Can life annuities mimic pensions?

Darren would like a worry-free retirement. So he wonders if life annuities would allow him to match his wife’s public-sector pension plan. “I want to be sure I’ll have income for the rest of my life, no matter what happens to the markets,” he says. “Essentially, I want a pension, [without having to] worry about the company going out of business.”

He wonders, however, about the potential pitfalls and risks of annuities. “What happens if the insurance company that supplies my annuity goes under? Is there something else I should consider?”

Darren is now only 38. He aims to retire at 55, with the mortgage on their home paid off, about $600,000 (today’s dollars) saved in his Registered Retirement Savings Plan, plus extra tax-free savings.

Many others are wary of handing their savings over to a life insurance company. Most prospective buyers of annuities tend to live longer than average, but some fear dying early and leaving money for strangers to enjoy what’s called a mortality credit. He could buy life insurance, or top up with a guaranteed period of annuity payments after his death to protect potential heirs, but that would add significantly to the cost.

With no children, Darren has only his wife to protect. So he’s thinking of buying one annuity when he retires, and another one six years later when his wife retires at age 60. (Luckily for him, she will serve as the gift that keeps on giving, paying more of the bills while he gets a jump start on leisure.)

To answer Darren’s questions, we turned for comment and recent annuity prices to Derek Polson and his father Kirk, both CFP professionals with Polson Bourbonniere Financial Planning Group in Markham.

Surprisingly, Derek would discourage Darren from placing his entire nest egg into annuities: “Your access to liquid cash is compromised,” he points out. You can’t tap into annuities for extra income or lump-sum withdrawals for emergencies, travel or the purchase of a new car. Expenses could increase later in life as opposed to decreasing. “Think spouse with nursing home care and the other spouse living at home. That’s double the expenses. Plus there’s a potential family emergency, or house repairs, and continuing to travel.”

Borrowing money for big-ticket items would only increase costs. So, in addition to maxing out his RRSP, the couple should follow through on the plan to keep pouring cash into Tax-free Savings Accounts (TFSAs) to pay for travel and major expenditures.

Annuities can’t match the variable inflation protection that a declining number of workplace pension plans still offer. The only option, not widely known but available on request, is choosing a fixed rate of annual increases.

Darren was considering a 4% annual increase, but that would severely reduce his early payouts. So Derek Polson suggested 2%, the average rise in Canadian consumer prices for the past 24 years.

As for the survivability of individual life insurers, that can’t be guaranteed. Darren could hedge his bets by buying his annuities from more than one insurer; or rely on Canada’s regulators and insurers to keep protecting consumers as well as they have in the past.

Only four federally licensed insurers have failed to date. The largest, Confederation Life of Toronto, failed in 1994. Top executives went bonkers for growth, real estate and mortgages, jeopardizing their own pensions. Yet no consumers lost money when chunks of it were sold to other insurers.

Barring a widespread disaster, the industry-run protection plan Assuris would transfer each insurer’s annuity obligations to another insurer. It guarantees payments up to “$2,000 per month or 85% of the promised monthly income benefit, whichever is higher.”

How good a deal could Darren expect from annuities these days? With $300,000 of registered savings he can buy lifetime income starting at $831.95 a month from age 55, rising 2% a year until his wife’s death, perhaps past 90.
In today’s interest rate environment, he could purchase a starting income of $919.84 a month if he waited until age 60; $1,028.80 (nearly as much as the maximum unreduced Canada Pension Plan benefit) at age 65; $1,162.96 at 70; or $1,366.76 at 75.

That’s not a lot of money, but inflation protection is costly. At the Ontario Teachers’ Pension Plan, it would cost nearly $1 million to fund a typical pension using secure government bonds. The typical pension is about $40,000 a year (in today’s dollars) until age 65, about 20% less once CPP pensions are paid without a reduction.

So Darren may have to adjust to the reality that insurers cannot perform magic. (After all, security does cost money.) To get both the security of an annuity and a higher income, he may have to work a little longer.

James Daw is a journalist and Certified Financial Planner in Toronto. Email [email protected]; on Twitter he’s @jamesfdaw.