Sunday, 21 June 2015

Buying a Life Annuity - Tips

When buying a Life Annuity it is especially important to get the best deal since it is a one-time decision that lasts a lifetime. Here are some points to consider in making the purchase.

1) Shop around, use a broker
Make sure you cover all the life insurance companies that sell annuities. As the listing of current rates on the Globe and Mail annuity table and our comparison table below show, the company offering the highest income usually differs according to your sex and age. The highest quoting company also change constantly. The best way to shop around is by using a good broker who deals with all the companies, such as (Ivon Hughes) and Canadian Annuity Broker Services (John Beaton).

There is a wide range between the highest and the lowest income quotes - anywhere from 3% to almost 30%. The range widens the longer the deferral period between purchase and income start date e.g. hi-lo quotes in our table below on the eight and a half year deferral to age 71 for a 62 year old span more than 20% for all types of life annuities for both men and women.

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2) Mind which account you use to buy the annuity
Men should buy with RRSP/RRIF funds first, and locked-in funds (LIRA/LIF/LRIF) funds second, for pension money regulated in all provinces except Quebec and Newfoundland & Labrador. Women should do the opposite and buy with locked-in funds first and RRSP/RRIF funds second.
That will obtain the most annuity income for both men and women. The reason is legislated mandatory unisex rates, which came into effect during the 1980s and which apply to all locked in pension money but not to RRSP/RRRIF funds. Under unisex rates, insurance companies are not allowed to price annuities differently for men and women, which would entail paying higher amounts to men and lower amounts to women in recognition of the fact that men die sooner than women and thus do not collect their lifetime annuity for as long.

The result, as our table shows, is that unisex-rated income lies somewhere in between the single sex-priced income for men and women, anywhere from 3% to 8% above - for women - or below - for men - the single sex income level. Men lose and women gain with unisex. Quebec still requires, and Newfoundland & Labrador still allows, single-sex annuity pricing in locked-in accounts. Standard Life has created a detailed table on pension legislation, part of which covers sex discrimination provisions across Canadian jurisdictions.

Most online sources of current annuity quotes seem to publish only the single-sex prices so getting unisex quotes for locked-in money will require contacting a broker.

3) Men - Unlock to get more income
Men should take advantage of unlocking privileges to be able to use single-sex pricing. Locked-in pension savings may be moved to unlocked accounts, like an RRSP or RRIF under certain conditions, including becoming non-resident, financial hardship, small remaining balances and reduced life expectancy as explains on Unlocking Your Locked-in Pension Accounts. The most generous provisions are under Federal (see FAQ here), Alberta and Manitoba jurisdictions, which allow a one-time unlocking of up to 50% of account value upon moving the funds from a LIRA or LRSP into a LIF or LRIF. Once inside the RRSP/RRIF the funds can be used to buy higher income single-sex annuities instead of unisex annuities. The same amount of original locked-in money will buy higher income.

4) Check out a short guarantee period
Choosing a guaranteed payment period of 5 or 10 years may offer higher income than a no guarantee period. This is a bit of a surprise. It would normally be expected that when the deal is that the insurance company stops paying out an annuity immediately upon the annuitant's death instead of guaranteeing to continue paying (into the estate after death), it would offer higher income. But due to the segmentation of the annuity market and the choice of some providers to offer only products with or without the guarantee, it seems to happen regularly that the highest income comes with a guarantee. For example, in the upper left area of our table, the unisex rate offered by Equitable Life with a 10-year guarantee is $5796 per year while the best no-guarantee rate is from Desjardins at $5760. The Equitable annuity would ensure getting back at least $57,960 of the $100k premium. It's an easy choice to buy from Equitable instead of Desjardins. Checking both guarantee and no-guarantee options at the time of purchase is worth it.

5) Check out the return of premium option 
Choosing the option that offers return of premium (to your estate) when you die before the income start date may offer higher income than no return of premium. Again, it is a quirk of the market segmentation but in many of the quotes in our table as highlighted in red text and numbers, the income from return of premium insurers was higher than the no-return offers. This is especially valuable for the long-deferred-annuities, where the income may start eight years or more down the road. Dying before the income start date without receiving a penny for the large premium handed over would be galling. Of course, the insurance company does not lose out by making the guarantee since it only hands back the premium whose value diminishes from inflation and in the meantime it is able to use the capital to invest and gain returns for itself.

6) Index income to offset inflation?
Indexation of income to try to match inflation seems to be of dubious value. Our first table above shows much lower income compared to non-indexed annuities from annuities indexed to rise by 2% a year to match the current best guess rate of many economists, which also happens to be the official target rate of the Bank of Canada.

To judge whether this is worth it, we calculated how long it would take for the indexed income to reach the same level as the non-indexed annuity. As our second table shows, it takes eleven years, till age 73, before the 2% indexed annuity reaches equality for a man buying today aged 62. With rising age of annuity purchase the levelling off happens sooner and sooner but then you have many fewer years of life expectancy to worry about inflation eating away at purchasing power. We believe's method for offsetting actual inflation, in which you set aside and reinvest a portion of the annuity income each year, offers a better solution. Instead of a one-time forever guess at inflation, you reinvest depending on actual inflation.
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7) Annuitize now, or wait?
It's almost surely not worth waiting to annuitize if you have retired and need to start taking income. Whether to wait or not is a trade-off between the investment return from a portfolio less withdrawals and the certain, steady income from an annuity. Annuity expert Professor Moshe Milevsky of York University has developed a formula to guide the choice. The formula is called Implied Longevity Yield (ILY). It measures what rate of return a portfolio or other investment would have to achieve to beat the annuity while withdrawing the same income as the annuity. ILY takes into account the fact that deferring purchase means you will be able to pay less later for the same annuity income because your remaining life expectancy will be lower. ILY also assumes interest rates remain the same as today. Below is a table of ILY calculations from as of June 2015.
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Even at relatively young ages in the 60s, it is hard to beat an annuity. Certainly, investments with the same rock solid triple A equivalent rating, like term deposits or Government of Canada bonds, can provide nowhere near the same return. Even broadly diversified portfolios of stocks and bonds, which can and do fluctuate and have no guarantee of producing a return, would be hard pressed to beat the ILYs in the above table. These days especially, expected future portfolio returns are likely to be muted compared to historical actuals i.e. not likely to exceed the ILYs of age 70+. We must remember that if interest rates were to move up and more attractive returns from investments were to be available, the annuity payouts would rise too and thus the ILY as well. Back in June 2000 interest rates were much higher - Government of Canada 10-Year bonds yielded 5.9%, but the ILY for a 65 year-old male at 6.9% and a 65 year old female at 6.4% both beat that per Milevsky's IFID research centre table.

The underlying reason why life annuities will always be very competitive with any type of portfolio investments is that annuities have the additional source of return from the forefeited funds of those annuitants who die sooner than expected, the so-called mortality credits. The following chart from Sun Life in the document Payout Annuity - Overcoming Objections. shows how large the mortality credits, which it calls insurance credits, become the older you get.
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Unfortunately, the latest ILY figures are available only from CANNEX and thus by contacting an insurance broker. shows on this webpage how to do a simplified "good enough" approximation.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Copyright 2015 Jean Lespérance All Rights Reserved

Wednesday, 10 June 2015

Retirement Investing - How an Annuity Complements an Equity-Fixed Income Portfolio

Retired investors face a challenging set of financial and investing risks. Several are not faced by those in the accumulation stage of life and are unique to the retirement withdrawal phase. Traditional portfolios of equities and fixed income, such as systematic withdrawal plans like the 4% rule (see posts here and here), can succeed in the face of such challenges. But they can do so more easily if combined with guaranteed lifetime income sources such as defined benefit pension plans, Canada Pension Plan (& OAS) and lifetime annuities.

Complementary Roles - Systematic Withdrawal Plan vs Lifetime Guaranteed Income
The table below shows how the two categories of income sources complement each other very well. Against most of the risks and the beneficial features, where one falls short with a NO, the other copes well with a YES. Only for inflation and tax minimization does neither type provide an ideal mechanism.
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Annuities fill a gap for retirees without a DB pension
Most retirees will get CPP and OAS but they max out at $12,780 and $6,765 (2015 figures) respectively, which probably is not enough to meet basic living expenses. Since fewer and fewer Canadians have defined benefit pensions and are saving in RRSPs, TFSAs or defined contribution retirement savings plans, all of which consist of equity-fixed income portfolios, the annuity can fill a significant gap.

One of the worst dangers of retirement, when money is being taken out of a investment portfolio for living expenses, is that withdrawals may be too high and the portfolio expires before the retiree, leaving the unfortunate person high and dry, usually at an advanced age when going back to work to make a shortfall is no longer possible.

An annuity is an investment income insurance product in which an investor hands over a lump sum to an insurance company and then receives a fixed, guaranteed, regular (monthly, quarterly, semi-annually or annually) income for life. In the plain vanilla version, the income continues only as long as the person lives (or the second of a couple to die, in the case of a joint annuity) and there is no return of principal at death.

Since many people balk at the idea of losing the whole principal if they live only a short time after the annuity starts paying - imagine handing over $100,000 of your lifetime savings to the insurance company and living only long enough to receive the first monthly cheque of $530 or so (per the Globe and Mail's table for single life 65 year old male as of June 10, 2015). Being dead you wouldn't be upset, but your heirs might be! The annuity purchase is irreversible. Consequently, insurance companies offer options to guarantee payments to the estate or a beneficiary for 5, 10 or even 20 years. Such guarantee options do come with the downside of lower payments.

Contrary to what some may imagine, the insurance company does not keep all the money of investors who buy a plain no-payout-guarantee annuity and then die early. The insurance company does keep some of the money of those who die early for its costs and profit margins, but this is kept in check by the fact that the annuity market is competitive amongst insurance companies. Given the guarantee of income provided by Assuris in Canada, most investors can safely opt for the best quote aka highest income so the companies are unable to profiteer. Instead, the bonus money, called mortality or insurance credits, goes to other investors who live a long time. The insurance company is able to calculate very accurately the average remaining lifespan for a population of retirees (and even that of retirees who buy annuities, which happens to be longer than retirees as a whole), which enable it to price out a payment level for everyone based on the average and to offer it for as long as you might happen to live. Live long like Merle Barwis, you win!

Research shows the annuity - SWP combination enhances retirement success > more income and less chance of running out
Economists are constantly puzzled by the relatively low rate of uptake of annuities because they are beneficial to retiree investors. Researcher Wade Pfau, Professor of Retirement Income at the American College of Financial Services on his blog has posted papers detailing the benefits of immediate and deferred annuities. Professor Mark Warshawsky of George Mason University compared life annuities head-to-head with the classic 4% portfolio withdrawal rule using US historical data in Government Policy on Distribution Methods for Assets in Individual Accounts for Retirees and found that annuities generally performed somewhat better for providing lifetime income during retirement. Canadian Associate Professor of Finance at York University Moshe Milevsky explains annuities in detail in the free 150 page Life Annuities: An Optimal Product for Retirement Income. He and co-author Alexandra Macqueen put forth a popularized exhortation to include annuities within a retirement income mix in the book Pensionize Your Nest Egg. David Blanchett, Head of Retirement Research at Morningstar in his Allocating to a Deferred Income Annuity in a Defined Contribution Plan even cites a source that found that investors with annuitized incomes were happiest! If money can't buy happiness, can it buy an annuity which can buy happiness?

Where to buy: Annuities are only available from insurance companies, so interested investors need to contact either a life insurance agent, who represents only one company, or better, a licensed broker who can source quotes from the whole market and get the best currently-available deal, which varies constantly amongst the various insurance companies. Specialized annuity brokers in Canada with an online presence are sparse - two we found (whose licensing claims check out as of June 2015) are (Ivon Hughes) and Canadian Annuity Broker Services (John Beaton).

Buying an annuity involves handing over a big chunk of money, so check that the agent or broker is licensed in your province:
- Financial Services Commission of Ontario
- Autorité des marchés financiers (Québec)
- Alberta Insurance Council
- Nova Scotia Superintendent of Insurance
- Insurance Council of British Columbia
- Insurance Councils of Saskatchewan
- Insurance Council of Manitoba
- Financial and Consumer Services Commission of New Brunswick
- Government of Prince Edward Island
- Newfoundland and Labrador
- Government of Nunavut
- Yukon Government

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Copyright 2015 Jean Lespérance All Rights Reserved