With interest rates low and many options for income available to clients, traditional annuities may seem forgotten. Some financial advisors, however, still prefer to use them in a few instances. Others even prefer them to products with guaranteed minimum withdrawal benefits.
Annuities are for risk-averse clients who are afraid they may outlive their savings. These clients are looking for a guarantee that they will receive a specific amount each month for as long as they live.
In that respect, annuities fall into the same category as GMWB products — known as “variable annuities” in the U.S. — even though the underlying product mechanics are completely different. In terms of safety, annuities are comparable to guaranteed investment certificates or government bonds.
In the most basic form, an annuity allows a client to buy from an insurance company, for a lump sum, a contract that provides a consistent, guaranteed annual cash flow for as long as the policyholder is alive.
Generally, because insurance companies that issue annuities invest in a broad portfolio of long-term, fixed-income instruments, annuities provide a slightly better rate of return — but much better cash flow — than GICs. That’s because of annuities’ greater tax efficiency. Part of the cash flow is return of capital and, therefore, not taxable.
For example, a $100,000 GIC with a 5% annual return provides $5,000 of return per year, but that’s all taxable as income. If your client is in the highest tax bracket, the Canada Revenue Agency will take $2,000 or more of that amount.
A $100,000 annuity that returns 5%, on the other hand, provides cash flow of about $7,500, $5,000 of which is return of capital that’s not taxable. In other words, the annuity contract simply bundles the client’s initial investment along with the investment return.
“More cash flow, less taxable income,” says Cindy David, a financial advisor with Toronto-based Raymond James Ltd. David, who holds the chartered life underwriter designation and specializes in estate planning, calls annuities a “huge win” from a tax point of view.
That tax efficiency applies only outside a registered retirement income fund, however. By comparison, all RRIF income is fully taxable.
Because income and its tax consequences are known in advance, advisors can recommend annuities in cases in which clients are approaching the old-age security clawback level, which is about $68,000 annually, David says. Clients can maintain cash flow and avoid concerns about fluctuating taxes.
But there is a caveat with annuities that troubles many clients: the absence of death benefits. If the policyholder dies at any point — even on the day he buys his annuity — he forfeits his capital and leaves it with the insurance company. No beneficiaries are allowed.
“It looks like a bad deal,” admits Bruce Cumming, an advisor and owner of Oakville, Ont.-based Cumming & Cumming Wealth Management Inc., which operates under theDundeeWealth Inc. umbrella.
But Cumming, who also holds a CLU, still prefers the most basic, life-only annuity, which he uses in a number of ways: “At that point in time when I want my dollars to work for me and deliver a consistent income stream, then the annuity is going to be top of my list.”
Cumming is among a few insurance brokers who don’t use any GMWBs for their clients.
GMWBs provide a 5% increase in the income base for every year the policyholder does not make a withdrawal. They also offer potential upside through exposure to equities markets via segregated funds.
“But the number of times the resets work to the client’s advantage is slim to none,” notes Cumming, citing calculations made by Jim Otar, an advisor in Thornhill, Ont., who is critical of GMWBs.
Instead, Cumming recommends that clients with cash on hand take two-thirds of that capital and invest it in a life annuity. So, if a client has a $100,000 capital base, $67,000 would go into a simple annuity that provides cash flow of 5%. With the remaining third of the capital, he would recommend buying a basket of exchange-traded funds and holding it in a tax-free savings account.
From an asset-allocation point of view, Cumming says, the annuity can be treated as fixed-income.
He calls this strategy a “vastly superior” option for clients who otherwise would pay 3.5% or more in management fees for a GMWB product that is not likely to provide more than 5% in return. Advisors who do not want to lose the income they get from a GMWB can charge a 1% fee on top of the ETFs; the cost of the investment for the client is still half that of a GMWB.
@page_break@Cumming notes that the strategy is especially sound if a couple buys the annuity on a joint, last-to-die basis, and if one spouse lacks the sophistication to make asset-allocation decisions.
“The surviving spouse can be disadvantaged and not know how to create an income,” Cumming says. “But the higher-acumen spouse can allay those concerns by knowing he or she can get guaranteed income.”
The caveat, again, is that client couples must be comfortable knowing that they will not be providing for beneficiaries with this arrangement; when they are both dead, the capital remains with the policy manufacturer. On that point, Cumming says, couples can use other instruments to provide for beneficiaries as part of their estate plan.
Similarly, other types of annuities have narrow markets and are mostly suitable for particular client situations. For example, “term certain” annuities provide up to 20 years of guaranteed income, so a spouse or beneficiary can collect the income within the guarantee period, even if the policyholder dies. “Insured” annuities add a life insurance contract to the product, thus providing a death benefit. This insurance benefit incurs extra cost, and the client will have to undergo a medical rating.
David says she recommends insured annuities much more often than life-only versions. The former work best when a couple makes the decision to buy life insurance when they are younger, so their rates are lower. When the annuity begins at the later date, part of the income from it can be used to pay the life insurance premium.
“Any medical issues that cause insurers to rate you [negatively] can throw the numbers off,” David says, “and you’re better off with a GIC.”
Some annuity manufacturers may offer slightly better rates than others. Sometimes, the rates will fluctuate when a company is going after market share. And, of course, the larger the contract, the better the price — especially on an insured annuity, on which there are wider profit margins.
As a caution, David notes, economists and analysts point to the potential for hyperinflation and higher interest rates in the near future. Clients who remember the 1980s, when those sorts of economic conditions prevailed, may shy away from annuities.
“The 8% cash flow doesn’t look like a good deal if interest rates jump to 10%,” she says. “The client has to believe that there’s no way they can get [better] returns from the [stock] market, and that they will not have to worry if the interest rates jump for one or two years.” IE
Taking another look at annuities
The traditional products, combined with an investment strategy, have appeal for some advisors and clients
- By: Gavin Adamson
- March 8, 2010 March 8, 2010
- 12:46