Everything you need to know about life annuities
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 areset 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
I think life annuities are greatly under-appreciated. I encourage folks to read “Pensionize Your Nest Egg” for a great analysis on this subject. Though, to really make it like many pension plans, and in my view to make it worth the investment, it needs to be pegged to the CPI. You pay a hefty charge for that kind of inflation protection, but seems well worth it to me. I’ll have a modest DB pension when I retire, but plan to buy a CPI indexed life annuity (or annuities) with my RRSP to provide me with some extra, guaranteed for life income.
I think indexing is important but it’s important to get quotes and compare them to the non-indexed quote. Here’s an example: https://retirehappy.ca/indexed-life-annuity/
Thanks, Jim. I agree than a non-indexed annuity makes more sense in comparison to one that is indexed according to some fixed percentage (like 2%). That kind of indexing seems like cold comfort as it doesn’t really protect you against a more sudden and unpredictable rise in inflation. If I’m going to make the trade off for lower starting monthly payments, I’d want it to pegged to an external measure that is actually tracking real inflation, like the CPI (although I realize even the CPI has some limitations).
You write “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.”
Does “non-RRSP” mean “non-Railroad Retirement Savings Plan? You didn’t define the term. In any event, if you’re describing U.S. “nonqualified” immediate annuities, your description is wrong. The interest is NOT amortized as you describe, but is allocated pro rata over the expected payout period (according to government tables). The excludible portion (representing return of “investment in the contract”) is level until all such principal has been paid out tax-free, after which 100% of the annuity payment is taxable (as Ordinary Income).
As for your comment that “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”, you seem to be describing a DEFERRED annuity, from which the tax treatment of distributions depends upon the nature of the distribution. There are two types of distributions:
1. “Amounts received as an annuity” – amounts paid under a regular annuity payout option. Such payments are taxed under the “exclusion ratio” rules of IRC Sect. 72(b).
2. “Amounts not received as an annuity” – all other distributions, including surrenders, partial withdrawals, loans, and cash value pledged as collateral for loans. The tax treatment of these distributions depends upon when the contract was issued. If before 8/14/82, the regime is “principal first”. No tax until all principal has been paid out. If the contract was issued after 8/14/82, distributions are taxable as Ordinary Income until all “gain” has been distributed.
For more information, see “The Advisor’s Guide to Annuities” by John Olsen & Michael Kitces (4th ed., National Underwriter Co., 2014).
Thanks for the comment. The description above applies to Canadian rules and laws for prescribed and non-prescribed annuities. The non-RRSP stands for not Registered Retirement Savings Plan.
Thanks, Jim. I apologize for my sloppiness in failing to recognize that you were talking about Canadian annuities and annuity taxation.
“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”
Now there is an understatement!
Shaun writes ““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”. Now there is an understatement!”
The answer depends upon WHAT TYPE of annuity the investor buys. (I am describing annuity contracts in the United States. As I’m afraid I made quite clear in my reply to Mr. Yi, I know NOTHING about Canadian annuity contracts or annuity taxation).
If it’s any kind of DEFERRED annuity contract, the owner’s death will cause the DEATH BENEFIT to be paid to the beneficiary. That death benefit will typically be NO LESS than the amount originally invested.
If the investor had invested in an IMMEDIATE annuity (one in which regular annuity income payments must commence within one year of purchase), the amount passing to the beneficiary will depend, once again, upon the TYPE of contract.
A “Life Only – No Refund” immediate annuity terminates without value upon the death of the annuitant, no matter when that occurs. It would be a terrible investment – if it were an investment, which it is not. This kind of contract is a pure RISK TRANSFER mechanism. The buyer transfers from himself to the insurance company the risk that the income from a pot of money will run out while the buyer lives. This type of contract provides the greatest amount of income on a fully guaranteed basis, per dollar invested, of any instrument on the planet. It can do so because of “mortality credits”, generated when one of the pool of buyers dies before receiving as income all he’d invested; that “remainder” is paid out by the insurer to those members of the buyers’ pool who live beyond that point.
A “Life With Refund” immediate annuity provides for a death benefit. If the annuitant dies before receiving all his investment, the remainder will be paid to his beneficiary either in a lump sum or in installments. (There are several variations of the “Refund feature”.
In any event, an immediate annuity is not an “investment”; it’s just an INCOME STREAM with no CASH VALUE. It’s purely LONGEVITY insurance.
Couldn’t you use an annuity to save taxes for your beneficiaries? When my father died, his RRIFs basically were cashed in and about 50% taxes paid to the government. If he had bought an annuity, the payments could have been paid out to the beneficiaries over time and they would have paid a lower tax rate.
Are annuities payouts taxable (in Canada)?