Are insured annuities a good option for retirement?
Transitioning to retirement, many Canadians shift their investment portfolios away from a growth-oriented approach and toward income generation and principal protection. This typically leads to investments such as government bonds, GICs and other lower-risk investments. While those investments may offer income and safety of principal, the flip side of that coin is that they typically come with less tax efficiency and lower net return.
If the goal is to maximize after-tax retirement income, and subsequently leave assets to others upon death, an insured annuity may be a strategy to consider.
What is an insured annuity?
An insured annuity isn't a single product, but rather, a combination of two products: a prescribed life annuity, and a life insurance policy. The prescribed life annuity provides a predictable and guaranteed income stream, with level payments for life and offers a blend of tax-free return of principal and taxable interest with each payment. The permanent life insurance is payable upon death and restores the value of the estate and provides a tax-free inheritance to heirs.
How does an insured annuity work?
The investor purchases a prescribed life annuity and a permanent life insurance policy. Although these are separate products, the strategy requires that both products be purchased in combination. The face amount of the life insurance policy is typically equal to the amount used to pay for the annuity. The annuity provides guaranteed income for life, a portion of which is used to pay the life insurance. Upon death, the life insurance policy then replaces the planned amount invested in the annuity, thereby supporting the client’s financial legacy goals.
Although the strategy requires that both products be purchased in combination, it doesn't require them to be purchased simultaneously. In fact, in many cases, it may be more advantageous to acquire the life insurance several years before purchasing the annuity. The cost of life insurance can increase considerably in later years and therefore purchasing life insurance while an individual is still relatively young and healthy often makes good sense, even if the annuity income isn't required until some point in the future.
Who are insured annuities for?
The insured annuity strategy may be suitable for conservative investors, typically age 60 or older and in good health, with at least $100,000 who want to:
- Maximize their retirement income.
- Enjoy a guaranteed and predictable retirement income stream.
- Preserve the value of their estate for their heirs.
Key benefits of insured annuities
The insured annuity strategy presents several attractive benefits to investors, including:
- Protection against longevity risk – Life annuities provide an income for life, thereby ensuring clients have guaranteed income regardless of life expectancy.
- Available on a joint basis - depending on the annuity structure chosen, income can continue for as long as either annuitant is alive.
- Protection against re-investment risk – Annuity rates are determined at purchase, thereby insulating against the risk of investing cash flows at potentially lower rates in the future.
- Tax management – Prescribed annuities offer a guaranteed and predictable taxable income stream to investors. (Prescribed annuities cannot be purchased in registered accounts.)
- Ease of estate settlement – The life insurance policy allows for a named beneficiary, thereby avoiding probate offering additional efficiency in estate settlement upon death.
Drawbacks of insured annuities
As with any investment strategy, the insured annuity strategy is not without drawbacks. Perhaps the biggest disadvantage to this strategy is the loss of liquidity. Purchasing an annuity essentially involves converting a lump sum of assets into a stream of guaranteed payments. However, this also means relinquishing control of capital and the original lump sum can no longer be accessed if needed in an emergency or other situation.
Furthermore, the loss of liquidity also presents an opportunity cost — after the annuity is purchased, the investor can no longer use the original pool of capital to take advantage of other investment opportunities that may arise in the future. This may also be coupled with interest rate risk, if annuity rates increase in the future and the investor is contractually bound to a lower rate.
A big picture approach
Like other investment products, annuities should be considered in the context of the client’s overall investment and income goals, time horizon, risk tolerance and other personal circumstances. Additionally, it’s important to recognize that annuities need not be an ‘all or nothing’ decision. Rather, it may make sense to strike a balance and use a portion of capital to purchase an annuity and retain another portion of the capital in other products such as GICs, mutual funds and ETFs.