Why Your Banker Never Talks About Annuities

Insurance products are a world onto themselves. And for most people, they are very mysterious, which is why you usually need a specialist to understand just what’s what. This guest post comes from Brian Poncelet, an independent certified financial planner who has been working with clients since 1994. Check out his website at www.rightinsurance.ca.

I’ll be back tomorrow with my Financial Literacy Rant!

Every year the financial industry adds new, ever more complicated financial products. But one of the most popular, the annuity, is an oldie but goodie that dates back to Roman times.

Stripped of all the investment world’s jargon, an annuity is a guaranteed and steady stream of income payments that is established at the time of purchase. A person gives money to a life insurance company and over a set period of time will receive a return of this money plus the income earned.

Have you seen the Cash for Life lotteries? Lucky winners get $1,000 per week for life.  Lottery organizers love them because instead of handing over a pile of money to the winner, they can buy an annuity from an insurance company and that annuity funds the monthly payments to the winner. See, annuities are everywhere.

Most annuities are bought by those nearing or just entering retirement. Popular among the 60s set, they have a distinct tax advantage.  Since those regular annuity payments are made up of both principal and interest and only the interest is taxable, the income doesn’t get gobbled up by taxes. Better yet, the interest can be spread out over the life of the annuity to further minimize taxes.

Perhaps the biggest advantage of the time-tested annuity is that it can be custom-fitted for your particular situation.

Term. If you want your money to last for a particular amount of time, buy a term annuity. Should you die before the term ends, your beneficiary will receive the annuity income payments.

Life Annuities. If you want to make sure there’s money right up until you die, a life annuity is best. You can buy a “single” life annuity for yourself or a “joint” life annuity if you want to make sure your partner also has some money.  Life annuities can be bought with or without a guarantee (insured) period.  If there is a guaranteed period, the annuity will continue to be paid out for the duration of the guarantee even you (the annuitant) die 5 years before (for example).  If there is no guaranteed period, then the 5 years of remaining payments are forfeited to the insurance company.

Indexed Annuity. This type of annuity guarantees a fixed percentage increase in the annuity payment to offset inflation.  Typical rates are 4% increase per year.

Insured Annuity (Back-to-Back Annuity). This is a strategy used to back up a life annuity that does not have a guaranteed period.  As illustrated above, if an annuitant dies earlier than expected, the balance of the life annuity remains with the insurance company.  However if there is a like amount of life insurance coverage in place and the annuitant dies early, the insurance funds will replace the amounts that are left behind by the non-guaranteed annuity.  And the heirs of the estate are happier.

Annuities are among the safest investments around because they are financially backed by Canada’s insurance companies, which, like the banks, are the envy of the world for their stability and asset quality. Insurance companies are backed by a nonprofit organization called Assuris  (www.assuris.ca).  In the event of an insurance company failure, the first $2,000 per month is insured at 100%. Amounts above this $24,000 a year are insured at 85%. Assuris is funded by the life insurance industry and endorsed by the Canadian government.

Why buy an annuity? Well, one reason is that they have a better after-tax return than do GICs. Let’s take a 65-year-old man living in Ontario in the 31.41% tax bracket (income of $40,970 to $65,345). He has $100,000 to invest in either an insured annuity or a GIC paying a rate of 3.25%.

Insured annuity                           GIC
Gross income    $8,165.28                             $3,250
Taxes payable   $742.90                                $1,012.37
Life insurance    $3,240                                  $0
Net Income       $4,182.38                             $2,237.63

To get the same net income of the insured annuity, the GIC would have to pay interest of more than 6%, about double what you can actually get these days. And if you’re in the highest tax bracket, it would have to pay more than 8%. The other advantages an annuity may provide include avoiding OAS claw backs and age amount (age 65) claw back.   Even though current interest rates are low, and people think that’s a reason to hold off on buying an annuity, it’s safe to say that if you’re a very conservative investor, annuities will always give you back more income than GICs because of the way they are taxed.

If you say to yourself, “Why haven’t I heard more about annuities before?” it may be because banks would rather you leave your money with them. As for advisors, only those licensed can sell annuities. Pick the wrong advisor, you’ll never hear a word about annuities. But now that you’ve had the introduction, get to know annuities a little better and you may find you’ve made a new friend.

Brian Poncelet is an independent certified financial planner (CFP) who serves clients in Oakville, Burlington, Mississauga, Toronto and surrounding areas.  Many of Brian’s clients are couples who are working toward retirement or have already retired.  A large number are self-employed. He specializes in finding money that is being transferred unknowingly or unnecessarily.

14 Responses to “Why Your Banker Never Talks About Annuities”

  1. avatar Melanie Reformed Spender Says:
    June 30, 2010 at 7:43 am

    Very informative post. Thank you!

  2. A charity I support, the Missionary Sisters of the Immaculate Conception, offers an annuity. I always wondered how that worked and if it would be a good idea. Basically I wasn’t going to look into it until I was closer to retirement, but maybe I should learn more about it now.

  3. avatar Michelle Says:
    June 30, 2010 at 10:26 am

    Do you have to be close to retirement to look into annuities? I’m wondering if there’s not a benefit of getting an annuity when you’re younger (say 55-55 range). Is there an age at which it’s more beneficial? I guess I can understand if you’re in your late 40s/early 50s and likely making or approaching your peak income as annuity income can be compounded with your salaried income…or have I read this all wrong? Time to go investigate maybe!

  4. Nice post.

    What sort of bulk amount of money is needed to start getting into annuities?

    For example if I have $20,000 can I get one? requiring a larger amount like $100,000 would put it out of range of a lot of young people like myself.

    I’d like to hear more about how young people (late 20s and early 30s) can use annuities to acquire Wealth.

    regards,

    Jason

  5. Jason,

    I think you buy one once you’re ready to cash in your RRSP, which is how you’d have the bulk amount.

    Gail and Brian,

    Thank you very much for this post, I never understood annuities until just now.

  6. I was hoping to split my retirement money into different income streams. I wanted to take the pension plan money to do one income option while doing another with my RSP. I wanted one of them to be an annuity.
    Someone told me that I might not be able to do that. Does anyone know the official rules or where to look it up?

  7. @ Jason – I suspect most of those people who are young and have acquired wealth have not done so through annuities but more likely wise stock market investing. It seems to be more a path to wealth and income preservation, than generation.

  8. great & informative. thank you for the information.

    forever oranje!

  9. avatar Catherine Says:
    June 30, 2010 at 3:50 pm

    Thank you Gail! Very informative – something to ponder.

  10. Great question Jason,

    What sort of bulk amount of money is needed to start getting into annuities?

    For example if I have $20,000 can I get one? requiring a larger amount like $100,000 would put it out of range of a lot of young people like myself.

    I’d like to hear more about how young people (late 20s and early 30s) can use annuities to acquire Wealth.

    Answer:

    You may not like this (the answer) but some insurance companies offer a 5% (simple interest guarantee) on the principle every year until you withdraw your money. It is like annuity. The reason I like it is is guaranteed. In simple terms it is a Segregated Fund with higher fees. The fact some insurance have removed some products from the market place should tell you something.

    If you think the market will go down or returns will be lousy for years like I do you may want to do your research and see if it is for you. This is not for everyone, only people who do not need to touch their RRSPs or other long term money should consider this. As with everything in life you do not put everything in one basket.

    As far as annuities go, lump sums as low as $10,000 maybe bought.

  11. Geoff,

    Your statement:

    @Jason – I suspect most of those people who are young and have acquired wealth have not done so through annuities but more likely wise stock market investing. It seems to be more a path to wealth and income preservation, than generation.

    You are right! People use annuities to pass the risk of running out of money to the insurance companies. A big worry for seniors.

    Unless you are in your 60’s generally annuities don’t make sense because you lose control of your money.

  12. Marie

    Your question

    I was hoping to split my retirement money into different income streams. I wanted to take the pension plan money to do one income option while doing another with my RSP. I wanted one of them to be an annuity.
    Someone told me that I might not be able to do that. Does anyone know the official rules or where to look it up?

    Answer:
    Yes you can divide your RRSPs/RRIF into different income streams. Though I am thinking you mean RRIF? RRSP is to accumulate money, RRIFs are for distribution of funds. Your banker or you advisor can show you how.

    Brian

  13. Amelia

    Your question:

    A charity I support, the Missionary Sisters of the Immaculate Conception, offers an annuity. I always wondered how that worked and if it would be a good idea. Basically I wasn’t going to look into it until I was closer to retirement, but maybe I should learn more about it now.

    Answer:

    Depending on what you want to do, buying life insurance maybe better for the charity.

    If a donor donates a life insurance policy to a charity or a charity takes out a policy on the donor’s life, the premiums paid by the donor will be considered a charitable donation eligible for a charitable tax credit or deduction.

    You need to get a second opinion (from a tax expert) before considering this. Like everything else, this is not for everybody.

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