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the long view

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Nothing provokes some investors so much as a kind word for annuities.

Last week's article compared an annuity's payout with that of a registered retirement income fund (RRIF) and concluded that "annuities deserve more of a role in retirement planning."

This rather tepid observation drew a flood of comments. Some readers were complimentary, many asked questions. A surprising number, though, were dismissive and even angry about the notion that annuities should play any role at all in your post-work portfolio.

The good news is that this provides us with a wonderful excuse to return to the always fascinating topic of life annuities. On a nice summer day, that's even more fun than running through a sprinkler!

'Is it an all-or-nothing decision?'

Many readers asked whether you can have both an annuity and a RRIF. Short answer: Yes.

In fact, splitting your RRSP money and using part to buy an annuity while putting the remainder into a RRIF makes loads of sense.

An annuity can provide you with the security of knowing you'll have an income for life, while a RRIF lets you invest in stocks or other investments that offer a shot at bigger gains, as well as providing protection against possible inflation in the years ahead.

'When should I buy an annuity?'

Annuities generally start looking attractive when you hit 70. The payouts become increasingly enticing with age and are usually very tempting by the time you hit 75, according to Fred Vettese, chief actuary at human-resource consultants Morneau Shepell.

Just one caveat: Annuities are expensive at the moment in comparison with their past prices, because they move in the opposite direction to bond yields. "Right now, annuities look worse than they have before because the U.S. is depressing interest rates around the world," Mr. Vettese says.

Given that, he suggests you may want to think about moving into annuities gradually, spreading your purchases over several years, in hopes that rates will revert to more normal levels.

'Why assume a comparison with a RRIF yielding only 2 per cent?'

The point of the comparison was to show how an annuity stacks up against a RRIF with roughly equal volatility and risk. That means a fixed-income portfolio, and 2 per cent, is a reasonable estimate of what such an investment-grade, bond-heavy portfolio might yield at today's rates.

'But I can get much higher returns with stocks!'

Sure, that's possible – but, unlike an annuity, those returns aren't guaranteed. Comparing a stock-packed RRIF against an annuity means balancing the certainty of the annuity against the potentially higher – or lower – returns from the RRIF.

I'm indebted to David Morris, a retired financial analyst in Calgary, for providing me with a detailed spreadsheet in which he lays out various scenarios for our hypothetical retired couple, Joe and Jane, assuming they invest their $1-million starting portfolio in both stocks and bonds.

Mr. Morris shows that steady, albeit modest, returns from a balanced portfolio can easily result in Joe and Jane winding up with hundreds of thousands of dollars in their RRIF at time of death. (Mr. Morris's baseline assumption is that Joe dies at 86, while Jane makes it to 91. He also assumes they receive equal income each year to what an annuity would provide.)

Those numbers make the case that annuities can be an expensive way to ensure you don't run out of money. But it's important to look at several factors before deciding whether an annuity is a good or bad deal for you.

For starters, much depends on how long you think you may live. "Annuities make a lot of sense if you think you have a reasonable chance of living to 90 or beyond," Mr. Vettese says. "That's when they really start to deliver value. If you don't think you have much chance of reaching that age, then annuities become less attractive."

Then there's an inconvenient reality to consider: The real world doesn't deliver steady annual returns. Returns are volatile and go through bad patches.

In real life, it's not just average returns that matter, but also the sequence of returns. Especially important are the profits you get – or don't – in the first few years of your retirement.

CLA Wealth Advisors, a U.S. firm, demonstrates this by looking at the case of an investor with $2-million (U.S.) who wants to withdraw an inflation-adjusted $90,000 a year from a portfolio invested in large-cap U.S. stocks.

If this investor began withdrawing money in 1979, just as the market was beginning a wonderful decade of strong returns, she would be delighted. Based on historical returns, she would be able to withdraw more than $5.6-million over the next 30 years and still be left with a fortune of more than $23-million in 2008.

But let's imagine that the sequence of annual returns had happened to unfold in the reverse order – an entirely possible event in an uncertain world. Instead of having her portfolio boosted by early strong returns, she begins retirement with the crash of 2008, then enjoys a much better 2007, 2006 and so on, before being hit again by losses in the dot-com debacle.

In this case, her money runs out after 13 years.

"Generally, when people say annuities are expensive or bad, they're not taking risk into account," Mr. Vettese says. "If you look at risk-adjusted returns, annuities usually deliver good value compared to the available alternatives."

'But how big is the risk?'

York University professor Moshe Milevsky wrote a paper in 2007 in which he calculated the probability of "portfolio ruin" – running out of money – for various investors.

One of the examples he uses is a 65-year-old retiree, with a remaining life expectancy of 25 years, who invests her $1-million retirement portfolio in mutual funds that are expected to earn 7 per cent a year after inflation, with moderate volatility. The retiree plans to withdraw an inflation-adjusted $45,000 a year.

What are her odds of portfolio ruin? About 10 per cent, according to Prof. Milevsky.

Different people will react to that forecast in different ways. Some will point out you do just fine in most cases. Others will decide they don't want a one-in-10 chance of living in a basement at age 90.

'But I want to leave something behind!'

That's understandable and praiseworthy. But it does raise the question of how to judge any retirement strategy.

Since we can't predict when we'll die, or how a RRIF portfolio might perform, it's difficult to premise your entire retirement plan on leaving behind a big bequest. Your best-laid plans can be undone if you simply happen to live a long, long time.

One thought: If you're intent on leaving something to your kids, why not give them the money now?

It'll mean more to them in their 20s or 30s than it will in their 50s or 60s. In addition, being free of the need to leave a bequest will enable you to focus your retirement planning on a single objective – achieving the most income possible for whatever level of risk suits your personal taste.


Annuity Tips

If you think annuities are right for you, here are helpful tips on buying them from Fred Vettese, chief actuary at Morneau Shepell.

  • Age matters: For most people, buying an annuity starts making sense around age 70 and becomes extremely attractive at 75.
  • Consider a mixed strategy: Putting half your money into annuities and half into equities can provide you with both security and a chance for growth.
  • Ease into annuities: If bond yields rise in coming years, annuity prices will become more attractive. Therefore, you may want to move into annuities in stages, in hopes that prices will improve.