Oran Hall | Annuity tips for the soon-to-retire
ADVISORY COLUMN: PERSONAL FINANCIAL ADVISER
QUESTION: I am about to retire and would like some information about annuities.
FINANCIAL ADVISER: An annuity is a contract between two parties – the issuer and the annuitant – whereby the issuer agrees for a stipulated premium deposit to pay to the annuitant regular payments, fixed or variable, at regular intervals, commencing on a specified date and guaranteed for a fixed period or for life or both.
There are two basic types of annuities: immediate and deferred.
An immediate annuity is bought with a single lump-sum payment, and annuity payments start one month later if it is to be paid monthly and one year later if it is to be paid annually. A deferred annuity is a lump sum paid now for regular benefit payments, starting at a specified date in the future, usually retirement.
Two common types of life annuities are straight life annuities and life annuities with a guaranteed payout period. A straight life annuity pays the annuitant a guaranteed monthly or annual income until death. This type of annuity provides the highest amount of guaranteed income per dollar of premium paid because payments stop when the annuitant dies, and no residual payment is made to the annuitant’s estate or beneficiaries.
The annuity payments are a mix of capital and income, which guarantees the annuitant a lifetime cash flow, so annuitants cannot outlive their capital. A straight life annuity is most suitable for annuitants who have no dependants and desire to have the highest possible guaranteed payout during their lifetime. They are also very suitable for people who have dependants who are fully provided for by other means.
Annuitants who are concerned about estate-planning issues and who wish to provide for their dependants in the event of premature death find life annuities with a guaranteed payout period attractive.
For example, if the purchaser of an annuity with a 10-year guaranteed term – that is, 10 years certain and life thereafter – dies after six years, the beneficiaries would continue to receive the same payments for the remaining four years. But if the annuitant lives beyond 10 years, payments would continue for the full lifetime of the annuitant. The longer the guaranteed payout period, though, the lower the periodic payments.
Two examples of other types of life annuities are the joint-and-last-survivor annuity, which provides for payments to continue to be made to the surviving spouse after the death of the annuitant up to the death of the survivor, and the life annuity increasing income, which has annuity payments increasing annually by a set percentage as a buffer against inflation.
This feature would add to the price of the annuity and would mean that the starting annuity payment would be smaller than a flat payment, which would not increase. Other factors that affect the price of the annuity are the age and gender of the annuitant.
The main factors that determine the payout of a life annuity are as follows: the funds available to purchase the annuity; the age and gender of the life on which a guarantee is based; the table of mortality used by the issuer; the interest rate applied in calculating the annuity; and the cost of the guarantee or guarantees, which involves a life- expectancy factor.
The benefit of a life annuity is that it fully protects the annuitant from longevity risk as it provides a stream of income as long as the annuitant lives, but it is not possible to change an annuity once it has been established.
Your retirement is imminent, so a deferred annuity would not apply to you, but I will say a few things about it. A deferred annuity permits the deferral of payments for up to several years from the date of purchase. It can be for life or for a fixed term with payments on a fixed or variable basis.
The size of the premium paid for the annuity is a function of factors such as how soon the annuitant wishes to receive income payments and how much income is desired.
Under current regulations, you will have two options at retirement: take a tax-free lump sum equivalent to 25 per cent of the accumulated funds for your pension and purchase an annuity with the balance, or buy an annuity with all of the accumulated funds.
I doubt you would be surprised to learn that the latter would yield a higher monthly payment to you, with the likelihood of paying more income tax, but would you prefer that to having the tax-free lump sum in the initial years of your retirement, not to diminish, but to earn additional income prudently and spend wisely, if necessary?
Oran A. Hall, principal author of The Handbook of Personal Financial Planning, offers personal financial planning advice and counsel.