Guaranteed Retirement Income, At a Price

03/02/2011 1:33 pm EST

Focus: GLOBAL

Rob Carrick

Columnist, The Globe and Mail

Life annuities have one major advantage—they’ll pay you a fixed amount every month for the rest of your life—and a host of disadvantages, which limit their actual value, writes Rob Carrick, columnist for The Globe and Mail.

The life annuity is a retirement investing product with to-die-for optics.

Life annuities pay a regular, guaranteed amount of money every month for as long as you live, which addresses two big retirement risks:

  • One, that the stock market will crash just as you’re about to start drawing down on your retirement savings;
  • Two, that you’ll outlive your savings.

Worry-free income for people who don’t have company pension plans—that’s the idealized view of life annuities. But for reasons that relate both to current financial market conditions and the way in which life annuities are constructed, their real-world appeal is limited.

“Longevity Insurance”
The term annuity is a broad one that encompasses segregated funds, a type of mutual fund with insurance guarantees, as well as the guaranteed minimum withdrawal benefit (GMWB), a retirement-income product that protects you from losses in the markets while offering the possibility of investment gains (read my column on GMWBs here).

Life annuities come in a few different variations, but the basic concept is that you turn over a lump sum to an insurance company that commits to paying you a fixed amount for the rest of your life.

Long-term interest rates have a big impact on the amount of your monthly payments, but there’s another factor as well, called mortality credits.

Think of mortality credits as premiums paid by annuity holders who died sooner than expected. These premiums help increase the amount of the monthly payments you'll get when you buy an annuity.

The Investor Education Fund has prepared this example of how the monthly payments on a $100,000 investment in a life annuity might vary according to the features you select.
Straight life Provides you with income for life. $650
Life plus five-year guarantee Provides you with income for life. Guarantees 60 payments to your estate in case you die within the first give years of your contract. $640
Life plus ten-year guarantee Provides you with income for life. Guarantees 120 payments to your estate in case you die within the first ten years of your contract. $620
Life plus joint-and-last-survivor Provides income for life for you and your spouse. Payments stop when both of you have died. $500
Indexed life annuity Provides income for life. Payments increase with inflation to maintain your buying power. $400 to start (goes up when prices rise)

Lowell Aronoff, an annuity expert and chief executive officer of Cannex Financial Exchanges, says life annuities are an answer for people who are worried about how they will cover the basic costs of living in retirement.

“You need to lock in a certain amount of assets to cover these costs for the rest of your life, and annuities do that more efficiently than anything else,” Aronoff said.

Alexandra Macqueen, a certified financial planner (CFP) and co-author of the recent book Pensionize Your Nest Egg, describes life annuities as “longevity insurance.”

More than that, they’re insulation from upheaval in financial markets. “You’re taking your money out of the stock market with a life annuity,” she said. “And, you’re guaranteed an income level for every month until you die.”

Ready to Get Locked In?
Life annuity sales have risen in recent years, but not as much as you might expect, given the level of financial market uncertainty we’ve seen.

The Canadian Life and Health Insurance Association reports that assets in life annuities totaled $25.9 billion as of last Sept. 30, up almost 6% from the end of 2009 (that’s premiums paid plus investment gains on that money, minus money paid out to annuitants).

Asher Tward, vice-president of estate planning at Tri-Delta Financial, has a theory that life annuities aren’t more popular because the rules are so rigid­—once you buy an annuity, you can’t cash it in or get your money back.

“People want to do the conservative thing, but they don’t want to lock in,” Tward said. “People hating locking themselves into something for a long time.”

The locked-in aspect is a particular worry now, with concern about inflation mounting. A life annuity cannot protect you against higher living costs unless you pay extra for one that offers inflation-indexed payments.

Macqueen said indexing is not widely available from sellers of life annuities in this country, which means there’s little price competition. Her preferred defense against inflation is to partner an annuity with investments in stocks and in real return bonds, which adjust their returns higher if the cost of living climbs.

Rates, Complexity Raise Red Flags for Annuities
There are also a couple of structural reasons that make life annuities unattractive, one of them being the fact that they’re a strikingly bad value if you buy one and die soon after. If you don’t ante up the extra money for an annuity that keeps money flowing to a spouse or your estate upon your death, your annuity investment passes to other investors through those mortality credits.

Another negative is that annuities can seem opaque when you try to compare them with other investing options. The mix of factors insurers consider in determining annuity payouts include the amount of money you contribute, your age, long-term government bond rates, mortality credits and fees to pay advisers who sell annuities.

It’s very difficult to compute the monthly payments of an annuity into an annualized rate of return based on a scenario where you, say, buy at 65 and live to 85 or 90.

Today’s very low interest rates add to the uncertainty about the long-term attractiveness of an investment in an annuity.

“If we were in a high-rate environment, it would be a fairly easy decision to buy one,” Tward said. “I’ve come into contact with clients who bought an annuity in the late 1980s [when rates were high]. That’s gold.”

Annuity payments vary from company to company, so shopping around is mandatory. A survey on Cannex’s database this week found that a 65-year-old male buying a plain $100,000 life annuity for a registered retirement savings plan (RRSP) would be able to generate monthly income ranging from $579 to $652, while a female of the same age would have had a range of $556 to $579.

Consider not just the amount of a life annuity payout, but also the insurer’s financial stability rating from a company such as A.M. Best. Note that the life insurance industry’s consumer protection plan, Assuris, covers the higher of $2,000 per month or 85% of your monthly payment if your insurer becomes insolvent.

A strategy for buying life annuities that address some of their drawbacks is to invest gradually rather than all at once. “First of all, you can invest in a variety of companies, which makes you a little bit safer,” Aronoff said. “Second, you’re hedging what’s happening in the interest rate environment.”

When considering an annuity, remember that the Canada Pension Plan and Old Age Security provide income for life, as does a company pension. “If you’re covered by lifetime income for your essential expenses, you probably don’t need to buy an annuity,” Aronoff said.

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