Annuities: Your DIY pension plan

Just about every expert who has studied annuities believes they are the most effective safeguard against “longevity risk,” or the possibility of outliving your wealth, says Moshe Milevsky. His recent book, Life Annuities: An Optimal Product for Retirement Income, includes a survey of studies on the topic. “That’s remarkable because you can’t get economists to agree on anything nowadays,” says Milevsky, professor of mathematics and finance at York University.

People with annuities also tend to be more content, Milevsky says. “As a rational economist, sometimes it’s hard to use terms like peace of mind and satisfaction, because they are not easy to quantify. But there’s growing behavioural evidence that this is something people value.”

So there are good reasons for retirees to give annuities more consideration. Unfortunately, while the concept is simple—you hand an insurance company a lump sum in return for a predictable cash flow—the details are complicated. There are several types, but we’ll focus on the most common: the “fixed annuity” with a prescribed payout for life. (See “Variable annuities revisited” on the facing page for more about the variable kind.) When weighing your decision you first need to determine whether annuities fit your circumstances and the role they should play in your portfolio. Then you can move on to when and how to buy them.

Are annuities right for you?

While annuities have many attractive features, they’re not for everyone. If there’s no chance you’ll run out of money, annuities are probably the wrong choice. They make little sense if you have an ample employer pension, since you already have the assurance of an income for life. Nor are they attractive if you’re in poor health: the best payoff from an annuity comes from living much longer than average. And if you’re very wealthy, outlasting your money isn’t a concern either. As Milevsky says, Warren Buffett and Bill Gates don’t need an annuity.

The other reason people avoid annuities is their finality: once you give your cash to the insurance company, you’re locked in for life. Conventional stock and bond investments, by contrast, provide growth potential and the flexibility to tap your nest egg for a lump sum if needed. And if leaving money to your heirs is a top priority, annuities preclude that option because the payouts end after your death (although you can purchase guarantee periods).

But annuities are not an all-or-nothing proposition. It’s best to think of them as one part of a larger retirement income plan: they can work uncommonly well in a portfolio alongside stocks and bonds guaranteed investment certificates (GICs). The goal is to figure out the right allocation to each of these assets, based on the trade-off between guaranteed income, access to a lump sum, and growth potential.

How much do you need?

If you rely solely on a portfolio of stocks and bonds for retirement income, you have to set a conservative withdrawal rate in case markets perform unusually poorly or you live exceptionally long (or both). A common rule of thumb if you retire at 65 is to plan on withdrawing 4% of your initial portfolio every year, plus inflation adjustments. But you should have a backup plan in case this withdrawal rate turns out to be unsustainable. Building annuities into your retirement strategy is one of the best backup plans, because they assure a relatively high level of withdrawals with no risk of depletion.

One popular strategy is to use annuities together with government pensions to meet all non-discretionary spending needs. “That provides peace of mind. You know the basics are covered no matter what happens,” says Jim Otar, retirement researcher and financial planner at retirementoptimizer.com. After purchasing annuities, you can afford to take more risks with the rest of your portfolio, which may actually increase the amount you leave your heirs if you live a long time and markets perform well.

To a large extent annuities should replace bonds in your portfolio, although there’s no perfect formula. Otar typically recommends 40% equities and 60% bonds for retired clients without annuities or employer pensions. However, once they’ve added annuities to ensure basic expenses are covered, he may recommend 60% equities and 40% bonds for the rest of their portfolio.

Wade Pfau, professor of retirement income at the American College in Bryn Mawr, PA, found in his research that if you’re looking for the optimal trade-off between growth and reliable income for life, the best solution may be to transition out of fixed income entirely and end up with whatever combination of stocks and annuities suits you best.

However, Pfau admits “practical issues” will keep most people from going that far. First, you should still keep some short-term investments for emergencies. And in my view, most people would find it too stressful to have their remaining portfolio 100% in stocks. Retaining some bonds adds stability, even if it detracts from growth.

Pfau suggests you think of an annuity as a kind of “superbond” that produces more income more reliably over a lifetime than do conventional bonds. Insurance companies are able to do this because they pool longevity risks, so those who die younger subsidize the relatively few long-livers. “They’re superbonds in the sense they don’t have the maturity date, so they will continue to pay fixed amounts as long as necessary.”

When to buy an annuity

As with conventional bonds, payout rates for new annuity purchases are greatly affected by interest rates, which are now relatively low by historical standards. However, unlike bonds, annuities pay more if you wait until you’re older before purchasing them. Waiting a few years can pay off, because the benefit of pooling longevity risk is greater as you get older.

Many experts say the “sweet spot” for buying annuities these days is about age 70. Milevsky recommends you start then and gradually annuitize over three to five years. For example, if you plan to annuitize $300,000, you might buy $100,000 of annuities at ages 70, 72, and 74. This timing works out well for retirees, since they must convert their RRSPs into either RRIFs or annuities by the end of the year they turn 71, so many will find it convenient to annuitize some registered money at that time. (If you buy annuities with registered funds, the entire payout is taxable, like RRIF or RRSP withdrawals. With non-registered funds you can buy a “prescribed annuity,” which is subject to tax only on the payout’s interest portion, not the return-of-capital portion.)

Annuities make sense in other situations too. Annuity broker John Beaton (annuitybrokers.ca) recently had an 87-year-old client who was looking to sell his condo to pay for the costs of a retirement home. He wasn’t sure the money would last if he lived into his late 90s. The client—who was exceptionally healthy and had many long-lived relatives—had no employer pension or other significant savings. So Beaton recommended using most of the condo proceeds—$500,000 out of $600,000—to buy an annuity paying $6,600 a month, ensuring the income would last as long as necessary.

How to buy an annuity

Given the financial industry’s penchant for promoting products, it can be surprisingly hard to find someone to sell you annuities. For one thing, although annuities are really an investment product, they can only be sold by someone with an insurance license. So unless they are dual licensed, investment advisers may not be able to help you with annuities even if they want to. Also, annuities pay lower commissions than mutual funds and other investments, so advisers need to overlook their self-interest to encourage you to convert some of your nest egg to annuities.

If you know what you want to buy, you can contact an independent annuity broker, though these are hard to find. You can also find agents affiliated with insurance companies, but make sure you get a competitive quote. To work annuities into your portfolio, you should have an investment adviser with the right licenses, who is committed to using annuities in the appropriate circumstances. If your adviser can’t do that, consider switching. “It would certainly raise a red flag if my adviser said, ‘No, I don’t do those.’ This is a collection of very important products,” says Milevsky.

It may take time and effort to find an annuity approach with which you can be comfortable, but the rewards can be enormous. “It’s a steady paycheque you cannot outlive,” says Milevsky. “Nobody is telling you to put all your assets in it. Nobody is telling you to do it all at once in an irreversible manner. It’s something you should be transitioning to slowly.”

Variable annuities revisited

While the most common type of annuity offers fixed payments for life, you can also get a “variable annuity” that offers the possibility of increasing payouts if stock and bond markets perform well.

But there’s a trade-off: you get upside potential if markets do well, but the minimum guaranteed income is substantially less than you get from a conventional fixed annuity.

Variable annuities—which include products such as Manulife’s Income Plus and Sun Life’s Elite Plus—were all the rage a few years ago. They promised a guaranteed minimum withdrawal benefit (GMWB) of 5% in their heyday, but critics argued increasing payouts were unlikely because of rigid rules and excessive fees (around 3.5%). As interest rates declined, they fell out of favour.

Sun Life recently introduced an updated version of its SunFlex variable annuity. It offers guaranteed minimum payouts for life, plus potential for additional income based on the performance of balanced mutual funds selected from a menu. You don’t actually own the funds but their fees—from 1.73% to 2.60%—are deducted when calculating income adjustments.

If you decide to lock in the income at some point, you can convert part or all of it to a conventional fixed annuity. The product is available only for registered money.

Jim Otar of retirementoptimizer.com thinks SunFlex is structured better than the previous generation of variable annuities, because the income adjustments more closely reflect actual fund performance. While he wishes Sun Life had included low-fee index funds among the choices, he believes “this is a good product.”

A bigger question is whether variable annuities try to do too much. Wouldn’t it be better to invest in fixed annuities for downside protection and stocks for upside potential, rather than trying to combine these two objectives? Wade Pfau’s research suggests it would. “By self-managing the stocks and fixed annuities, you can meet those goals more efficiently than by paying the higher fees to have a company package it as one product,” he says.

A buyers guide to annuities

Shop around

Getting quotes from different insurers can save you money. The range between the highest and lowest quotes is typically 5% to 10%, says Lowell Aronoff, CEO of Cannex Financial Exchanges Limited, which provides online annuity quotes for advisers. Key rates are also published regularly in some newspapers.

Get a guarantee

Many seniors worry they’ll get hit by the proverbial bus soon after buying an annuity, leaving their heirs with nothing. However, annuities are almost always sold with guaranteed payments for a minimum number of years. The cost of a 10-year guarantee on a joint annuity purchased at age 70 is less than $3 a month on an income of $517, according to a recent quote from Cannex. (With a joint annuity, payments continue until the death of the second spouse.)

Guard against inflation

A regular fixed annuity is vulnerable to inflation, but payouts indexed to the Consumer Price Index are rare and expensive, says retirement researcher Jim Otar. A more cost-effective solution is to buy a fixed-rate annuity that has set increases of about 2% a year, he says. Payments start lower than a regular annuity, but they grow over time and protect your purchasing power unless inflation spikes dramatically.

Insure the insurer

When you buy an annuity you’re relying on the insurance company to make payments for decades. Going with an insurance company that is large, well-established, and well-capitalized helps. So does the insurer’s membership in Assuris, the industry-sponsored guarantor, and staying within guarantee limits: up to $2,000 a month, or 85%, whichever is larger.

David Aston, CFA, CMA, MA, writes about personal finance. You can share your retirement spending experiences by emailing [email protected] He might include your experience in a future article.