Using annuities to guarantee retirement income
As investors approach retirement, they often begin to look for products that do a better job of protecting their money. They’re willing to give up some growth potential to guarantee a comfortable, worry-free retirement.
For decades GICs have been the product of choice for risk-averse investors. GICs do secure your money, but after losses due to the twin evils of taxes and inflation your real return may be negative.
Related article: 6 reasons why retirees need to be more conservative with investments
That has increased interest in products such as guaranteed minimum withdrawal balance (GMWB) funds and annuities. GMWBs, which I’ve written about before, are a newer entrant onto the market. They can be a good way of creating your own personal pension plan, to secure your dream retirement.
Related article: The proliferation of hybrid products
Annuities, on the other hand, have been around for a long time. Sales have lagged due to low interest rates but are expected to triple in 2014 from 2012 numbers. Annuities are purchased from insurance companies, which calculate your life expectancy and pay you a guaranteed lifetime income.
Related article: Everything you need to know about life annuities
There are various kinds of annuities, each with different features. None is necessarily better than another so buy the one that best suits your needs.
For example, a single person with no children who doesn’t care to leave money but wants to maximize her income might select a single-life annuity with no return of principal. A couple with children might buy an annuity with a return of principal to leave money for the kids.
In their book The Facts of Life, authors Paul Grimes and Susan Goldberg point out that an annuity can pay a significantly higher after-tax income than what a GIC pays.
GIC income is heavily taxed at your marginal rate. Depending on your province of residence, that can be more than 40 per cent. In Alberta where I live, if your $100,000 GIC pays four per cent your $4,000 income may produce only $2,440 after taxes. Only part of an annuity payment is taxable, which is a serious advantage over a GIC.
Annuities can make sense, but few financial advisors recommend them because income payments are calculated based on current low interest rates.
Related article: The math of annuities
So, you can customize your annuity to provide the highest income while meeting your personal goals.
Consider a deferred annuity If you don’t need your income immediately. Here you buy a lifetime income that can be deferred to your retirement age, or later. This pays a higher income than an immediate annuity.
Current low interest rates and inflation make annuities less attractive, but they can still be a good option for some of your retirement savings. Imagine that you have $500,000 in savings, and need income of $1,100 a month to supplement other income sources such as a small pension plan, Canada Pension Plan and Old Age Security.
Related article: How much will the government pay you in retirement
A 55-year-old man who puts $200,000 into an annuity can get $1,121 per month of immediate income. If he doesn’t need income until age 65, he can make the deposit now and defer the income until retirement age, which increases his monthly income to $1,549. The balance of $300,000 can then be invested for growth.
Consider a back-to-back annuity (Lifetime GIC) if you want to guarantee some of your income AND leave money for your children. You use some of the annuity income to buy a life insurance policy with a death benefit for the amount your want to leave to your children.
Related article: The Lifetime GIC: Higher income without the risk
“As long as the cost of the premiums doesn’t cancel out the tax savings, you’ve come out ahead,” Grimes and Goldberg write. “While you’re at it, you could consider investing some of your extra cash in vehicles that have a better rate of return than your annuity.”
As I’ve written, an annuity can still be useful if you need to guarantee some income to cover your fixed expenses, after which you can consider investing the balance of your money for growth.
These issues need to be discussed with your financial planner in the context of your personal situation, including your projected incomes and spending needs. Your advisor must be insurance licensed to advise on annuities.
What about perpetual preferreds? If not bought at a premium and held until all capital is returned through dividends then one has a specific return and some, possibly all capital still available for reinvestment or draw down.
I’ve read annuities don’t make much financial sense until your 70s. What are your thoughts on that? Folks using annuities in their 50s or 60s?
Interested to read about that.
Jim, I am looking for clarification on your comment regarding the taxation of GIC’s versus Annuities. Is this applicable only to non registered accounts or does it apply to registered funds as well? Thanks.