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Wednesday, 1 May 2013

Financing My Retirement - Part 5 - Annuities

Here's a continued look at some guaranteed retirement income strategies and ways of making the most out of your nest egg whether you're selling your home or using other savings for your retirement income.

In part four we looked at some guaranteed solutions that allow investors to stay in control, decrease taxes, increase income and leave more to heirs. This  continues the theme:

For many people their home is the largest part of their nest egg, in fact all through life, many people see the value of their home as the one thing that will be able to provide enough money to support them in their later years. If you are planning to sell your house to use your nest egg for retirement income,  and/ or are looking for guaranteed safe ways to increase your income, annuities should be the first thing you consider.

Here are a few reasons why:

1. Low Interest Rates: Traditional expectations were that interest earned on the value of a home and other saved assets would be enough to live on for life. The principal would then pass on to one's beneficiaries. Unfortunately, for many of us low interest rates don't provide enough of an income to support a decent retirement.

2. Negative returns in the market can wipe out your nest egg:  There is a fair amount of research on the effect of negative markets on savings that require regular withdrawals. My favourite source on this topic is Dr. Moshe Milevsky Ph.D. Professor of Finance at the Schulich School of Business at York University.  He and his team have a large body of excellent research that quantifies the severe and rapid financial devastation that can result from a negative sequence of returns in your retirement years. If you'd like to learn more about  the technical aspects of this topic I'd definitely recommend you check his website. Also, his book Pensionize Your Nest Egg  is an important piece that details some practical methods of ensuring lifetime income.

3. Psychology: The reality is that the majority of people are more afraid of running out of money in their lifetime than of dying. Financial planners and those planning or who are already retired need to rely on products and strategies that give lifetime income guarantees. This primary need, once fulfilled, lets everyone sleep comfortably at night.

4. Pensions: Traditional defined benefit pensions used to provide guaranteed income for life but fewer and fewer people have access to pensions of this kind and many people who have them want to enhance their guaranteed income.  Most people now have defined contribution plans which are at risk in the market.

So what are the available options to replace that?
1. There are variable annuities which I talked about briefly in part 4 of this series
2. There are annuities which also guarantee income for life.

An overview of annuities and their many benefits can be found here.  In general, annuities provide you with the best, tax friendly way of generating income for life that is available today. Your annuity income is determined by a number of factors including your age and the prevailing interest rates. In general, the older you are, the higher the income you can expect. Your after-tax income will generally be much higher than what you get from other typical guaranteed fixed income products such as government bonds, term deposits or GIC's  and in fact, most of the income from an annuity is tax free so that income tested benefits such as Old Age Security or the Guaranteed Income Supplement are less likely to be impacted, if at all.

A sample annuity:  at March 2015, a 65 year old male could expect an income of $15,194.86*  from a $250,000 annuity every year, guaranteed for life. The taxable portion of this income would be a mere $1,712.87.

* (Please note that these rates are like fresh bread, becoming stale very quickly, so contacting a licensed insurance broker will get you up to date numbers when you need them). 

Our same 65 year old may also wish that some or all of his capital be replenished on his passing so that everything goes to his beneficiaries. Buying a $250,000 GIC or term deposit today is an often used solution that might do the trick however, it will get him a fully taxable income of only $6,150 per year. This low income level would be fully taxable and as such this may not be the best solution.

Combining an Annuity with life insurance: To replenish his capital, (also known as an estate preservation strategy), our 65 year old would be much better off to do the following. The first is to purchase a life insurance policy for the amount he wishes to replenish. The benefit goes to his beneficiaries tax free, fast and outside of the estate so there are no probate taxes, fees or delays. He then buys an annuity to pay for the life insurance premium payments.  Interestingly, premium costs on a $250,000 of life insurance policy would cost him $7,122.50/ year which is more than offset by the $15,194.86 income he gets from a $250,000 annuity.

By combining the two ideas, the annuity payments will give him an income which is the difference between the cost of the premiums and the income from the annuity. In this example he gets an  income of $8,072.36 per $250,000 after paying the life insurance premiums.  This income is still higher than he would get with a GIC or government bond but more importantly because most of it is tax free he has much more money in his pocket each year. Of course, when he passes away his beneficiaries also get the full value of his estate through the insurance policy.  It's simple for the executor of the estate and, there are no probate taxes, fees or unnecessary delays for the beneficiaries.

Some of the reasons I like the use of annuities for retirement income and using some simple strategies where they are appropriate include :

1. Annuity after-tax income is higher than other guaranteed alternatives
2. Annuities can be set up as joint plans for couples 
3. Annuities are often the best guaranteed solution available for core retirement income needs
4. Annuities can be used to help to ensure meaningful and lasting legacies.
5. Annuity income normally won't interfere with income-tested government benefits such as Old age   Security or the Guaranteed Income Supplement.

Annuities can be used as an excellent guaranteed income strategy to satisfy anyone's core income needs.  There are many additional alternatives for improved income that can be explored once the guaranteed income foundation that meets your needs has been put in place.

And as always, if you have questions or would like to learn more, please feel free to drop me a line anytime.