Monday, October 26, 2009

Maximum Retirement Income

You have saved all your life for retirement, you have a nice little nest egg of cash and are ready to start drawing an income. How do you get the best bang for your buck while taking a minimum amount of risk?

People at or near retirement are naturally more conservative with their money and investments, they like to color within the lines. Most retirees gravitate towards guaranteed investments like GIC’s. While safe, GIC’s provide poor returns and notoriously bad after tax returns. GIC’s are treated as income, and fully taxed at your marginal tax rate. This can be as high as 43.7% in BC. Why give up almost have of your gains to taxes if you don’t have too.

Enter stage left, the Insured Annuity. Annuities provide a guaranteed stream of income just like GIC’s but, they are far more tax efficient than a GIC and they provide a substantially higher ROI than a GIC.

A brief primer on annuities.
Annuities pay the highest ROI of any guaranteed investment product. An annuity, in a nut shell is a backwards life insurance policy. Instead of paying a small monthly premium and getting a big payout from the insurance company at death, you give the insurance company a big cheque now, and they agree to pay you for the rest of your life. There are lots of options and guarantees which can be added but in its simplest form a life annuity will pay you from today to the day you die, be it next week or decades from now. The catch, if you do die next week, the insurance company keeps all your cash, even if you only received a single payment. Flip side of that coin is, if you live a long time, the insurance company has to keep paying you even after your money is long gone. The people who die young subsidize those who live to a ripe old age. Because some people die before their money is paid back, there is more money to go around, which is why annuities pay such a high rate of return.
An annuity will pay you a big income, but what good is it if you die tomorrow and your spouse gets nothing? Risk of dying too soon, sounds to me like you need life insurance...

Life Insurance, more specifically low cost, permanent life insurance.
Term 100 or minimum pay Universal Life will provide a guaranteed premium, and a guaranteed payout. Remember retiree’s life guarantees! Purchasing a permanent life insurance policy for the face amount of the annuity will allow us to preserve our original capital in the event of dying too soon. There is an insurance premium that needs to be paid of course, we take part of the annuity payment and earmark it for the insurance cost. As luck would have it the insurance costs are about half of what the annuity will pay us.

To summarize, we buy a Single Life Annuity to get the highest income from our capital, we have a risk that we could die too soon and lose our capital before it’s repaid so we buy life insurance which replaces our capital when we die. Still following along?

Now, the bright crayons in the box will be thinking, “why pay all that insurance premium, when I could just live off the capital in the first place?” good job Burnt Sienna, one word, taxes. I have to harken back to the beginning of the post, retiree’s like guarantees. Other than annuities, GICs are the main player, and they are a tax nightmare. The insurance cost pales in comparison to the brutal tax bill CRA is going to exact from your GIC’s.

Math time.

(FYI, current annuity payout as of Oct 26 2009 $46,578.00, current 5 year GIC rate 3.925% so the example above is fairly accurate)

Starting with the same amount of capital, $500,000 we compare an annuity payout to the annual return of a long term GIC. All of the GIC earnings are spent and the original capital is reinvested.
Right off the bat you can see that the annuity provides more than double the pre-tax income of the GIC, $45,668 vs $20,000. This increased payout is due to those people who died young, subsidizing the rest. Other than the superior ROI, the tax situation is very noteworthy. As previously mentioned the GIC earnings are treated as income, and are fully taxable at your marginal tax rate. The Annuity in its “prescribed” form, includes a Return of Capital, which basically means you are spending a portion of your own money (tax free), and a portion of investment earnings (taxable). This greatly reduces the tax bill in the early years of the annuity. Tax payable at the end of the year, $4023 for the annuity and $9000 for the GIC’s. The annuity can produce a net after tax income to nearly FOUR TIMES that of the GIC $41,645 compared to just $11,000.

Carnation Pink has pointed out that while the Annuity has a better cash flow; if you die early you lose all your capital, while the GIC retains its capital every year. When you have a risk of dying too soon you buy insurance. That insurance costs $21,305 in this example, which again is accurate as of today’s date. As long as you pay your insurance premiums your capital will be restored tax free with a death benefit. So while you have lost your original nest egg to the annuity gods, your heirs receive a brand new infusion from the insurance fairy.

What’s the catch? You have to pay your insurance premium, if you let the life insurance policy lapse the whole plan falls apart. If you are uninsurable or have health problems, you can’t get the insurance in the first place; this strategy is not for you.

Lastly, Insured annuities used to be really popular about 20 years ago, they have recently reared their heads again due to the global economic crisis. The reason they fell out of practice for so long comes down to two words, lapse rates. Permanent insurance is only as cheap as it is because some of the policies lapse, people paid premiums but never collected. Lapse rates need to be predicted accurately to know how to set the life insurance rates, problem is; insured annuity strategies necessitate NOT lapsing a policy, which skewed the predicted lapse rates. Insurance companies either lost money or had to increase their premiums. Most companies stopped offering both the insurance and the annuity, as doing both was a losing game; Multi-Company insured annuities were still available but the added complexity, as well as the better performance and taxation of equities made GICs and insured annuities less popular. BMO Insurance (formerly AIG Canada) has recently started promoting Insured Annuities again, they are providing both the annuity and the insurance, their rates for both products are quite good as well. I am not entirely sure how they plan on making a profit given the lapse rate problem I mention above, I can only assume their underwriters and actuaries have accounted for it.

TL;DR – Double your retirement income, guaranteed. Maintain your capital, guaranteed. Pay less tax, guaranteed.


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