Many of us will be fortunate to live longer than previous generations. The average life expectancy for a man and woman is 80 and 84, respectively. Although that’s good news, many fear they may outlive their savings while others may be concerned about geopolitical risk and the volatility it may create in the domestic and global financial markets.
Annuities are considered insurance products and pay a stream of payments that are structured over a pre-determined period. These payments can be distributed monthly or annually. The terms of various annuities can be for a set period (i.e. 10 or 20 years) or for life. Life annuities normally come with a guarantee period to ensure a minimum amount of payments in case of premature death. They may also be set up on a joint basis with the income payable until the last death. Individuals who are concerned about outliving their savings may find the life annuities of particular interest.
Not all individuals have the desire to leave an estate. Those who do may still consider annuities provided they qualify for an amount of life insurance equal to the desired estate. When a life insurance policy is purchased in conjunction with an annuity it is referred to as an insured annuity. Often the after tax net cash flow from an insured annuity exceeds the after tax investment returns of an individual investment in guaranteed investment certificates (GICs).
Annuities may be purchased from either registered or non-registered accounts. When purchased with non-registered funds, the payments from an annuity may be taxed on a prescribed basis resulting in only a small portion of the payments being taxable. A portion of each payment is considered a return of capital (non-taxable portion) and the remainder is reported as income. When the payment is received from a registered account the full payment is generally reported as income.
The latest federal budget announced that for 2006 and subsequent years the Pension Income Credit amount is increased to $2,000 from $1,000. Individuals that are age 65 and older that do not have others pensions (CPP and OAS do not apply) may want to consider purchasing an annuity that would create at least $2,000 of qualifying pension income annually. Couples may each take advantage of this credit. The pension credit would offset the qualifying income allowing some couples the ability to withdrawal up to $4,000 per year tax-free from their RRSP.
In a previous article we introduced Mrs. Taylor, age 75 and in the highest marginal tax bracket in British Columbia. Through our discussion she was considering charitable insured annuities. Today we are comparing a regular annuity against an insured annuity. Below we have outlined the monthly cash flow for three scenarios, a GIC investment, insured annuity and regular annuity:
The three options above reveal that the greatest net cash flow comes from the regular annuity. Remember that the regular annuity provides no estate; the capital used to purchase the annuity is not returned. With the insured annuity above, the monthly cash flow is greater than a GIC investment earning 4.5 per cent and the capital is returned through the death benefit of the life insurance proceeds. The life insurance component of the insured annuity provides the ability to allocate the death benefit proceeds to more than one beneficiary, bypass probate and avoid public record.
Points of Concern
It is important to note that the investor is comfortable with the determined cash flow which generally does not adjust with movements in interest rates or keep pace with inflation. Investors would be wise to consider their current state of health along with their family medical history.
Our rule of thumb when it comes to annuities is that an individual should never put more than one third of their investments into an annuity. It is important to keep some funds liquid in the event of an emergency.
Many individuals may want to take a hands-off approach to their finances during retirement. Most certainly would prefer not to worry about their finances and know exactly how much income is available each month. A life annuity may provide the equivalent safety of fixed income and the comfort of knowing the payments will last a lifetime.
Before implementing any strategy noted in our columns we recommend that individuals consult with their professional advisors.