Life Annuities and the Lifetime GIC

The Financialist • Issue 92 •January 2007
BY CHRIS EYNON CFP

In this article, we will refresh your memory on the basics of life annuities as touched upon in past editions of the Financialist, as well as illustrate a unique life annuity strategy for seniors who need monthly income but are wary of stock market fluctuations.

During pre-retirement years, investment income is not the main focus for most investors; usually the primary objectives are growth or capital preservation. However, once you have retired it is often necessary to supplement your employer and government pensions and other sources of income. This is where an annuity can form an integral part of your retirement plan.

LIFE ANNUITY

A Life Annuity is a promise to pay a stream of income over the life of the
annuitant(s). Differences in terms of the annuity can greatly affect the size of the regular payments from the plan and how much (if any) is left for your family or estate. Careful consideration with your Financial Advisor is important to ensure that your specific goals are achieved.

The calculation of the annuity payments is based on three main factors: the capital deposited, prevailing interest rates and life expectancy of the annuitant(s).

Capital Deposited

Obviously, the greater the amount deposited, the greater the income generated; however, other factors, like the source of the funds, also affect the payments.

Deposits can be made from an RRSP or RRIF, through a pension transfer, and even with non-registered cash. The source of capital will also affect the level and type of taxation of the payments, which will be discussed later in this article.

Interest Rates

Prevailing interest rates are another key factor when purchasing an annuity. All other factors being the same (capital and actuarial assumptions), the higher the long term interest rates in the marketplace, the higher your income will be.

Life Expectancy

Generally, the most important factor in calculating the level of income paid by a life annuity is the life expectancy of the annuitant(s). A life annuity is intended to pay an income for the rest of your life, thus the longer you expect to live the more advantageous an annuity will be as part of your retirement plan. A life annuity for a 50 year old will pay significantly less than the same annuity based on the life expectancy of a 75 year old.

However, if you have a pre-existing medical condition which may shorten your life expectancy, a life annuity may not be as appealing an option for your retirement plan.

A life expectancy chart has been attached to this article for your interest. Life expectancy is the age at which 50% of a certain age group is still alive. For example, 50% of females aged 60 today will survive 26.03 years, and 50% will not.

TYPES OF LIFE ANNUITIES

Single Life

The single life annuity is calculated on the life of one annuitant and will pay a guaranteed income as long as the annuitant is alive. This annuity type typically has the highest income payout amount; however, once the annuitant dies, payments cease, with no remaining capital.

Joint Life

The joint life annuity’s calculations are based on the lives of two annuitants - a primary annuitant and a secondary annuitant. This type of annuity will continue to pay as long as the primary and/or secondary annuitant is alive. When one annuitant passes away, the annuity will continue to pay the same income (or a pre-determined reduced amount) to the surviving annuitant for as long as he or she continues to live.

Estate Guarantee

A common concern with annuities is the perception that there will be nothing left to the estate when the annuitant passes away. This may or may not be the case depending on how the annuity is initially set up. Some common annuity options include guarantees of 5, 10 and 15 years, which guarantee funds for beneficiaries on the passing of the annuitant, if the annuitant dies within the guarantee period. The longer the term of the guarantee the less the income payments will be. For example, a "zero guarantee" annuity will cease payments upon the death of the annuitant but will have the highest income possible, as this type of annuity has no guarantee of a minimum number of payments.

An annuity with a guarantee will ensure the payments for the pre-determined term to either your estate or your beneficiaries. If you purchase an annuity with a 10-year guarantee and you pass away after 9 years of payments, the present value of the remaining year’s income will be paid in a lump sum to your beneficiaries. Alternatively, if you purchase an annuity with a 10-year guarantee and you pass away after the 10th year, then you have effectively outlived the guarantee period and no further payments will go to the estate/beneficiaries. With a joint annuity, the estate guarantees are determined by the year in which the second surviving annuitant passes away.

OTHER POINTS OF INTEREST

It is important to remember that with a life annuity, the payments continue as long as you live, regardless of the guarantee period. Annuitants will occasionally receive customer confirmation letters from the life insurance company that issued the annuity, asking for a letter to be signed and returned so they can keep their records up to date. The purpose of this letter is to make sure that the life insurance company is not making payments to deceased annuitants. With annuity income being paid directly to the annuitant’s bank account, this is an important administrative issue for insurance companies. These letters are very common and should be signed and returned promptly so that income payments are not interrupted.

With both registered and non-registered annuity contracts, you can assign a named beneficiary when a guarantee period is elected. One main advantage of assigning a named beneficiary is the ability for the remaining annuity payments to bypass the will at death, avoiding probate fees.

TAXATION

The source of the funds will determine the taxation of the income from a life annuity.

Annuities that are funded from an RRSP/RRIF or a pension will be considered taxable income and attributed to the primary annuitant. However, once the primary annuitant passes away, the income is then taxable to the secondary annuitant.

If the annuity is purchased with non-registered funds, only the interest portion is taxable. This taxable portion of a non-registered annuity can taxed in one of two ways:

1. Prescribed: The taxable portion is constant each year.
2. Non-prescribed: The taxable portion varies each year, typically high in the early years, declining over time.

As noted, a non-prescribed annuity has a taxable portion that reduces every year. However, in the first year, the taxable portion is much higher than that of a prescribed annuity. Thus a prescribed annuity effectively can defer tax which is often a very valuable tax planning strategy.

CASE STUDY

“Lifetime GIC”, also known as the Insured Annuity

A Retirement Plan which includes a "Lifetime GIC" will provide guaranteed income and "insures" that your estate objectives are met. Lifetime GICs can be ideal for seniors who are healthy, in a middle-to-high tax bracket and require income from their investments but are concerned about the risks involved with the markets.

Lifetime GICs work on a simple principle; you purchase a life annuity (with non-registered capital) and at the same time take out a life insurance policy in the original amount that was used for the capital payment to buy the annuity. The annuity provides you with an income for the rest of your life, a portion of which is dedicated to paying the premium on the life insurance. The income that is paid from the annuity is tax-preferred (using a prescribed annuity), as a portion is considered to be a return of capital. As only a portion of the income that you receive is taxable, the after tax yield is much greater than that of a GIC or government bond. It is important to note that the insured annuity strategy only works with funds from outside of your registered plan due to the "prescribed" tax treatment of the annuity income.

The purpose of the life insurance in this arrangement is to ensure that when you pass away, the capital used to purchase the annuity is replaced with the tax-free insurance death benefit. When you pass away, the annuity payments cease; however, the life insurance is paid to the named beneficiary, free of probate (unless paid into the estate).

SAMPLE ILLUSTRATION

A traditional 5-year Guaranteed Investment Certificate purchased today with $100,000 would pay a pre-tax monthly income of $333 (4.0% annual yield). This would provide an after tax income of approximately $188 (assuming a top marginal tax rate of 43.7%).

In contrast, below is an illustration of an Insured Annuity using the same $100,000, for a couple, both aged 70:

The result of this financial strategy is a considerable increase in spendable monthly income of $194 ($362 instead of $188) versus that of a Guaranteed Income Certificate for the couple.

The monthly income of $362 will continue for as long as either one of the annuitants lives, after which the monthly payments will cease and the $100,000 of insurance will be paid tax free to the estate or the named beneficiaries.
Many readers will recall that we have touched on this topic in the past; however, we wanted to illustrate that, even with today’s relatively low interest rates, it is still a very valid income solution. For more information about insured annuities please contact your Rogers Group Financial Advisor.

(This example is for illustrative purposes only, assuming that the individuals are in the 43.7% tax bracket and in average or better health. For a personalized illustration, please contact your Rogers Group Financial advisor).