Is an annuity right for you?
As a growing number of Baby Boomers retire, the question of what to do with maturing Registered Retirement Savings Plans is becoming more pressing. RRSPs must be shut down by the end of the year in which you turn 69, and the proceeds either taken into income in a lump sum, rolled over into Registered Retirement Income Fund (RRIF), or used to purchase an annuity. Often, retirees will opt for some combination of these. While RRIFs are reasonably well understood, annuities are still a bit of a mystery for many.
When you purchase an annuity, you essentially buy a contract under which the issuing company (usually an insurance company) invests the lump sum you provide and guarantees a regular payout with interest over the life of the annuity contract. Typically, monthly annuity payouts are quoted per $100,000 of the contracted amount. Very simply, an annuity provides a guaranteed income stream for life. Annuities are sometimes used as an RRSP maturity option; however, annuities have been less popular for this purpose in recent years, owing to the historically low level of interest rates.
Types of annuities
There are several types of annuities, with various types of payout schemes. You can, for example, choose payments for a fixed number of years, or you might choose payments that last for the rest of your life, however long that might be. You can opt for monthly, quarterly, or semi-annual, or annual payments.
For example, a “Term Certain Annuity” guarantees an income for as long as you want, up to age 90. If you die before all payments are received, the balance will go to your estate.
Another option is a “Life Annuity,” which guarantees a regular income for as long as you live. However, payments stop when you die, and no money will go to your estate.
Many people who must choose an RRSP maturity option opt for some combination of an active RRIF portfolio and an annuity to continue providing growth, inflation protection, and a guaranteed income stream. Another option may be to invest a portion of your portfolio in an insurance product that offers a guaranteed income withdrawal feature.
This type of product, called a Guaranteed Minimum Withdrawal Benefit product is similar to an annuity in that it guarantees a specific regular monthly, quarterly, or annual payment until you pass away. But unlike an annuity, the guaranteed income stream could increase as the investments in your portfolio increase. You can cash out of this type of policy and take the “cash surrender value” if your situation changes dramatically and you need the cash. (But I do not recommend taking the cash out of this type of policy except as a last resort.)
Once you buy an annuity, of whatever type, you’re locked into its terms, and you won’t be able to change them.
Factors affecting annuity payout
Because annuities are ultra-conservative products, they are typically tied to the level of prevailing interest rates. And those rates have been ultra-low since 2008. Annuity rates have thus also been correspondingly low, making annuities a less desirable RRSP maturity option than RRIFs for the past few years.
Other factors that typically affect the annuity payment you’ll receive are your age and gender (the older you are, the higher your payments, and women typically live longer than men), the amount you deposit and the length of the term, and any options or riders you add to the policy (such as joint-and-last-survivor), which increase the insurance company’s costs.
Annuity income is not taxed if the policy is purchased with non-registered funds (that is, you’re buying it with after-tax dollars). Income from annuities purchased with RRSP or RRIF funds will be taxed at your marginal rate (you’re purchasing the annuity with dollars from registered funds that have not been taxed). A “Prescribed Annuity,” which levels out the interest and principal portion in each payment, is one way to defer the tax bill, at least in the early years of the annuity payout.
Not for the do-it-yourselfer
Annuities are complex products, and it is important that you understand how interest rates and other factors affect how much income you will receive. It may not be advisable to convert all of your RRSP into an annuity – this will depend on your investment objectives and risk tolerance. I recommend seeking the advice of your financial planner and/or a licensed insurance agent to discuss annuity options and how they might best fit into your overall retirement plan.
© 2017 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited. This article is for information only and is not intended as personal investment or financial advice. Securities mentioned are not guaranteed and carry risk of loss.