Annuities help build retirement income that lasts
Creating sustainable retirement income has become a real challenge.
Historically low interest rates have put the squeeze on potential returns for bonds and term deposits. At the same time, the unsteady economic recovery and volatile markets have combined to make consistently growing your capital difficult. If you rely on dividends, you've likely learned that even blue-chip firms can reduce or eliminate payouts in times of uncertainty.
Company pensions you can count on are getting harder to find as defined-benefit plans with guaranteed payouts continue to go the way of the dodo bird. And to top it off, we're spending more years in retirement so income has to last longer than ever before.
If you're recently retired or soon will be, you have to make sure you don't outlive your savings, and ensure that bear markets won't shrink your assets and investment income, so you'll always be able to cover your living expenses.
It's in times like these that annuities – as part of your overall portfolio – can help create income security for your retirement years.
Creating guaranteed income
Transforming your retirement savings into guaranteed income is what annuities are all about.
Let's start with the basics. To purchase an annuity, you turn over a portion of your retirement savings (either registered or non-registered funds) to an insurance company. In exchange, the insurer provides you with a steady stream of guaranteed income payments. There are many types of annuities† which have flexible options to suit your needs.
For example, if you want predictable income over the long-term, a "life" annuity will deliver payments indefinitely. If you only need guaranteed income for a specific period, then a "term certain" annuity would be your choice. Create income for as long as you live through a "single life" annuity. Or, if you're married and want to guarantee income for your partner, choose a "joint life" annuity. Should you die first, your spouse would continue to receive payments.
You can also opt for a guarantee period so your beneficiaries can recoup value from your original investment should you die prematurely before you've had a chance to benefit from the bulk of your investment. You can even have your income indexed to inflation.
Only part of the picture
While they're a powerful tool to secure retirement income, in most situations annuities won't be the whole solution because they cannot easily replace the benefits of a traditional retirement portfolio.
It's true that embracing an all-annuity approach takes away the need to manage your investments, worry about volatile stock markets or predict interest rates. But the trade-off is that you lose flexibility and control over your capital.
Having a diversified mix of stocks, bonds and cash provides you with options. You decide where to invest or how much income to draw. Best of all, a balanced portfolio gives you the opportunity to grow your wealth, not just preserve it.
For these reasons annuities should be considered a valuable, but complimentary, part of most retirement income plans.
Annuities aren't necessarily for everyone. If you have a top-notch defined-benefit pension plan indexed to inflation, are wealthy enough to endure a prolonged market downturn, or have a shorter life expectancy, purchasing an annuity may not be worthwhile. But most people can use at least some of the guaranteed income that annuities provide.
How much is enough?
To determine how much annuity income is enough, start by identifying what sources of annuity income you already have, or can expect. Canada Pension Plan, OAS and defined-benefit pension plans are fundamentally annuities, since they provide a guaranteed level of income through regular payments. Determine how much income you can expect from these sources.
Next, look at your expenses. You can get an approximate measure of your spending by first figuring out your monthly take-home pay after deductions. From this, take off your debt payments and any amount you're contributing to savings plans. Assuming your mortgage and other obligations are paid off, this gives you a rough idea of how much income you'll need.
For example, say you clear $6,000 a month, make $1,500 in mortgage payments and put away another $1,000. You're spending $3,500 monthly that you'll have to cover off with retirement income.
Obviously, a portion of this spending is for life's basics like food, heat, transportation and other expenses you can't avoid. Your guaranteed retirement sources should, at the very least, cover these basic costs. If they can't, an annuity can make up the shortfall.
The rest of your retirement portfolio, like your RRIF and non-registered assets, can be structured to create tax-efficient income to suit your lifestyle, help provide inflation protection and deliver growth. If you don't want to worry about the impact of a market downturn or any missteps with your investments, you can go with a larger annuity purchase to create more income certainty.
A thorough income assessment can be complex, so before making any final decisions it's wise to review your circumstances with your advisor to get the most accurate picture.
Does GLWB spell security?
Guaranteed Lifetime Withdrawal Benefit products are the latest twist on the annuity concept. GLWBs are designed to give retirees the best of both worlds: income security for life and the opportunity to capture the stock market's upside.
The key benefits? Investors are guaranteed an annual payout for life (typically 5% per year) and have the opportunity to add to their contract's value by locking in any rise in equity values.
GLWBs have proven popular in tough markets. Total amount of assets held in these products more than doubled through the financial crisis when many other asset categories suffered steep declines.
Despite their obvious advantages over traditional annuities, there are tradeoffs with GLWBs to consider. First they have high fees; 3% to 4% annually is not uncommon. There isn't an option for inflation protection and if you need to withdraw more money than your contract allows, you may lose the lifetime guarantee.
Are GLWBs for you? While they offer peace of mind and growth potential, there may be other strategies that will give you income security with more flexibility at less cost. Ask your advisor to help you weigh the pros and cons.
A strategy over time
Annuities can be set up at any age. But buying them doesn't have to be a one-time event. In fact, spreading out your purchase or delaying it can have its advantages.
Will you need more income early in retirement and less later on? Term certain annuities can bridge an income gap if you want to retire sooner but don't have the bulk of your pension income immediately. By having a way to cover living expenses in the interim, you avoid the pressure to sell assets, perhaps in the midst of a bear market.
Similar to bonds, annuity prices move inversely with interest rates. As rates have moved steadily lower, the cost of annuities has crept up. To help manage this interest rate risk, annuities can be purchased at different times and "laddered" like any other fixed rate investment.
Can you delay your annuity investment? If you can, you'll be able to enjoy higher income. Because you're insuring a shorter period, waiting until age 70 to purchase rather than diving in at 60 can add approximately 30% to your payments at current prices.
A tax-smart solution
Beyond offering secure income, annuities can be a tax-smart investment, particularly if purchased with non-registered funds.
Create more cash flow, pay less tax. Each annuity payment combines some return of principal along with interest. This creates greater cash flow on an after-tax basis than from interest alone.
For example, a 65-year-old woman with $300,000 to invest could receive over $18,000 a year, a 6% return, with a single life annuity. On the other hand, by choosing a term deposit instead she would be hard-pressed to generate much more than 2% annually. With an annuity, only the interest portion of the payment is taxable; the remainder is a return of principal.
Gain a tax deferral. Non-registered funds used to purchase a "prescribed" annuity can help defer tax. Normally, interest income from an annuity – and tax owing – are greatest in the early years when the principal is at its maximum. However, with a prescribed annuity, interest income, and the tax obligation, is distributed evenly over the life of the annuity contract. This adjustment amounts to a tax deferral.
Fully use the Pension Income Tax Credit. For those over 65, annuity income generally qualifies for the $2,000 pension income tax credit and for pension income splitting. Annuities can help you generate enough qualifying income to take full advantage of these opportunities.
Reduce the Old Age Security(OAS) clawback. Higher income individuals are at particular risk for the OAS clawback. Because most of the income from a prescribed annuity is principal rather than interest, you can lower your taxable income and in turn reduce the chances of a potential clawback.
The advantages of an Insured Annuity
Retirees often hesitate to consider annuities because once funds are turned over to an insurer, that decision is irreversible. With that money now ‘gone', it can leave less for the investor's heirs.
How do you insure an annuity? Purchase enough life insurance to match its cost. Once the annuitant dies, the insurance policy pays out. If beneficiaries are named on the policy, the insurance proceeds can bypass probate saving time and expense.
Even after deducting the cost of insurance, an insured annuity can deliver superior after-tax cash flow versus other fixed income options. Here's an example of how an insured annuity stacks up to an equal investment in a term deposit. The investor will enjoy almost twice as much income by choosing an insured annuity over a term deposit.
|Female, age 65, $300,000 investment|
|Insured Annuity||5 Year term deposit @ 2.30%|
|Taxes payable (30% bracket)||($1,090)||($2,070)|
|Annual life insurance premium||($8,052)||---|
|After-tax cash flow||$9,418||$4,830|
Insurance: Manulife Family Term life policy, $300,000 for 35 years
Annuity: Manulife single life prescribed annuity, $300,000, with 3-year guarantee
Advice is key
There's a lot that goes into determining a retirement income plan that's right for you, including your lifestyle, assets, health, risk tolerance and goals. Since we've entered a period of slower economic growth, choppy equity returns and low interest rates mean you'll need to make finding sustainable income a priority.
In this kind of market, tax-advantaged guaranteed income through an annuity can be a key part of your overall income strategy. Contact your BlueShore Financial advisor to learn more about how annuities can help you.