A life annuity is a contract provided by a life insurance company that pays an investor a guaranteed income for a lifetime. No matter how long the investor (annuitant) lives, he/she is guaranteed never to outlive their income from a life annuity. It's not much different than having a lifetime defined benefit pension plan.
Essentially what happens when you buy an annuity, you give the insurance company a lump sum of money and in exchange, they will pay you a specified income for the rest of your life. The income that you receive is a combination of interest and principal.
RRSP vs. non-RRSP
Life annuities can be purchased with both RRSP money as well as non-RRSP money. If you are using RRSP funds, the income is fully taxable to the investor.
With non-RRSP money, only the interest portion is taxable. With non-RRSP annuities, the default works in a similar concept to a reverse mortgage. The payments in the early years are comprised of mostly interest and little principal. The disadvantage in this scenario is investors will pay more tax because the interest portions are higher. Under certain conditions, investors can choose a prescribed annuity, which simply levels out the interest. Prescribed annuities have the tax benefit of deferring interest income to a future date.
Related article: Prescribed Life annuities
Why choose Life Annuities?
The biggest advantage to choosing a life annuity for income is the same reason investors choose GICs over mutual funds: Guarantees. Choosing a life annuity gives the investor certainty, predictability and peace of mind knowing that their investment income will never drop or change. Life annuities require little to no management once they are set up. Investors who prefer a low maintenance approach to income should take a good look at life annuities. For those concerned about security, you can take comfort in knowing that life annuities are insured under Assuris up to $2000 per month in case the life insurance company becomes insolvent.
Are there any downsides?
The biggest potential downside to annuities is that once you buy an annuity, you are locked-in for the rest of your life. There are no provisions for liquidity or change. In a low interest environment, investors who purchase an annuity are locking into lower interest rates for the rest of their lives. Annuities were extremely popular in the days of double-digit returns but they have not been as popular in lower interest periods.
Related article: The math of life annuities
The other major criticism of life annuities surrounds the issue of life expectancy. Although income is guaranteed for life, what happens if an investor buys an annuity for $100,000 and then a month later he/she dies? The simple answer is the investor is out of luck and the insurance company is the big winner. There are ways to deal with this potential pitfall that we will discuss later.
What factors determine income on a life annuity?
We've already talked about one of the key factors that determine income, which are interest rates. There are many other factors that affect your income:
- Life expectancy. Life annuity incomes are calculated by actuaries who must look at how long you are likely to live. One of the key factors that determine life expectancy is whether you are male or female. Generally speaking women tend to live longer. This means that if you compare the income from a 65 year old male to a 65 year old female, the male will get a higher income because the life insurance company expects that the male will have a shorter life expectancy and thus they will have to pay income for a shorter period of time.
- Age. Generally speaking, the older you are, the higher your income. This makes intuitive sense given that insurance companies are likely to pay a 50-year-old income for a lot longer than an 80 year old.
- Health. If you are not healthy and you expect to have a shorter life expectancy, you may be able to request a special quote on your annuity. This is usually known as an impaired annuity.
- Annuity Options. Once life annuities are set up, it is set for life. At the time of setting up the annuity, there are many options that the investor must consider. All of these options can have a dramatic effect on income.
Related article: Three things to consider when buying a life annuity