Given increasing longevity and as equity markets continue to go through a rough patch, some investors have asked whether there is value in revisiting the opportunity for an annuity as a component of a retirement income strategy.
In general, the best time to purchase an annuity is when interest rates are high and prospective inflation is low. This is because an annuity provides fixed payments to an individual, so inflation will erode the purchasing power of future annuity payments. However, with inflation appearing as though it may have peaked, and with interest rates at levels not seen in years and likely to climb in the near term, there may be a potential opportunity.
What is an Annuity?
An annuity is a form of insurance that provides a stream of payments to an individual for life, in exchange for a lump sum premium. One of the greatest benefits of an annuity is the income stream that is guaranteed until death. For individuals who want a reliable flow of income or worry about outliving their assets, this may be a suitable option.
However, the corresponding drawback of the annuity is that the initial capital put into the annuity cannot be retrieved as it has been exchanged for the ongoing stream of income. As such, the idea of locking up a substantial amount of retirement funds into an annuity may not be a recommended strategy for many individuals due to the lack of liquidity. As well, annuities generally do not provide funds to be left within the estate after death, although an insured annuity strategy could be implemented for estate planning purposes.
The Effect of Interest Rates
Interest rates affect the amount of income that will be paid out to the holder and this amount is generally set at the time of purchase. If an annuity is purchased during a time of lower interest rates, the payments will be less than if it is purchased when interest rates are higher.
Including an Annuity in a Balanced Portfolio
Generally, an annuity acts like an illiquid, permanent type of fixed-income instrument. It can be considered “permanent” because, unlike traditional bonds which fall in price when interest rates rise, the income generated by an annuity remains unaffected by changes in interest rates. Generally, many investors hold fixed-income investments to help provide income and stability against stock market declines and an annuity can play a similar complementary role in a portfolio. To take advantage of this, an investor may wish to put a smaller proportion of savings into an annuity and increase the amount over time. This may also be a way of mitigating any concerns over the potential for future rises in interest rates.
What Is an Insured Annuity?
An insured annuity provides the benefits of a guaranteed stream of income from the annuity, while still maintaining capital that is available for transfer to the next generation. It consists of two components: (1) the purchase of an exempt life insurance policy; and (2) the purchase of a life annuity that provides regular cash flows. The life insurance policy is purchased with a death benefit equal to the amount of the annuity investment. This is to
replace the capital used to purchase the annuity in your estate for the benefit of your heirs. The premiums for the life insurance policy can be funded by a portion of the annuity payments you receive and insurance proceeds are paid to your named beneficiaries. Since a portion of the payments you receive is considered to be a return of principal, only the interest-income portion of the payment is subject to tax annually.
As only part of the income received is taxable, when non-registered funds are used, the preferential tax treatment can be significant. This may result in a higher guaranteed after-tax cash flow relative to comparable investments in guaranteed investment certificates (GICs), term deposits or bonds. As only a smaller portion of income is deemed to be taxable, this may also help to preserve income-tested benefits such as Old Age Security (OAS) benefits. In addition, the death benefit is received tax-free by the beneficiaries. Where there is a named beneficiary, insurance proceeds will not form part of the deceased’s estate and, as such, will not be subject to estate administration fees, in provinces where applicable.
Keep in mind that the amount of regular annuity payments received and the insurance premiums you are required to pay will vary depending on such factors as age, gender, the amounts involved and the type of annuity and insurance purchased (and others). The higher insurance risk you pose, the higher your insurance premiums will be, resulting in lower after-tax cash flow.
The inclusion of an annuity or an insured annuity should be part of a larger diversified plan. Please get in touch to discuss whether this may be beneficial for your particular situation.
The information contained herein has been provided for information purposes only. The information does not provide financial, legal, tax or investment advice. This does not constitute a recommendation or solicitation to buy or sell securities of any kind. Market conditions may change which may impact the information contained in this document. Wellington-Altus Private Wealth Inc. (WAPW) and the authors do not guarantee the accuracy or completeness of the information contained herein, nor does WAPW, nor the authors, assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. All insurance products and services are offered by life licensed advisors of Wellington-Altus Insurance Inc. or other insurance companies separate from WAPW. WAPW is a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada.
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