Question. I’m planning to retire soon, and working on my retirement plan. I have a small pension, but most of my income in retirement will come from my own investments. A friend of mine recently told me that I should consider buying an annuity with my retirement savings. How can I decide if an annuity is right for me?
Answer. Annuities can be a great tool for providing a guaranteed and predictable income stream. For those of us who have saved and invested during our working years, and now need to convert our retirement nest eggs into an income stream that will sustain us for the rest of our lives, annuities can be highly beneficial.
Let’s take a look at the basics of annuities, some of the key risks that face us in retirement, and how annuities can help address those risks.
An annuity is a financial product that provides series of payments over time. While there are many different types of annuities, the general concept is that an annuity is a product that provides the investor with a regular income stream.
The easiest way to understand the concept of annuities is that they function somewhat the opposite of a mortgage. With a mortgage, the institution provides you with a lump sum of money, and in return, you pay the institution back a stream of payments over time. The mechanics of an annuity are the opposite – you provide the institution with a lump sum, and in return, the institution provides you with a stream of payments over time.
Some of the different variations of annuities include:
Payout vs. accumulation annuity
The most common type is that which is described above: a finance product that provides the investor with a stream of payments. This is known as a payout annuity. However, there is another form of annuity known as an accumulation annuity, which functions very much like a guaranteed investment certificate (GIC) in the sense that it is designed for savings, and provides a guaranteed rate of interest.
Immediate vs. deferred
With a payout annuity, the stream of payments can begin immediately, or at a future date. When payments begin immediately, the annuity is known as an immediate annuity, and when the payments begin at a future date, the annuity is known as a deferred annuity. For example, an investor may decide to purchase an annuity at age 55, but doesn’t want to start receiving the payments until age 60. In this case, the investor would purchase a deferred annuity.
Term vs. life
A term annuity is designed to provide the investor with a stream of payments for a specific length of time, such as 10 or 20 years. On the other hand, a life annuity provides the investor with an income stream for life. Life annuities can sometimes have a guarantee period as well, in which case the remaining payments are made to a designated beneficiary if the investor dies before the guarantee period ends.
Registered vs. non-registered
This distinction isn’t a choice made by the investor, but rather, is determined by the source of the funds used to purchase the annuity. If the source of the funds used to purchase an annuity is a registered investment account, such as an RRSP or RRIF, then the annuity is said to be a registered annuity, and every dollar is taxable as regular income. Conversely, if the annuity is purchased with non-registered funds, the annuity is said to be a non-registered annuity. One further distinction for non-registered annuities whether or not the annuity is prescribed, which refers to the tax treatment of the payments.
Key Retirement Risks
One of reasons annuities can be of particular benefit to retirees is that they can help protect retirees against some key risks that threaten retirement income. In particular:
Quite simply, longevity risk is the risk of running out of money in retirement. It’s great that we’re living longer than ever before, but failing to account for a longer lifespan can leave retirees in financial difficulty in later years.
Sequence of returns risk
Although we often talk about average rates of return, the reality is that poor investment performance in early years can be devastating for retirees. This is because money is being withdrawn from the account, so even if the average rate of return is adequate, poor returns experienced in the early years of retirement can cause the portfolio to be depleted much faster and ultimately collapse.
With annuities, both of these risks have been taken away from the investor and placed with the annuity provider, which is typically an insurance company. When you purchase one, the insurance company promises to make a stream of payments of a certain amount of money, and for a guaranteed period of time (or for life).
Therefore, an annuity completely insulates you against both longevity risk and sequence of returns risk. When you purchase one, longevity risk, stock market volatility, and poor investment returns are not your problem anymore – the insurance company now bears those risks, and is contractually obligated to make the payments to you. In this sense, annuities can provide retirees with both income security and peace of mind.