Every retiree should have a pension
When you’re retired, it generally makes good sense to have some part of your wealth producing a regular monthly income no matter how long you live.
If you don’t have a defined benefit pension, then you might consider a life annuity. If the annuity is funded from personal resources (as opposed to RRSPs and corporate monies) the annuity qualifies for special tax treatment as a ‘Prescribed Annuity’. As a result, most of the monthly receipts may be considered a tax-free return of capital giving you more after-tax income than what you’d receive from bonds or GICs. We’ll talk about how an annuity works, how it is taxed, and the pros and cons.
In retirement, one should have a pension that pays you an income every month covering most of your basic living needs no matter how long you live. If you don’t have a defined benefit pension plan, then you might consider buying a pension to supplement your retirement income – one such type of pension is a life annuity.
What’s an Annuity?
An annuity is a contract providing you with periodic cash receipts (normally monthly) in exchange for an up-front lump sum payment. Those receipts may be for a pre-determined fixed number of payments (a “term annuity”) or they may be guaranteed for your life (a “life annuity”).
Where the annuity is with a life insurance company, the annuity contract is considered to be a form of insurance and may be protected from your creditors.
If the life insurance company defaults on its payment obligation to you, your periodic cash receipts may be covered for up to $2,000 per month or 85% of the promised monthly annuity receipts, whichever is higher through Assuris (formerly Compcorp).
Where we expect to buy annuities that pay more than $2,000 a month, we might buy annuities from more than one insurer so that your entire annuity receipts are protected.
For an annuity, the amount of the periodic cash receipt you will receive for your lump sum purchase amount is dependent upon:
- whether you select a term certain annuity or life annuity;
- for a life annuity, the type of survivor annuity guarantee, if any, that you choose; and
- prevailing interest rates and whether the cash receipts are to be indexed.
Having guaranteed periodic cash receipts is very attractive as you are assured a guaranteed return on your annuity capital and assured to receive a set amount regularly to cover part of your living expenses no matter how long you live.
Taxation of an Annuity
For Canadian tax purposes, annuities purchased with monies from a registered plan (eg. RRSP, RRIF or DPSP) result in the entire amount of annuity receipts to be taxed as income when received.
For annuities purchased out of “tax-paid dollars”, the receipts represent a blend of capital and interest. The capital component being non-taxable and the interest component taxed as ordinary income.
For personal annuities purchased out of tax-paid dollars, you may choose the annuity to be taxed as a “Prescribed Annuity”. In a Prescribed Annuity, the capital and interest receipts are fixed over the entire term of the annuity. The estimated term of a life annuity is based on a standard mortality table of life expectancies.
So a Prescribed Annuity generates less taxable income in the early years than a non-Prescribed Annuity. And if you believe you will live longer than your life expectancy, you may find a Prescribed Annuity may result in a lower amount of taxable income from the annuity throughout your lifetime.
Types of Life Annuities
- a) Straight Life Annuity
Life annuities ensure that you receive a guaranteed income throughout your lifetime and not outlive your resources – no matter how long you live.
On your death the cash receipts will terminate, regardless of whether they were made for one week or for thirty years.
The amount of the cash receipts are based on annuity rates set by actuaries based on average life expectancies. As women have a longer expected life span, the cash receipt paid to a woman will generally be lower than the annual receipt paid to a man. A life annuity may only be sold by a life insurance company.
The Straight Life Annuity has the highest periodic cash receipt – but it is considered the riskiest form of annuity because of the possibility of premature death.
- b) Joint Life Annuity
Under a Joint Life Annuity, in the event of your death, some portion of the cash receipts (such as 50%, 60%, 75% or 100% of the original cash receipt) will be paid to your spouse (or other named beneficiary) for the remainder of their life.
- c) Life Annuity with Guarantee Period
Under a Life Annuity with Guarantee Period, cash receipts are guaranteed to be paid for your life but are guaranteed to be paid for at least a pre-determined number of years (typically 5, 10, 15 or 20 years).
In the event of your death occurring before the end of the guarantee period, cash receipts may continue to be paid for the remainder of the guarantee period to a named beneficiary, a trust or to your estate. Alternatively, the remaining value of the guaranteed payments may be commuted with the lump sum paid to either your estate or to a named beneficiary.
- d) Insured Annuity
Where preserving capital is also important, an Insured Annuity might make sense.
Under this option, both a life annuity and Term-to-100 life insurance are purchased. Purchasing a life annuity allows you to receive higher cash receipts, but a portion of the receipts are used to make insurance premium payments. So, on your death, part of your estate is preserved by the insurance proceeds that are paid either to your estate, to a named beneficiary, or to a trust.
- e) Corporate Owned Insured Annuity
An insured annuity can also make good sense as a strategy to reduce tax where it is owned through your private company.
If you own private company shares, on the last to die of you and your spouse, these shares are deemed disposed at market value resulting in capital gains taxes. Taxes are payable a second time where company assets are disposed of (creating taxable capital gains) and distributed to shareholders (which might be in the form of dividends subject to tax). So, your company investments are subjected to tax twice – once at your death and then again when realized and distributed.
If your company has surplus assets, it may be possible to reduce these taxes where the company buys a Non-Prescribed life annuity which reduces the pool of surplus assets. Term-to-100 life insurance is then separately bought having a death benefit sufficient to replace the annuity capital.
What this does is convert surplus assets to a death benefit that can be excluded in valuing the company for tax purposes. Most or all of this death benefit is credited to the Capital Dividend Account that can then be paid to your heirs tax-free.
The result is that the through a corporate owned insured annuity you may be able to reduce capital gains taxes at death. And this reduction in taxes can be greater than a plan to simply redeem company shares at death.
Let’s say you’re a 65-year old man and you have $250,000 personally to invest. You want to invest this money to provide you with regular income to meet your living needs.
One possibility (see “Option 1” on Schedule 1) is to buy a bond that earns 4.0%. At the 40% tax bracket, your after-tax return is 2.7%.
Another choice (see “Option 2” on Schedule 1) is to buy a Prescribed Annuity for $250,000. The annuity will pay you $19,996 each year no matter how long you live. And as a Prescribed Annuity, only $5,431 of each year’s receipts is subject to income tax (i.e. 72.8% of the total receipts is a tax-free return of capital). So at the 40% tax bracket, you’ll end up with $17,793 in your pocket each year. A bond would have to pay interest at a rate of 11.86% to give you the same amount of income after-tax.
There are two reasons why you receive this big boost in yield. First, you lose access to the capital – you’re only entitled to the monthly cash receipts. This makes sense because the insurance company must invest those monies for the long term to generate excess returns to pay you your guaranteed return.
Second, on death, the cash receipts terminate leaving no annuity capital for your loved ones. That’s where life insurance comes in.
This return of annuity capital is shown under the third alternative (see “Option 3” on Schedule 1). For a 65 year old non-smoking man, $250,000 of term-to-100 life insurance is purchased costing $656 per month. (Note that with insurance you pay the first premium up-front). That leaves $249,344 to buy the Prescribed Annuity. The annuity will pay $19,913 each year of which $5,416 is taxable income. When taxes of $2,167 and the full-year’s insurance premium of $7,872 are paid, you end up each year with $9,875 in your pocket. A bond would have to pay interest at a rate of 6.58% to give you the same amount of income after-tax.
|Schedule 1: Comparing the Returns of Bonds to Annuities|
|Option 1||Option 2||Option 3||Option 4|
|Bonds||Prescribed Annuity||Insured Annuity||Charitable Insured Annuity|
|Less: up-front insurance premium||–||–||($656)||($656)|
|Net Amount of Bond/Annuity Purchase||$250,000||$250,000||$249,344||$249,344|
|Gross Annual Income||$10,000||$19,966||$19,913||$19,913|
|Income Tax (40%)||($4,000)||($2,172)||($2,167)||($2,167)|
|Add: Charitable Credit||–||–||–||$3,440|
|Less: Annual Insurance Premium||–||–||($7,872)||($7,872)|
|Net Annual Income Receipts||$6,000||$17,793||$9,875||$13,315|
|After-Tax Cash Yield||2.40%||7.12%||3.95%||5.33%|
Note: The annuity is a life only annuity with no guaranteed years of payments based on a 65 year old male. The life insurance is a Term to 100 policy for a non-smoker male age 65 at a cost of $656 per month. This is an illustration only and does not constitute an offer to buy an annuity or life insurance.
One of the neat things about an Insured Annuity is that if your spouse dies before you, you can discontinue the term insurance. As a result, your net after-tax receipts increase from $9,875 to $17,747; that’s 7.1% after-tax. A bond would have to yield 11.83% to provide the same return.
If you need income and are charitably inclined, you can boost your income and also provide a nice endowment to your favorite charity. Under this option (see “Option 4” on Schedule 1) your insurance premiums payments become charitable donations (as the charity owns the insurance) for which you’ll be entitled to the charitable credit. Assuming you have more than $200 annually in other donations, the charitable credit on the $7,872 insurance premiums will be $3,440 (based on the highest tax bracket rate of 43.7%). Here you’ll end up with $13,315 after-tax in your pocket each year as long as you live – almost double the after-tax income of the bond of Option 1. A bond would have to yield 8.88% to provide the same return. By your age 84, you’ve gotten your capital back and you’re still receiving $13,315 a year. On your death your favorite charity receives $250,000.
Disadvantages of Annuities
The main disadvantages of annuities are:
- you generally lose control and access to the annuity capital – all you are entitled to is the agreed to periodic cash receipts;
- if it is a life annuity, cash receipts terminate on your death leaving nothing for the estate value or survivors (you can, at a cost, build in guarantees – such as joint-life, guaranteed number of years of payments, or a life insurance death benefit to pay back the annuity capital);
- Tax preferred Prescribed Annuities are by statute not indexed to inflation. As such, the purchasing power of the monthly receipts is eroded by inflation. So, you still need other investments to provide the inflation indexing and protect the purchasing power of your annuity;
- with interest rates at historically low levels, the annuity monthly cash receipts have also dropped to relatively low levels.
Where an annuity makes good sense
In today’s environment of low interest rates, a life annuity can make good sense:
- as an insured annuity where you’re in your 70s and you have at least $250,000 personally where you don’t need to touch the annuity capital to meet your living needs; or
- as a corporate owned insured annuity where you’re in your mid-60s or older, in relatively good health, and have at least $250,000 corporately of surplus funds not needed to meet living needs.
We suggest you consider having most of your basic living needs covered by an income guaranteed to be paid no matter how long you live.
The amount of pension income you might consider buying might be:
- your monthly living needs in retirement (say $5,000), less
- CPP, OAS and any defined benefit pension benefits you receive.
Let’s say that the amount of pension income to buy came to $2,000, then you might consider buying a life annuity paying you $2,000 a month.
We have found that clients who have most of their living needs met with pension income are generally less stressed about their investing. They also tend to act more rationally by emotionally being able to invest for the long term through adding to equities when they are down and taking profits when they are high.
Where an annuity doesn’t make sense for you because you require more income or require leaving an estate, then you might consider investing with Steve who follows an investment philosophy of generating income through selecting income oriented quality stocks and bonds.
The Next Step
If you would like more information about life annuities or if an annuity makes sense for you, please call me, Steve Nyvik at (604) 288-2083 (x2) or email me at Steve@lycosasset.com.
Written by Steve Nyvik, BBA, MBA ,CIM, CFP, R.F.P.
Financial Planner and Portfolio Manager, Lycos Asset Management Inc.
 Assuris is a non-profit corporation that protects Canadian policy holders against loss of benefits due to the financial failure of a member company. All life insurance companies authorized to sell insurance policies in Canada are required, by the federal, provincial and territorial regulators, to become members of Assuris.
- The annuity must be purchased with non-registered funds (not with RRSP/RRIF or corporate funds);
- The owner and the person entitled to the payments (payee) must be the same and may not be a corporation [i.e. the owner may be an individual, testamentary trust or spouse trust];
- The payments must begin in the current or next calendar year;
- Annuity payments continue for a fixed term or for the life of the owner;
- If there is a guaranteed or fixed term of payments, the guarantee cannot extend beyond the annuitant’s 91st birthday;
- If a joint and last survivor contract, the annuitants are limited to spouses or siblings of each other;
- The annuitant cannot surrender or commute the annuity, except on death;
- The payments must be level (indexing is not allowed) and made at regular intervals, not less frequently than annually.