an annuity as a supplement to other investment assets.”

Diane McCurdy, president of Vancouver-based McCurdy Financial Planning Inc. , says that because annuities involve no investment risk or responsibility, they can be suitable for clients who have little financial expertise or who may be losing some of their mental faculties with age. The funds can’t be accessed by unscrupulous con artists or greedy relatives and caregivers, and there’s no need to make ongoing investment decisions or to roll over funds in GICs and bonds when they mature.

“An annuity could provide enough money to take care of a client in a nursing home, and the guaranteed income means they won’t be vulnerable to someone coming along and scooping up their assets,” says McCurdy. “It’s something to have in the tool box, to provide clients with protection.”

There are also solutions for clients who are concerned that buying an annuity may take an inheritance away from their loved ones. For an extra cost, “term-certain” annuities come with a “guaranteed payment period” of three to 30 years, determined by the purchaser. If the annuityholder dies within the guarantee period, the annuity will continue to make payments for the rest of the period to a named beneficiary. There is also a strategy known as an “insured” or “back-to-back” annuity. This involves purchasing a life insurance policy — usually “term to age 100” — at the same time as the annuity. The insurance policy can be established for an amount that will preserve for heirs the value of the investment made in the annuity, regardless of how much is paid out in income to the annuity purchaser.

Because costs are based on mortality tables, the older the client and the fewer years left to live, the better the rate of return. Conversely, older clients will pay more for life insurance, or may not even be eligible for life insurance if their health is poor, so this back-to-back strategy should be put in place relatively early on.

It’s wise to make sure the client is eligible for life insurance before signing on for the annuity.

Generally, the back-to-back strategy can be designed so that the premiums for the life insurance come out of the income paid by the annuity but still leave the annuityholder with a healthier income on an after-tax basis than if the same amount had been invested in a GIC. An added bonus is that the life insurance proceeds would be received tax-free by the beneficiaries, without probate fees.

“As boomers age, products that offer income and security are seeing increased demand,” says Bell. “But it’s a matter of what compromises the client wants to make.” IE



Next issue: Preferred shares