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Annuities—should you take another look?

At retirement, people can transfer their RRSP balance to a RRIF or they can buy an annuity.

Buying an annuity means you receive a monthly payment for life, so you no longer need to worry about outliving your savings. It also removes the need to make investment decisions during your retirement. Finally, the Canadian insurance industry is solid, so your annuity is safe. So why are not more people buying annuities?

Some may feel that the insurance industry is making excessive profits on these products and, therefore, it is a bad buy. This fear may stem from what was happening in the U.S. during the 1970s to 1990s when the present value of the annuity payments made equaled only 80% to 90% of the premiums paid. But that has changed in recent years. Generally, the present value of annuity payments now equals 95% to over 100% of the premiums paid. Therefore, the fear of overfeeding insurance company profits is currently unfounded.

Other people are afraid to annuitize because they feel that their savings will go to the insurers rather than their family if they die early. However, there are annuities that come with generous death benefits, so this fear can also be addressed (albeit at an additional premium).

Other reasons people give for not investing in annuities: not being able to access funds should there be an emergency, the preference for variable rather than fixed payments, and expectations about being able to get high returns in a RRIF. But mostly people seem to be put off by the very nature of annuities. People are not enthusiastic about handing their money over to an insurance company just so that they can be paid a seemingly low allowance in return.

Nonetheless, annuities can simplify your life. And you do not have to go all in. For example, you could purchase an annuity with the portion of your RRIF that is currently invested in fixed income, and leave the equity portion of your RRIF whole. This provides you with a stable monthly allowance plus a pool of assets on the side to invest as you please or have in case of an emergency.

Even if you are not interested in purchasing an annuity as you start retirement, you should consider looking at them as you approach age 75. At that age, the annuity may be more interesting than a RRIF. This is best illustrated by example.

Let us say John is 75 and has $100,000 in his RRIF invested safely in GICs earning 2%/year. The minimum rate for RRIFs is 7.85% at age 75. If he withdraws the minimum, he would get $7,850 that year.

Given his safe investment strategy and the minimum amounts he is required to withdraw due to RRIF rules, John’s RRIF balance declines quickly. By age 85, John’s minimum withdrawal will have decreased to $5,093 that year, even though the minimum annual withdrawal rate will have risen to 10.33% from 7.85%. At age 95, John’s minimum withdrawal will be $2,701 (one-third of his withdrawal at 75), and his RRIF balance will be $13,507.

Had John used his $100,000 to buy an annuity at age 75, he could have received instead a monthly payment of $690, which works out to $8,280 a year. This amount would have been guaranteed for 10 years; after 10 years, payments would have continued to be paid to John until his death. (Annuity information was based on competitive quotes for non-indexed annuities as provided by CANNEX Financial Exchanges).

Of course, you do not want to be earning 2% in your RRIF. For the sake of the example, let us optimistically assume that John invested more heavily in equities and that there is no volatility attached to these equity investments. So instead of 2%, John earns a steady 7% a year net of expenses. In that case, the RRIF and the annuity provide similar results. In some years the RRIF gives a bit more than $8,280, in others less. Realistically, however, there is a lot more risk attached to the RRIF. Since the 1930s, the longest equities have gone before veering into negative return territory was six years.

So take another look at annuities, especially if you are nearing age 75.