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The following is an excerpt from Chapter 6 of Pensionize Your Nest Egg: How to Use Product Allocation to Create a Guaranteed Income for Life.

An Introduction to Life Annuities

With any luck, our description of the new risks of retirement in the first part of the book didn't alarm you too much and you are actually looking forward to the possibility of 35 years of retirement (or perhaps even longer!). Still, what should cause some apprehension is the chance that your retirement nest egg (your financial capital) will not last as long as you do. Paying for 30 to 40 years of retirement can create quite a burden on you, your portfolio, and perhaps even your children. The good news is that you can insure against this kind of risk, and at a very reasonable price.

Now, yes, one normally thinks about buying insurance to protect you if terrible things happen, like your house burning down, or your car getting totalled, or you being paralyzed from an accident, or some other horrible thing like that. But the truth is that these days you can also buy insurance against things that are only kind of bad, including almost anything that might cause you personal stress or economic discomfort. For example, you can buy insurance to protect you against the price of your morning Starbucks coffee doubling next year as a result of a drought in the Ivory Coast, and you can buy insurance to protect your stock portfolio from suffering losses in the market, which can be catastrophic when you are about to retire.

In general, our view on insurance policies-whether they are extended warranties, product replacement plans, or life insurance-is that you should only pay to insure against financially devastating events that can wreak serious havoc on your personal finances. We believe you should not waste money on insurance policies and products that only protect you against financial losses that are relatively minor. (This will vary between individuals and depend on your total resources. If a kidney transplant for your beloved cat will bankrupt you, go ahead and purchase pet insurance from the veterinarian. Otherwise, save the cost of premiums instead.)

Back to our point: as we've demonstrated, longevity risk can potentially ruin your retirement if you don't have a true pension, and longevity insurance can protect you against longevity risk. At first consideration, we agree that it might seem quite odd to buy insurance against a blessing (living a long life), but the insurance doesn't protect you against living a long life-it protects you against the cost of this outcome if it materializes. Moreover, this longevity insurance is embedded inside a product that you are already familiar with by now-yes, pensions.

Pension Contributions as Insurance Premiums

Think about how a full and proper pension works. Once you retire, you become entitled to a monthly income that lasts for the rest of your natural life. This pension obviously isn't free to provide. Most likely your employer (if they offer such a pension) will have deducted a few hundred dollars from your paycheque each and every month to fund it. You can think about these deductions as if they are insurance premiums paid to an insurance company while you are working. Then, when you retire, the periodic income a pension generates is your insurance payoff. This payoff usually continues to your spouse if he or she outlives you.

Let's do some basic annuity math to demonstrate how a pension might work (leaving aside inflation, taxes, and other real-world variables for the moment). In the simplest of cases, if you are receiving $1,000 per month from age 65 and you live to age 105, your pension will pay $480,000 over the course of your life (that is, $1,000 per month-480 months). On the other hand, if you only survive to age 80, the total payout will be $180,000 (or $1,000 per month-180 months). The basic rule of pension math is: the longer you live, the greater the payoff. Now, given that basic rule, we're suggesting you can think about pensions like your insurance against longevity risk.

As you can see from our discussion so far, a pension has characteristics similar to a bond that pays monthly interest (the pension cheque), in addition to its elements of insurance. Whether your pension behaves more like a bond or more like insurance depends entirely on how long you live. If you don't end up living very long, your pension may act like a bond in your portfolio, in that it simply repays your own money back to you at regular intervals. But if you live longer than expected, your pension will be more like an insurance policy, which not only returns your money but adds more (possibly much more). Just like with your house insurance, if the risk against which you are insuring is realized (you live longer than expected), you receive value from the insurance company that may well exceed the total value of the premiums you paid. This is exactly the protection that pensions provide.

Buying a Personal Pension

So, where do you get your longevity insurance if you don't have a pension from your employer? The answer is that you can buy your own personal pension. It will likely not be called a pension, but a life annuity, and, as we've said, that is the term we will use in this book to describe a personal pension.

Now, you might think we are talking about some kind of life insurance-but we aren't. Life insurance (perhaps best understood as premature death insurance) pays off when you die. But the financial products we are thinking about pay off during your lifetime-if you don't die. And what distinguishes these products from any other kind of investment product are "mortality credits," or contributions that are reallocated from those who die to those who survive, and which form part of the payments to surviving purchasers.

Before we go any further, please note that we are not advocating you turn all of your cash over to an insurance company to purchase a life annuity. We will discuss how much of your nest egg to invest in annuities later in this part, and then in detail in Part III, but we aren't quite there yet.

Back to annuities. An annuity is actually an ancient product, reaching back to Roman times. Life annuities were paid to Roman soldiers in exchange for their military service, and wealthy Romans could bequeath an income for life to their heirs. Today, anyone can give an insurance company a lump sum in exchange for monthly income for life-no military service or rich relatives required. You can buy a life annuity at retirement with one lump sum payment (this is known as an "immediate annuity"), or you can buy annuities slowly, a few thousand dollars' worth at a time, starting at or before retirement (these are immediate annuities purchased over time). Finally, you can buy annuities at or before retirement and elect to start receiving payments later (this is a "deferred income annuity").

If you are interested in purchasing an annuity, you can get quotes (different insurance companies will pay out at different rates) and compare your alternatives. You can also purchase many different riders that will affect the payout you will receive, including riders to provide inflation protection, cost of living increases, and guaranteed payout periods (i.e., you are guaranteed to receive payments for a set period, whether you are living or not). You can also buy term annuities (for a specified term, not a lifetime annuity), joint annuities that pay out as long as one member of a couple is alive, and so on. Individual annuities can be bought with registered funds from individual RRSPs, locked-in RRSPs, defined contribution pension plans, or deferred profit sharing plans. Annuities can also be purchased with "after-tax" (non-registered) funds. In addition, when you are buying an annuity, you can choose between options that affect how the payments are taxed.

In sum, there's a lot to consider if you are contemplating purchasing an annuity.

Excerpted from Pensionize Your Nest Egg: How to Use Product Allocation to Create a Guaranteed Income for Life. Copyright (c) 2010 by Moshe Milevsky and Alexandra Macqueen. Excerpted with permission of the publisher John Wiley & Sons Canada, Ltd.

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