How annuities can gold-plate a silver pension

We worship defined benefit plans, but we disrespect annuities. This is illogical.

DB pensions offer a set amount of monthly income for as long as you live, just as annuities do. This is why DB pensions are considered so desirable. If you're a member of one of these plans at a financially solid employer, you have zero worries about outliving your money.

How much do we value the DB plan's income-for-life feature? Upon retiring, members of DB plans may get the option to commute their pensions and receive a lump sum of money they can invest on their own. How many make this choice? Next to no one, says Tom Reid, senior vice-president of group retirement services at Sun Life Financial Canada.

The preference for the pension is totally understandable, Mr. Reid said. For one thing, people have had their pensions described to them for years in terms of monthly income, rather than the lump sum amount at the end. But there's also a practical aspect to the monthly pension. "People say, 'I get that' – I can plan the rest of my life accordingly, and plan my consumption accordingly," he said.

A life annuity does pretty much the same thing as DB pensions in providing income for life and helping people plan their spending. And yet, only a small number of people without a DB pension choose annuities to help generate retirement income. Illogically, the annuity's promise of income for life just doesn't resonate.

It's becoming an annual ritual for this column to make a case for people to consider the idea of portioning out some of their retirement savings to an annuity. Inspiration for this latest effort came from the National Summit on Pension Reform that I participated in last fall in Toronto (read a final report on the summit online at http://bit.ly/1yYXHLz). Mr. Reid made a presentation there in which he talked about some new thinking on making annuities an option for people who have defined contribution (DC) pensions.

DC plans have both employers and employees making contributions, just as with defined benefit plans. But with the DC plan, the employee ends up with a lump sum of money that he or she must invest to generate retirement income. What retirees need is income. What they get is a bunch of money that must be intelligently invested to produce that income.

Mr. Reid said some employers are thinking more about this disconnect and, in the United States, a few have introduced an "auto-annuitization" option that allows retiring employees to convert a portion of their DC plan into an annuity. A move such as this makes sense for two reasons, the first being that it reduces the risk that people will outlive their savings. "An annuity is the only product available today that can hedge against your personal longevity," Mr. Reid said.

The second reason is that money put into an annuity is set apart from volatile stock markets and therefore immune to emotion-driven mistakes such as selling after a pullback. Inflation is a significant risk with an annuity, but you can cover that off by investing in stocks with some of your other retirement savings, or by purchasing an indexed annuity with cost of living increases.

Mr. Reid said retiring members of DC pensions and group registered retirement savings plans administered by Sun Life are routinely told that annuities are a possibility for their retirement savings, as are other Sun Life investment products and moving the money to another financial company.

The take-up rate on annuities perfectly sums up the country's attitude toward this product. According to Mr. Reid, annuities are used by just 5 per cent of plan members administered by Sun Life, and they capture only 3 per cent of the total dollars available.

Finance professors struggle to understand numbers like this. "Rational-choice theory predicts that at the onset of retirement, households will find annuities attractive because they address the risk of outliving one's income," says a 2011 paper by Alessandro Previtero of the University of Western Ontario's Richard Ivey School of Business, Shlomo Benartzi of the University of California at Los Angeles and Richard Thaler of the University of Chicago's Booth School of Business. "But relatively few of those facing retirement choose to annuitize a substantial portion of their wealth."

One of the main objections to annuities is that the monthly payments they produce are influenced in large part by interest rates. "The low-rate environment definitely sits on annuity sales right now," Mr. Reid said. "People are thinking, 'I don't want to buy now and have post-purchase regrets because rates backed up – if only I had waited.'"

So don't invest all the money you want to put into an annuity at one go. Instead, consider Mr. Reid's suggestion to use an annuity ladder, where you divide your money into separate annuities purchased over a span of time. You minimize the risk of locking in during a low ebb for rates this way, and you also benefit from the fact annuities pay more to older buyers.

As the chart shows, an annuity bought at 70 pays more than one bought at the age of 65.

It's worth noting that the interest rates influencing annuity payouts are long-term rates, which means they're higher than the one- to five-year rates that people typically focus on. In Mr. Reid's group-benefits division at Sun Life, the yields used to price annuities come in around 2.6 per cent, or the 30-year Government of Canada bond yield plus half a percentage point.

People also worry about buying income for life through an annuity and then dying in a few years. Mr. Reid said you can offset this risk with a guaranteed annuity, where income will be paid to you or your beneficiary for a set period of time, say 10 or 20 years. There are also joint survivor annuities that continue payments for life to your spouse if you die.

Another common objection to annuities is a loss of control over your money. Basically, you've traded a lump sum of money that you could do almost anything with for a guaranteed monthly income. For this reason, annuities are best used as a part of your retirement investing strategy and not the whole thing.

The insurance companies that sell annuities could do a lot more to de-mystify them, maybe by offering more online quotes and by helping people compare the rate of return on annuities with bond and GIC yields. But individuals approaching retirement have some work to do, too. The question they should ask: If I don't have a DB pension but wish I did, why would I not consider an annuity for some of my retirement savings?"