Annuity bashers, please contain yourselves.
This edition of the Portfolio Strategy column is a how-to on diversifying retirement income portfolios with life annuities, which are basically a lifelong stream of guaranteed income that you buy from an insurance company with a lump sum of money. It's considered a sign of investing acumen to trash annuities, but let's lay off them for a moment.
The top investing challenge for people approaching retirement is to convert their savings into a flow of income that lasts the duration of our increasingly long lifespans. In a recent Portfolio Strategy column, we looked at using monthly income mutual funds for this purpose (read it online here). Think of annuities as just another tool for income-seeking retirees.
One of the biggest problems people have with annuities is lack of control. You hand over a sum of money to an insurance company and it commits to paying you on a monthly, quarterly or annual basis for as long as you live. Annuities can't be cashed in or sold to someone else.
A way around this limitation is to invest some of your money in annuities while leaving the rest in stocks, bonds and cash, or funds of various types. Start by calculating what kind of income you can expect in retirement based on government programs and pensions you expect to receive. Right now, Canada Pension Plan and Old Age Security benefits together provide as much as $18,702.84 per person per year.
Next, compare your combined CPP, OAS and pension income to your estimated annual income needs in retirement. "If you have a gap, consider filling it with an annuity," said Alexandra Macqueen, a financial industry consultant, certified financial planner (CFP) and co-author of the book Pensionize Your Nest Egg.
This is simple stuff – you use some of your retirement savings, registered or unregistered, to buy the needed income stream. Let's say you've calculated that an additional $12,000 beyond CPP, OAS and pensions will get your retirement income where you want it. According to Royal Bank of Canada's online annuity calculator, a 65-year-old male could buy $1,000 per month for life for a lump sum of $171,726.51.
If you ask for opinions on annuities, you'll be told it's a terrible time to buy them because interest rates are low. In fact, rates are a key factor in determining annuity payouts. If rates were higher, annuities would look better. That's why Ms. Macqueen suggests you buy your annuities a bit at a time, just as you might if you were nervous about jumping into the stock market all at once.
For example, you could buy three separate annuities at age 65, 75 and 85. "People always say interest rates are low, it's not a good time to annuitize," she said. "But interest rates have a diminishing role in pricing annuities as the retiree ages."
Basically, annuities get better as you age because insurers don't expect to have to pay you for as long a period as if you had bought earlier. RBC's online annuity calculator shows a 75-year-old would have to pay $124,659.82 to generate an income of $1,000 per month for life.
An additional benefit of buying annuities in separate batches is that you'll be able to capitalize if interest rates rise from today's low levels. Also, you can limit the already minimal risk that the insurance company issuing your annuity will fail. Note: The life and health insurance industry's policyholder protection plan, called Assuris, covers annuity payouts up to the higher of $2,000 per month or 85 per cent of the promised monthly payment.
The low level of credibility that annuities have with investors can in part be explained by the sterile way insurance companies market them. Insurers treat annuities as something opaque, full of terms and conditions and, most importantly, utterly disconnected from today's investor anxiety about the financial markets.
While not ideal for everyone, or even a majority of people, annuities should be much more popular than they are right now. We're in an age of conservative investing, where bond funds have been a constant challenger in the past several years for title of best-selling mutual fund category, and where mountains of investable cash are sitting in savings accounts. Three of the past four years have been good for stocks, but only now is money starting to move back into equity funds.
Those people who are familiar with annuities keep coming back to the interest rate issue, which is certainly relevant, and to the loss of control that comes from trading a large sum of money for a steady trickle of income.
There are two counter-arguments to consider, the first being that annuity returns are not solely tied to interest rates. There's also a component called mortality credits, which in simple terms are annuity payments that other people never got to collect because they died unexpectedly soon after retiring. Mortality credits have the effect of augmenting your annuity returns beyond what interest rates on their own dictate.
Secondly, annuities buy you peace of mind as well as a regular flow of income. With some of your retirement savings annuitized, you will have fewer investing decisions to worry about. You may also feel more comfortable with whatever stock market exposure you have in addition to your annuity.
Ms. Macqueen said annuities are especially relevant for people who are worried about outliving their money. She said the chances of living to 95 are less than one in 10 for people now aged 50, but living an active life through your 80s is far from uncommon.
One answer to the loss of control in buying annuities is the joint annuity, where for a substantially higher cost you can arrange for an annuity to pay your spouse in full or in part after you die. Ms. Macqueen said buying annuities gradually is a way to keep some control over your money and possibly leave a legacy after you die. If you get to age 75 and decide you don't need more guaranteed income, you can make a decision not to buy additional annuities and instead keep the money aside for inheritances or charitable giving.
Learn the basics:
Pricing:
Morningstar.ca's quick survey of payouts from various companies
Royal Bank of Canada's annuity payout calculator
Hughes Trustcos' 2013 annuity rate survey
For more personal finance coverage, follow me on Twitter (@rcarrick) and Facebook (robcarrickfinance).
Rob Carrick