There are two basic types of annuities:
The Immediate Annuity
You hand over a lump-sum premium to an insurance company and in return you get an immediate flow of regular income payments.
The Deferred Annuity
A deferred annuity is a savings vehicle. It has an accumulation phase and a withdrawal phase. It is more tax-efficient than a bank deposit. Many people use a deferred annuity as a tax-efficient way to save for their retirement. The withdrawal phase need not be in the form of regular income to the investor; it could be a lump sum. Annuities are sold by life insurance companies. Traditionally, in return for your lump sum premium the insurance company paid you an income. The income was guaranteed for your lifetime.
Annuities paid a higher interest rate than banks could. This was because annuities and bank deposits were (and are) completely different. When you buy a lifetime annuity, you effectively sell your money for ever in return for an interest rate and lifetime income. Banks only have your money on loan; they don’t get to keep it at the end of your life, so they cannot offer you as good a return as an annuity can.
Annuities have traditionally been used as a means of providing a lifetime pension. People saved while they worked and bought an annuity to provide an ongoing income in retirement.
Nowadays, innovations in financial products have led to a broadening of the meaning of an annuity.
To offer a explanation of annuities in a modern context, we’ve split them into immediate annuities and deferred annuities.
Immediate Annuities Explained
Immediate annuities turn a lump sum into an income stream. The income stream you receive depends on the type of immediate annuity you purchase.
There are three main decisions you need to make when choosing an immediate annuity.
- How long do you want your annuity to last? Your lifetime, or for a fixed amount of time, say 20 years?
- At the end of your life would you like the annuity payments to end also, or would you prefer the annuity to continue and provide income to your spouse?
- Would you like the income from your annuity to be guaranteed not to fall below a certain miniumum level, or are you willing to have its performance linked to the ups and downs of the stock market?
Let’s address each of these questions in turn.
How Long Would You Like The Income To Last?
You can choose whether the annuity income should stop after a chosen number of years or stop at the end of your lifetime. The longer the annuity has to pay you an income for, the lower your interest rate will be. Your age will be taken into account in the interest rate you receive. The older you are or the lower your life expectancy, the higher the interest rate you receive will be.
Term Certain Annuities
In a term certain contract, you specify the number of years you will receive an income for. The shorter the time span, the higher the monthly payments you receive will be. If you die during the stated period, your heir(s) will continue to receive the payments.
A term certain annuity can be useful to bridge an income gap – for example, if you stop work at 60 but your pension isn’t due to be paid for some years. There are legal limits on how many years a term certain annuity can cover.
Single Life Annuities
If you opt for single life annuity payments, these will continue until your life comes to an end. If you begin receiving payments at the age of 60, even if you lived to be 120 years old, your payments would not stop; they would continue for the whole 60 years.
If, however, you live only to the age of 61, all of your annuity income stops after one year. Your spouse gets nothing from the annuity. In these circumstances your annuity will have been a poor purchase.
If you live to be 90, your payments will continue for 30 years. 30 years is a long time in the commercial world. Companies come and go in this time frame. Make sure you buy an annuity from a company you believe will stand the test of time.
An Income For Your Spouse After Your Demise
Joint life annuities address the issue of a couple requiring an income until the demise of both partners.
Joint Life Annuities
Joint life payments are paid while one person from a couple continues to live. If you opt for a joint life annuity, your monthly checks will be lower than for a single life annuity. (There’s no such thing as a free lunch. It’s likely more checks will have to be paid by the insurance company for a joint life than for a single life annuity.) One way for a couple to get a higher payment is to choose a plan that, after the demise of one partner, pays a reduced income – say 75% or 50% of the original payment – to the surviving partner.
Fixed, Variable or Equity Indexed Annuity?
Although they are called fixed, some fixed annuities don’t actually offer you a fixed interest rate. Instead they offer you a guaranteed minimum interest rate of say 4.0 percent and a better introductory interest rate in your annuity’s first year. The interest rate can move up or down but will never go below your minimum guaranteed rate. The fact that there is a floor on payments can be a useful tool in planning your retirement income.
The fixed nature of the payments can, however, be a disadvantage if the purchasing power of your annuity payments are eroded by inflation. To counter the effects of inflation, annuities are available that will pay you a growing income each year – growing by 3 percent or 5 percent – but this type of annuity pays a lower initial return.
Returns from fixed annuities depend on the general level of interest rates in the economy. When interest rates are low, returns from fixed annuities are also quite low. To obtain a comfortable income in these circumstances, you will need to invest quite a large lump sum in your annuity.
For example, a return of 4.2% provides a gross income of $350 a month for each $100,000 of lump sum you invest. For a gross income of $1,750 a month you’d need to spend $500,000 on your annuity.
Variable or Equity Indexed Annuities
If you are willing to sacrifice the security of a minimum guaranteed income, variable and equity indexed annuities offer the possibility of better returns. Investors in the early years of the 21st century, however, have grown increasingly sceptical of the ability of stock-linked annuities to provide a reliable retirement income.
Deferred Annuity (Prepaid RRIF)
- You purchase a deferred annuity policy (term certain to age 90) with the option of converting to a RRIF at the earlier of age 71 and within 7 years of the annuity purchase date; an interest rate and term are selected for the RRIF
- The single premium accumulates at the annuity policy’s interest rate
- If you convert to a RRIF, the accumulated value of the policy is transferred to the RRIF while maintaining the RRIF interest rate for the balance of the term selected
- If you choose not to convert to a RRIF, annuity payments automatically start at the annuity policy’s commencement date
- Income payments are the same for the duration of the annuity
- Income payments increase each year by a fixed percentage
- Maximum increase per year
- 4% for registered annuities
- 6% for non-registered annuities
- Income payments increase each year according to the level of the Consumer Price Index (CPI)
- Payments can be fully or partially indexed to the CPI
- Payments will never decrease or be subject to clawbacks
- Payments can be indexed during the deferral period (from the date of the single premium payment to the annuity commencement date) to a maximum of 10 years
- Payments can be converted to U.S. dollars and deposited in client’s U.S. bank account
- “Snowbirds” can receive payments in a Canadian bank account in Canadian dollars, or in a U.S. bank account in American dollars
Frequency of income
- Monthly, quarterly, semi-annually or annually
- Direct deposit to client’s bank account
- The annuity payment is fully taxable
- Only the interest portion is taxable
- The taxable portion can be reported on a “prescribed” or “non-prescribed” basis
- Prescribed: level taxable portion each year
- Non-prescribed: taxable portion changes each year
(interest reported each year reduces)
The prescribed taxation basis is attractive to taxpayers as it allows for the deferral of taxes. It is regulated and can only be used with specific types of annuities. All other annuities must be on a non-prescribed taxation basis.