With retirement-minded clients focused on ways of obtaining income during this time of extremely low yields, financial advisors should be recommending annuities a lot more, suggests a longtime fan of the product category.

“People need to embrace annuities,” says Bruce Cumming, an advisor and owner of Oakville, Ont.-based Cumming & Cumming Wealth Management Inc., which operates under the DundeeWealth Inc. umbrella. “First and foremost, they haven’t been able to save as much as they expected and, coincident with that, the growth on their savings hasn’t been as great as they expected.”

A combination of market crashes and low interest rates has led pre-retirees to this “screwed up” time, he says — and it’s time to make some choices.

As a refresher, annuities are like life insurance in reverse. The client buys an annuity policy with a lump-sum payment, then the life insurance company pays the client a guaranteed amount for the rest of his or her life. The cash is distributed partly as interest income, but chiefly as return of capital.

Cumming argues that a large portion of every client’s retirement capital should be allotted to an annuity, when the time comes, according to a basic formula. The annuity contract should comprise the same proportion of total available capital as the portion of the client’s fixed expenses relative to his or her variable expenses.

So, if your client has fixed expenses (basic food costs, for example) of $3,000 and variable expenses (such as entertainment and golfing) of $3,000, that’s a ratio of 1:1. Assuming the client has retirement capital of $2 million, he or she should invest half — $1 million — in an annuity, Cumming suggests.

The annuity in this example would be returned to the client in cash at 6.5%-7.5% a month (at today’s rates), for a total of $65,000-$70,000 a year. “That will give them a higher level of income,” he says, “more commensurate with what they expected. The estate won’t be as large as expected, but so what?”@page_break@There’s a catch, though: once the capital has been allotted to the annuity, it can’t be retrieved — even in the event of an emergency. So, if an annuitant dies literally a year into the policy, the capital generally stays with the insurance company — although there are more expensive options available that allow for some return of capital.

Cumming concedes the potential loss of capital is a significant trade-off, but says it’s worth it in many cases.

Generally, people have other assets, such as a house and/or cottage, that can be bequeathed to children or to their estates. The annuity may leave some money on the table with the insurance company, he says, but it’s worth the cost of enjoying a great retirement.

A strategy for clients who can’t conceive of losing capital that they might otherwise keep in a guaranteed investment, such as a guaranteed investment certificate, is to set up the so-called “back-to-back” annuity, says Brian Burlacoff, an advisor with Sun Life Financial Inc. in Toronto.

In this strategy, a client buys the same annuity as above, but he or she would invest part of the cash flow in a term life insurance policy that will pay out a lump sum to the estate when the client dies.

From a tax perspective, it’s more efficient to hold an annuity outside registered plans such as RRSPs or RRIFs. That’s because annuity payments — a blend of interest and principal — are treated as interest income and are fully taxable when withdrawn from a registered plan.

However, outside a registered account, the Canada Revenue Agency considers part of the cash flow as return of capital and, therefore, it’s not taxed. The interest-income portion is taxable.

Note that the interest income from traditional annuities is higher in the early years. It might be useful from a tax-efficiency perspective to consider so-called “prescribed” annuities, which level out the taxable portion of the cash flow throughout the policy’s life.

As with all insurance products, bells and whistles are available. The most common are guarantee periods on the annuity, ranging from five to 25 years, that guarantee the income can be paid to a beneficiary. After that period, the income provides no benefit to heirs.

So-called “term certain” versions of annuities will pay out for, say, 20 years — and then no longer. The payout is higher, but it literally ends after 20 years and the annuitant’s income can drop off quickly at that point.

Clients would need some other assets, if they want to use this type of annuity, Cumming says. “But, they have 20 years to rock and roll.” IE