Trading liquidity for certainty with an annuity

Great article in the Globe and Mail on the Insured Annuity concept.

Tim Cestnick

Published on Thursday, Jan. 14, 2010 12:00AM EST
Globe and Mail

Tim Cestnick is managing director at WaterStreet Family Wealth Counsel and author of 101 Tax Secrets for Canadians. 
 
Perhaps you've heard the story of the elderly gentleman? The story, which varies a little depending on where you first heard it, goes like this: A reporter was sent to interview a man as he turned 100 and find out if there were a formula to his longevity. "Sir, do you have any secrets you can share that have allowed you to maintain such good health for so long?" "Well, I go to bed early, get up at six in the morning, eat lots of vegetables, I don't smoke or drink, and I go for a brisk walk every day," the man replied. "There must be more to it," said the reporter. "I had an uncle who lived the same way and he died at age 60. I'm not sure how to explain that." "That's easy," the man said. "He didn't keep it up long enough."

Everyone is searching for the secret to longevity. The question is: Will you run out of income before running out of retirement? Today, I want to share a retirement income idea that can provide an increase in your after-tax cash flow in retirement, preserve your capital, boost your returns after tax and other costs, and remove interest rate risk from your portfolio. I'm talking about an insured annuity.

The idea
The insured annuity concept involves doing two things: First, purchasing an annuity to provide you with cash flow in retirement, and purchasing life insurance at the same time. Why life insurance? Simple. When you carve out some capital to purchase the annuity, those are dollars that your heirs will never receive. Once you're gone, the annuity payments cease, and whatever capital might have been invested in that annuity is also gone - nothing will generally be given to your heirs (you can purchase a guarantee so that, if you die young, your heirs are guaranteed to receive some minimum amount, but this is not generally done due to the added cost).
The insured annuity idea works well provided that you or your spouse are insurable at standard rates (if you're high risk and the insurance is more costly, the idea may not make sense).

The example
Here's an example that comes courtesy of John Jordan, CFP. Consider Mike and Shannon. Both are 70 years of age and are in good health. They're concerned that their retirement income has been eroded by low interest rates and poor investment returns. The couple has a portfolio that includes $400,000 in GICs and T-Bills, earning an average of 4.5 per cent annually. Mike and Shannon would like to keep $150,000 fairly liquid for emergency purposes, but would like to increase their after-tax returns on the other $250,000.

Currently, the couple will earn $11,250 annually (4.5 per cent on $250,000) on the GICs and T-Bills. At a marginal tax rate of 43.41 per cent (the second highest marginal tax rate in Ontario), the couple will pay taxes of $4,884, and will be left with $6,366 after taxes annually.

Mike and Shannon have chosen to implement an insured annuity strategy. Here's what they did: They used $250,000 to purchase an annuity. The annuity will pay them $20,286 annually. Just $5,042 of the annuity payments are taxable. Why? Because each annuity payment is partly a tax-free return of their original capital, and partly interest income. The tax owing annually on the annuity payments will be just $2,189, and they will recoup some Old Age Security benefits in this case as well ($527 annually) since their taxable income won't be as high, leaving $18,624 after taxes annually in their hands.

Now, Mike and Shannon will use some of this annuity income to pay for a $250,000 life insurance policy that will pay out on the second spouse's death. This will replace the $250,000 that was used to buy the annuity. Their heirs will get this cash upon the second death. The life insurance premium annually is $6,252 in this case. So, the amount left in their hands annually until the second spouse dies (after taxes and insurance costs) is $12,372. This is much higher than the $6,366 with the GICs and T-Bills. In fact, the couple is better off by $6,006 annually.

Keep in mind that you'll be giving up some liquidity with this idea; you can't pull money out of the annuity except by way of your set monthly payments. So don't invest all of your cash in this strategy. Finally, be sure to apply for the life insurance first; if you're not insurable, you may choose not to buy the annuity.

This is a great strategy if you are in good health, or if you already have a permanent life insurance policy in force. This strategy was very popular in years gone by, but with the stock market vastly outperforming GIC's and Term Deposits over the last decade;save the last 18 months, keeping liquid in a RRIF was more popular. Now that growth and income is down the tubes, the insured annuity strategy is paying the highest return in town.

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Edit: Nerding out a little, I ran real quotes for the life insurance and annuity.

Best life insurance rate for a couple age 70 in good health is $5,047.50/y from Industrial Alliance Pacific

A non-reducing Annuity, (payments stay the same after the first death) will currently pay $17,917.47/y from Canada Life. Taxable portion $4964.10

A reducing Annuity, which drops to 70% after the first death is currently paying $19,773.15/y also from Canada Life. Taxable portion $4803.09

A reducing Annuity, which drops to 50% after the first death will pay $21,229.32 from, you guessed it, Canada Life. Taxable portion $4450.80

You also can't get 4.5% from a GIC right now, highest I see is 3.55% for 5 years from Empire Life, but lets assume they have some older GICs that are paying 4.5%

Going the GIC route the couple will be left with $6,366 after taxes annually.

Non-reducing Annuity $10,715.05 after taxes and insurance.

70% reducing Annuity $12,640.63 after taxes and insurance, until the first death then, $10,479.04  after taxes. There is no insurance cost as the policy is paid up on the first death.

50% reducing Annuity $14,249.73 after taxes and insurance, until the first death then, $9,648.61 after taxes. There is no insurance cost as the policy is paid up on the first death.

So which would you prefer?
One point that needs to be made, is that using a prescribed annuity, which uses return of capital to keep taxes down, starts to result in higher taxes in later years. As the original capital is paid out the the annuity more and more of the payments come from interest earned. Eventually the taxable portion will grow to the entire annuity payment. In later years the benefit from the strategy starts to reduce.

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.

E.O.&E.