Risk is a funny word. What does it really mean? To most investors risk means losing money. However, there are many other types of risk – risk related to inflation and purchasing power, security risk, market risk, volatility, etc.
The fact of the matter is everyone is looking for the same thing – the highest return for the least amount of risk as consistently as possible. Does such a creature really exist?
Seniors who are really conservative and looking to boost their income from non-registered sources may want to take a look at the Insured Annuity. The insured annuity is an income concept that combines a life annuity with an insurance policy to provide higher income but still preserves the capital to the estate. The insured annuity is an excellent alternative to a GIC investor who is trying to live off the interest in a low interest rate environment.
I will try to walk you through an example to help you understand the insured annuity concept.
A review of GICs
In you invested $100,000 in a 5 year GIC and you could get 4.5%, you would receive $4,500 per year in interest (or $375 per month). On an after tax basis, this return might only be 2.88% or $240 per month.
Insured Annuity – Step 1 – Buy an annuity
Let’s say that instead of investing in the GIC, you went out and bought an annuity for higher income. The income for $100,000 for a 65-year-old male is about $786.42 per month. This monthly income is significantly higher than the GIC because the difference is the annuity is repaying capital as well as interest.
From a tax perspective, the annuity has some tax preferred treatment in that the interest is distributed evenly over a lifetime. In this same example, you would pay $108.69 per month in taxes instead of $135 per month with a plain GIC. Your after tax income would be $677.73.
Step 2 – Recreate the capital
So far the annuity sounds great because of a significantly higher income, however, it is unfair to compare the two because the GIC preserves the capital where the annuity spends the capital. To make things fair, we need to recreate the capital using a low cost Term To 100 insurance contract. Continuing with this example, the cost of insurance for a 65-year-old male is $271 per month. This would leave $406.73 after tax income, after the cost of insurance has been deducted. If you compare that to the $240 per month if you invested in a GIC, that is almost 70% more spendable income. In fact, that is the equivalent of earning 7.6% on a GIC for the rest of your life. Would you buy a GIC at 7.6% today if you could?
The advantages of the insured annuity are clear: higher after tax income, less taxes, no management, guaranteed lifetime income, guaranteed capital to the estate, and probate protection. The insured annuity may be an excellent alternative for investors living off income on their non-RRSP investments.
Too good to be true?
Not really! The insured annuity is not for everybody. In fact, you must be in pretty good health or else the cost of insurance becomes overly prohibitive. The other drawback to the insured annuity is lack of liquidity. You will not be able to access capital like you can when a GIC matures. Once you invest in an insured annuity you are locked-in for life.
Insured annuities do not need to be run on a single person. In fact, they can work for couples too. The difference is you would invest in a joint life annuity and invest in a joint last to die term insurance policy.
Like anything else, insured annuities have their pros and cons. As you can see they are not necessarily simple to understand either because of the after-tax implications. If you like the concept because you are a fixed income investor looking for more income, you should get a financial advisor to run the numbers specifically for you.