For most investment savvy individuals looking for a fixed income, the annuity is often overlooked. It’s usually something your grandparents talked about. But what are annuities and how do they work?
What is An Annuity?
An annuity is a contract with a life insurance company where you purchase a stream of income that will be returned to you over time. Simply, you turnover a sum of money to the annuity provider and you receive your money back with interest.
An annuity can be purchased with registered money from your RRSP or RRIF (known as a registered annuity) or with non-registered money.
Other Features of Annuities
The plain vanilla life annuity pays you a fixed sum of money monthly or quarterly for life. You can have other features added to spice things up and customize the annuity to meet your specific needs. Some common features include:
- Guarantee Periods For Estate Purposes: If you purchase an annuity with a guarantee period (5, 10, 15 years etc.) and die before the guarantee period is up, your beneficiaries will continue to receive the payments as an inheritance.
- Joint Life: If you are married, you can have the annuity continue to pay until the second spouse passes away.
- Indexing: If you are concerned about inflation and want to have your annuity payments increase annually, you can have the payments increased set percentage. The indexing amount is set in advance and reduces the amount of money you will receive now.
- Prescribed Annuities: Annuities work like bank loan in reverse and regular annuities (i.e. not purchased from an RRSP or RRIF) have a portion of your payment as interest. Over the life of the annuity, the amount of interest goes down. A prescribed annuity is a special annuity that includes a level annual interest payment.
Many of these features come at a cost. So be aware that the more features you select will decrease your annuity payments.
How Are Annuity Payments Determined?
The two main factors used to calculate payments is life expectancy and log term interest rates. With life expectancy, the life insurance company is guessing at how long they will have to pay out on the annuity.
Interest rates are important because they are used to match the rate of return the insurance company expect to receive by investing the funds themselves. They are betting they can earn more income on the annuity deposited with them than they will have to pay to you with your regular payments.
Print This Post
{ 4 comments }
I always thought of indexing as increases at the rate of inflation. Unfortunately, it doesn’t seem possible in Canada to get an annuity indexed to inflation. I find little comfort in escalating payments at a fixed percentage each year. The worry is a period of high inflation.
Hi Michael,
I suppose the insurance company doesn’t like the risk of inflation and prefers more certainty.
I personally think that fixed source income should be limited to about 25% of income. This gives some fixed source income with access to capital.
You can by annuities that are indexed to inflation but you will experience quite a drop in income by electing the indexed option. Typically the option is to pick a rate of indexing like 2% for example as opposed to the option of picking a variable indexing rate where the indexing rate changes with the rate of inflation. Having run the numbers regularly, the math is not very rewarding in the indexed option because the breakeven point is quite a ways out (well into your 80’s). In most cases I have looked at it is better to choose a non-indexed annuity. that being said, annuities in general and not popular because of low interest rates.
Wealth Web Guru:
Yes. From a purely financial point of view, the returns imputed in an annuity are not great. However, for those looking for guaranteed income or with very low risk tolerance, they can be an attractive alternative.
Comments on this entry are closed.