Annuities

Just To Be Clear

The annuities discussed here refer to insurance products where mortality risks are shared. In exchange for a lump-sum payment, the issuer provides a stream of benefits until the owner dies. The benefits are larger than the income that could be earned by each individual buying risk-free bonds, because the remaining principal of members of the cohort who die early, subsidize the ongoing payments to those who live longer.

This is completely different from the word ‘annuity’ used in finance or math or the time-value-of-money equations for ‘Present Value of an Annuity’ or ‘Future Value of an Annuity’. That use of the term refers to a stream of equal payments as well, but there is no transfer of value between population cohorts. That is a concept, not a product. If you find something called an ‘annuity calculator’ on the web, chances are it is a TVM calculator with nothing at all to do with annuity products.

This page does not pretend to discuss all the issues relevant to annuities. To simplify the ideas, unless stated otherwise presume that the annuities discussed here are Single Premium Immediate Annuities that:

• pay fixed benefits for life,
• start benefits immediately after purchase,
• provide no minimum guaranteed period,
• provide no death benefits,
• provide no increases for inflation, and
• attract no taxes.

Resources

• Canadian Life Insurance quotes
• Different quotes from same data provider?
• US quotes with more detail
• Probability of outliving different ages
• Choose between Immediate Pay vs Deferred, or Delay purchase of Life Annuity spreadsheet.
• Equate Flat Pay to Indexed Math Annuity spreadsheet
• 1971 Mortality Tables – used to determine %benefit is taxable for prescribed annuities bought before 2016.
• 2000 Mortality Tables – used to determine %benefit is taxable for prescribed annuities bought after 2015.
• Taxable Income of Prescribed vs Non-Prescribed Life Annuities spreadsheet.

Risks

Annuities are insurance contracts. They insure against longevity risk – the risk that you run out of money because you live too long. The product distributes wealth from those who die early to those who die later. Like most insurance products, its value to the buyer depends on his ability to self-finance long-life living costs. Its value depends on the buyer’s need for insurance.

The need to get rid of longevity risk decreases as your wealth increases – relative to spending requirements. The very rich may have enough assets to cover costs to 150 years old – spending only profits and never principal – even if market prices drop in half. But the less-wealthy person is probably forced to gradually liquidate their nest-egg’s principal during retirement. He faces the risk of running out of both income and capital. Longevity insurance is very important to him.

A reasonable objective is to finance all basic living costs with guaranteed income of some sort, including annuities. This will prevent drawing down risky-asset portfolios in down markets. There are other sources of guaranteed income — GIS, OAS, CPP, company defined benefit pensions, the free rent from a mortgage-free home, or even on-going support from children. The very poor who continue to live cheaply may not need additional annuity income.

Annuities also insure investment returns. Investors who have lost money in the markets are drawn to annuities as a form of professionally-managed-guaranteed-return investment. While DIY investment returns may seem easy when you are young, your risk tolerance, attention to the markets, and mental discrimination will not be the same when you are 90. Will you have the self-knowledge to know when your mental acuity has deteriorated? Probably not. Better to buy insurance before investment losses make it clear.

The annuity’s guaranteed benefits cannot be compared to % yields from other market securities. Only a small portion of the payment comes from investment returns. Most is financed by a return of principal, and the allocation of the wealth from those who die early. You should not consider the spending from principal to be ‘a bad thing’ because it will not result in longevity risk.

Counterparty risk should not be ignored. This is your risk that the underwriter goes belly-up. The risky issuer should be offering higher benefits as compensation but it is impossible to determine your effective risk – now and in the future. Companies in the industry contribute to a fund (Canadian and US) for covering the contracts of defaulting issuers. But it is not limitless. Nor is it backstopped by the taxpayer. In the U.S. annuity divisions of insurers have been sold to Private Equity and Hedge Funds who channel the back-stop-assets into risky securities. The new owners stand to capture all the potential upside, with annuity owners suffering the downside.

It is common practice for individual underwriters to spread their own risk wider by themselves buying re-insurance. You should check the company’s credit rating even though that will change over the 40 years of your policy. If you are making a large purchase, spread it between different issuers. It has been suggested that you should buy from either a very small issuer or one that is too-big-to-fail. The industry fund should be large enough to cover the smaller book of contracts of the small issuer, and the taxpayer will bail out the too-big-to-fail issuer’s contracts. But again, the status quo won’t last the life of the contract.

Social risks. E.g. elder abuse should be considered at least, before rejecting with “My family would never do that.” Hitting up grandma to ‘co-sign my loan’, to fund ‘this great idea’, to ‘just get me back on my feet’, etc. is probably not infrequent. Locking away your money where it cannot be touched in an annuity may be good protection.

E.g. when the first spouse of a couple gets ill, there is huge pressure for the healthy spouse to insist that ‘no cost be spared’ – even if it bankrupts her or leaves her with no money for her own later illness, which she must handle without a built-in care-giver. The pre-existence of an annuity safe-guards her support and prevents the issue from arising.

E.g. Cyber-warfare is a reality everyone should consider. Imagine that the world-wide internet were compromised. Stock portfolios could conceivably become worthless. An annuity cheque in the mail every month with a contractual agreement would feel pretty good.

The Annuity Puzzle

In real life people consistently under-utilize annuities. There is resistance to their purchase to such an extent that given a choice between a lump-sum payment and the annuity, people are willing to accept a lump-sum far lower than the annuity’s fair value. Brown, et al (2013) found that in order to give up a portion of their US Social Security payment, people settled for compensation even 18% below its fair value. Brown, et al (2007) found that more than a third of their subjects would accept a payoff 25% below fair value.

Possible causes include

• Fear of dying before recovering the entire purchase price.
• The belief they can earn a higher return in the stock market.
• The inability to sell the product when unexpected cash is needed (e.g. health care bills).
• The limited availability of inflation-adjusted annuities.
• The default risk of issuers.
• The desire to leave a bequest after death.
• Self-insurance by families who undertake to care for their parents come what may.
• Fear that interest rates or inflation will rise and cause the benefits to lose value.
• Hatred of Insurance companies after experiencing a failure to honour a P&C; claim.

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Loss aversion makes annuities less attractive to many people. They ask “What is the probability that I die before recovering the investment cost?” Instead of seeing the product as risk-reducing, they see it as gambling on their own death. These people are segregating their mental accounting. They look at the product in isolation. It makes more sense to consider it as integral with all the other retirement purchases, benefits and spending – to consider its effect on your ending $$ wealth.

The industry response has been to provide guarantees. Either the payments will continue for a guaranteed period, or there is a residual lump sum at death like a life insurance benefit. The guarantee makes the product seem less risky, but reduces $benefits. Some researchers have found that guarantee periods add value to policies bought by those over age 75. They postulate two possible reasons. “First, it is possible that annuitants who buy annuities with a guarantee have shorter than average life expectancy and providers adjust for that. Second, guaranteed annuities are by definition less risky products for the insurers compared to level annuities, so they are able to offer a better rate. This is because during the period of the guarantee all payments are certain rather than dependent on annuitant’s mortality. Further, as annuity payments after the guaranteed period are lower, the impact of annuitant living an extra year is smaller than compared to a level annuity. For younger annuitants, guarantees cover periods when retirees are relatively less likely to die and therefore there is a smaller difference in rates and Money’s Worth.”

Maybe a better strategy is to promote the purchase of annuities from within an RRSP or RRIF. If you die early with an annuity your heirs ‘lose’ all its value, but If you die early with a large RRSP your heirs lose almost 50% to taxes anyways. So the additional ‘loss’ from owning the annuity is reduced by half.

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Fear of ‘tying up your money’ is a major deterrent. A few products allow the owner to sell the contract back to the issuer. Because the public under-values annuities and will accept a lump-sum far below the annuity’s fair value, it can be to the Insurance company’s benefit. The resale fair value will never be at the original transaction value for the same reason that annuities bought at older ages are cheaper.

A close-cousin to the normal annuity deals with this better. These are called Equity Indexed Annuities (EIA, or Fixed Indexed Annuities FIA) with a Guaranteed Lifetime Benefit (GLB) rider. Because they include the option to surrender, along with hefty penalties, the issuer can offer higher benefits to those who stay.

A synthetic ‘sale’ of an annuity can be accomplished by borrowing an amount equal to the value of the annuity and buying a life insurance policy. The borrowed cash is available for your current needs. The annuity payments cover the interest payments on the borrowed money. At death the life insurance benefit is used to pay off the loan. This works because annuities and life insurance are essentially the same product with just the buyer and seller switched. The different timing of the lump-sum (beginning for annuity and end for life insurance) is accounted for by the basic time-value-of-money equation using the market interest rate for Treasury debt.

For example, at the date of writing this paragraph the Canadian Long Treasury Bonds paid 2.86%. For a 65 year old male the quotes for a $100,000 annuity were between $560 and $575 per month. The quotes for Term-to-100 life insurance were between $321 and $336. A $100,000 annuity purchase could be reversed by borrowing $100,000. The annuity’s payment of $565 would cover the $326 insurance premium leaving $239 / month to pay the interest on the $100,000 debt at 2.86%.

Of course you can rarely borrow at the same rates as governments borrow. As well, that interest rate calculation is locked in until death, while the rates may rise on your debt before then. Academics get rid of this problem by assuming you can buy a very long-term interest rate swap. Most unlikely. Then there is the problem that whoever gives you the loan will want collateral. If you own a house, OK, but what happens when you move out before death? Consider also that life insurance is not widely available to the elderly who would need the liquidity of this swap. So this idea is all easier said than done.

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Another use of life insurance to reverse out an annuity is when all you need for living expenses is a guaranteed after-tax-return that is slightly higher than current government bond yields, and you want to leave an estate after death. You pair a Prescribed annuity with a term-to-100 life insurance policy, without borrowing anything. This removes the cost of longevity insurance. The industry calls it a ”back to back insurance and annuity contract” or “mortality swap”.

If you match the value of the life insurance to the cost of the annuity, the cashflow (net of both products and tax) is your guaranteed return. You get no tax break from the life insurance premium costs, but the preferential tax on the annuity income (see below) is low. (Warning, after 2015 the new longevity table that will be used may make the tax impact much greater.) Be clear you cannot reverse the decision. The principal only becomes available after your death, and the net income payments will not change with changing inflation. You must source each contract from a different insurer. See discussion in Milevsky’s book on page 40.

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A close cousin to the insurance company’s annuity is a Reverse Mortgage where you borrow against the principal value of your home. Although borrowing a lump-sum is most common, you can also structure deals that pay benefits that provide an income stream until the end of the contract. Assuming you stay in your home until close to death, this product incorporates longevity insurance, as well as protection from market returns.

You might mentally consider yourself to have ‘sold’ your home to pay for this income stream, just like you pay cash to buy a normal annuity. But there is a big difference between the products if you die early. Owners of an annuity always die broke, while owners of a Reverse Mortgage need only repay the debt and accrued interest. If little time has passed, then there will be equity remaining.

Here is an interesting paper discussing the different types of Reverse Mortgages from the issuer’s point of view. Beware that rules and regulations differ greatly between counties. Canada’s reverse mortgage industry is restrictive.

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The flip side of the argument is that there are valid reasons to NOT buy an annuity.

• Many don’t have the wealth to tie up except as dribbles out.
• Many have enough guaranteed income already from their OAS, CPP and pensions to cover their essential needs.
• Some are so affluent that they just don’t need the income guarantees, and instead can afford to take the risk of losing money in volatile markets.
• Retiree in poor health don’t plan for a long retirement.

Factors Determining Annuity Prices

Math Theory: In theory, the fair value of an annuity equals the sum of each payment, multiplied by the probability the person is still alive at its date, discounted to the date of purchase by the market interest rate. Notice that the value does not depend on the expected longevity but on the cumulative probability distribution of expected longevity. In practice the issuer will charge a ‘load factor’ to cover his administration costs and his profit margin. 5% would be acceptable. This is the value to the issuer, not to the purchaser. Your personal valuation is discussed below.

Supply and Demand: Issuers know that most buyers will compare quotes from competitors. They will compete by offering higher benefits to offset their corporation’s lower credit rating or because they are more motivated to gain market share. Differentiating their product with bells-and-whistles attracts certain sub-sets of buyers. It has been claimed that the value of extras (like inflation protection and guarantee periods) doesn’t justify their price, but without insider information it is impossible to judge. It may be that there is seasonality to pricing due to the annual rush to convert RRSPs into RRIFs. It is at this time that most people make their annuity purchase.

Interest Rates: The issuer takes your purchase price and buys a portfolio of debt. The rate of return on that debt will be the bedrock of the annuity’s pricing. Bond yields have declined since the 1970’s inflation. But bond yields cannot decline forever. They may even increase. Charaput et al found that 30 year mortgage rates are better than risk-free Treasury bonds at explaining changes in annuity prices.

Annuity pricing is much less influenced by interest rates than most people think. It appears that companies delay changing their prices for fear of losing market share, and in order to see the longer-term rate trends. The price changes are very sticky when rates fall, but react more swiftly when rates rise.

Mortality Rates: Annuities depend on people dying, the faster the better, except for you of course. Their pricing depends on actuaries predicting your probability of dying 20, 30, 40 years ahead of time. Each company develops their own proprietary mortality tables. There are publicly available tables for the general population, but these do not represent the reality faced by annuity issuers. The mortality tables used by insurers may not represent your much-shorter longevity because ……

• The people buying annuities self-select for health and an expected long life. Nobody buys longevity insurance when they expect to die soon. (Although if you have a poor medical history you can buy special annuities with higher benefits.)
• Insurance companies face advertising and administrative costs that are more easily covered by large policies, so they target the wealthy who have longer live spans.
• The people buying longevity insurance are probably more risk averse than the general public. They are less likely to engage in risky behavior and will probably live longer as a result.

The following chart compares the probability of dying in any particular year between the general population and a population of annuity-buyers. Note at age 70 the probability of an annuity buyer dying is almost half that of the general population. Half the cohort has died by the age of 83 in the general population, but not till 86 for annuity-buyers.

Mortality tables change over time as society gets healthier. When timing your purchase of an annuity be aware of issues that may change the issuer’s perception of your longevity.

• A delay may result in the industry using updated mortality tables with longer longevity.
• An influx of people into your postal code of people with longer/shorter longevity.
• When you move to another postal code with different longevity.
• When you lose weight or give up smoking.
• When a new medical treatment makes surviving of your condition more likely.

The issuers can only afford to pay you more than the market rate for bonds because they distribute the remaining principal from members of your cohort who die. If the bond portfolio earns a 5% return, and 2% of your cohort die in the year, the company can distribute 7% to the people remaining alive (roughly). The pricing of products available to younger people reflects little benefit from mortality credits because few people that age die. The probability of death only starts becoming meaningful after about age 65, so the buyer gains little from annuities purchased before that age.

The graph above represents cumulative benefits from two points of view – the owner and the issuer. The top line reflects the cumulative value of benefits received from the POV of the individual owner. Each year’s benefit equals all the others, and the cumulative total increases in a straight line. The lower line reflects the issuer’s POV. As the years go by fewer of the original cohort are left alive, so the issuer’s yearly outlay shrinks. The cumulative outlays line flattens out. The outlay added each year equals
(the quoted benefit paid to each person) multiplied by (the percentage of the cohort still alive- per the table above).
The difference between the two lines equals the mortality credit – the remaining principal value of those who die that accrues to those remaining alive. When taxation is discussed below you will see that non-prescribed annuities are taxed ‘from the POV of the issuer’ – the bottom line.

Life Expectancy

‘Life Expectancy’ is not the same as asking when 50% of you will have died. The 50% number gives you the statistical median. For Life Expectancy you want the average or statistical mean. The total person-years remaining for your cohort is divided by the size of your cohort today. Think of it as the ratio of the area under the survivorship curve BEYOND your age, divided by the height of the line AT your age. In the chart below the area under the curve, beyond age 60 is 17,647. The surviving cohort at age 60 was 868. The life expectancy at age 60 was 17,647 / 868 = 20 years. This is from the 1971 mortality table spreadsheet.

The number of that same cohort of 60-year-olds (only 868 remaining of the original 1,000 births) that die each year is a function of both the rising probability of dying, and also the declining size of the cohort.

Is the Price Right?

The pricing of annuities can be looked at from the point of view of the buyer or the issuer. Some people claim that the insurance company is laughing all the way to the bank and the products are a rip-off. But from the issuer’s POV, pricing in Canada was very fair in 2009. The table below shows the money’s-worth-ratio for different countries. This measures the total benefits paid out as a ratio of the original funding, assumed to earn the risk-free Treasury return. A ratio greater than 1 shows benefits paid greater than costs. Of the two columns only Annuitants column is relevant because it reflects the mortality table for those who self-select to buy annuities. ( paper by N. Nielson for C D Howe).

Most discussions present generalized conclusions that completely ignore the product’s price from the buyer’s POV. But like all financial products, it is the price you pay that determines your profits. The industry norm is to quote monthly benefits for a standard $100,000 purchase. So instead of comparing the product’s price, you compare the yields. Same thing. Price determines yield – yield determines price. Monthly $ benefits times 12 months divided by $100,000.

People typically under-estimate the power of compound interest. At the extreme, they wrongly value annuities without discounting. E.g. they think an annuity paying $8,000 a year, when they expect to live another 20 years, is worth $160,000. But payments decades in the future are worth less to you today. They must be discounted.

The annuity’s yield is not directly comparable to other securities’ yields, because part of each payment is a return of the purchase price. When you die there is no remaining value. Think of it like a mortgage. The payments are a blend of interest and principal. Calculate the interest rate using different assumptions for your age at death.

Use the Present Value of an Annuity ( PVA ) function on your calculator. You already know two of the inputs :
PV = the $100,000 purchase price, and
Pmt = the monthly benefits quoted by the salesman (times 12).
n = the number of years until you die (lifespan) is a subjective input.

The longer lifespan you use, the higher the resulting interest rate and the more attractive the annuity will appear. Your choice of lifespan depends on how much value you put on longevity insurance (discussed above). If you are the rich person, who benefits little from longevity insurance, you could use your own expected lifespan. Add (say) 10 years to your parent’s age at death, or 20 years to your grandparent’s. The less wealthy person should use a lifespan that is super safe – at least to age 100.

Do NOT use the average lifespan for people your age. Averages are relevant to the issuer, but not to you. The variability around that average is huge. Think of a bell curve. Two thirds of people would die within +/- one standard deviation of the expected. From the chart below a 70 year old’s life expectancy falls between +/- 50% of the average. Using the same Social Security Table above the life expectancy of that 70-year-old was 13.6 years. So the range of highly probable life expectancy is between 6.8 and 20.4 years. A VERY wide range.

Once you have calculated the implicit interest rate (i%), compare that rate to the yields of super safe government bonds that are laddered with different maturities. Or if you are willing to assume some investment risk, compare to the total returns you expect from other investments. But beware of the risk mismatch. The annuity insures your rate of return as well as longevity risk, so your comparative investment should also be on the safe side.

Should You Delay A Purchase?

Even if you decide that it makes sense to buy an annuity today, you may find it better to delay the purchase. There are two ways to evaluate this choice. Both ways model the results of a choice between buying an annuity today, or instead, investing somewhere in the interim and then buying the annuity at a later date. If necessary in the interim, the alternate investment is gradually sold, so that cash flows are equal between the choices. The following is an example showing HOW to evaluate the choice. The process is automated in the Choose between Immediate Pay vs Deferred, or Delay purchase of Life Annuity spreadsheet.

There are four unquantified risks in the decision that must be considered.

1. He may die in the intervening 10 years. Does he care himself? Probably not because … he is dead. That is the only logical reaction. His beneficiaries would much prefer he had NOT bought the annuity because all value evaporates on death. But that is only hindsight. They would much prefer he HAD bought the annuity if during the delay he loses all his money in poor investments – leaving them to support him. From the beneficiary’s POV the risks offset each other. Many do care though. It is this fear of dying early and losing the entire principal that prevents many people from buying annuities. This fear is the reason the issuers provide the option of a guaranteed minimum period. But the value you personally place on this risk is purely subjective. Logically there is little to justify the market price for this risk implicit in products with guarantee periods.
2. He may face expenses that exceed his normal-course budget covered by the annuity. If he gets sick, not only will his life expectancy fall (and the value to him of an annuity), he may face bills that are larger than the annuity’s benefits. Delaying the annuity purchase keeps savings liquid and useful.But that same argument can be used to justify never buying an annuity. The problem is solved, not by delaying the purchase, but by not spending all your savings on an annuity – keep some liquid for emergencies.
3. The annuity pricing for the 75 year old may have changed by the time of purchase 10 years later. A 2016 paper by Moshe Milevsky found that the market was continually pricing in longer and longer expected lifespans. As for interest rates, everyone has been saying they cannot possibly go still lower for a decade – yet they continue to decline. A delay in buying an annuity may not benefit from higher interest rates and mortality.
4. Preferred shares (or any other alternate investment) have values determined by the market. Unlike bonds, preferreds do not guarantee a Par Value on resale. Interest rate changes will impact the pricing of preferreds MORE than the pricing of the delayed annuity. There is a mis-match of risk between these choices. You should not accept the risky choice unless the expected benefit from delaying is LARGE.

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Moshe Milevsky has come up with another way to evaluate the decision to delay a purchase. He uses the same math as the example above and the spreadsheet. But instead of using the quote for a basic annuity at (eg above) age 65 with no guarantees, he uses the quote for a product that includes a rider guaranteeing 10 years (equal to the delay) of payments.

He calls this the Implied Longevity Yield ILY – a misleading choice of names. A value for the risk of dying (the first risk above) in the interim period is integrated by the implicit pricing for the guarantee. Whether you care that your principal evaporates on death in the interim is a personal choice.

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The chart below plots the annualized rates of return for two choices (buy-now vs. delay) using same-day quotes for 60 and 70 year old males in 2017. The annual benefit for the 60 year old was $5,512. A choice to delay the purchase for 10 years, to buy a 7.2% product paying the same $5,512, would require the investment to earn an after-tax return of 3.5% in the interim. That is a risky return when Treasury bonds pay only 1.5%. With those profits the original $100,000 principal would be only $76,770 after 10 years.

Both options expose you to years of negative returns once the annuity is purchased – 18 years for buy-at-60 and 13 years for buy-at-70. It would be better to get through those negative years while you are younger and least likely to die — as long as you don’t expect to die within the first 10 years. But the higher yielding product bought-at-70 starts producing higher annualized rates of return if you live past age 90.

Remember that this comparison leaves both options receiving the same $5,512 each year until death. The point here is the choice between buy-now vs delay is not decided by comparing the 5.5% vs 7.2% yields. The choice is not decided by calculating the annuities’ IRR assuming some age-at-death. It is decided by your probability of dying within the delay period. It is decided by the risk your DIY investments will not generate the necessary return.

Deferred Annuities

A lot of the risks faced by delaying the purchase of an annuity are reduced with the product called a Deferred Annuity. You pay today and the benefits are set at the time of purchase but they don’t start until a later date. Consider.

• You get the benefit of the larger yield paid for older purchasers.
• You get that rate set so that they cannot change it in the interim.
• The price for the policy is discounted for paying ahead of time, so your investment at the start is smaller.
• Compared to simply delaying the purchase, the $$ at risk (for investing in the interim) is much smaller.
• The pricing of the policy allows you to benefit from mortality credits from deaths in your cohort in the interim before your benefits start.
• The cash paid upfront grows in value inside the plan tax free.

This choice will almost always trump the choice to delay a purchase. It will hurt to think about dying before receiving a cent, but the smaller investment helps with that mental hurdle. The Choose between Immediate Pay vs Deferred, or Delay purchase of Life Annuity spreadsheet includes this option.

Annuity Ladders

Instead of buying your whole quota of annuity at once, you can stagger purchases of smaller amounts over time. Multiple smaller purchases address the buyer’s reluctance to commit capital that may turn out to be needed for some big-ticket item, or his reluctance to commit capital that may disappear tomorrow if he dies. Laddering may reduce the risk of regret.

Beware of advice that prescribes set percentage top-ups based on supposed historical data. The decision to ladder is exactly the same as the decision to delay. The math is the same, and the risks are the same. Some people claim that laddering reduces interest rate risk and is comparable to laddering your debt holdings. But risk refers to the unknown. With any delay in purchase you face unexpected changes to interest rates, and group mortality, and your health. Product prices may rise … or fall.

Inflation Protection

The insurance industry offers some products where the benefits increase with the Consumer Price Index (CPI). But

• The products are very hard to find and rarely sold.
• They often have provisions that any increases will not exceed (say) 6% inflation. Exactly when you need the coverage, they don’t work.
• Other products provide for set (say) 3% yearly increases in the benefit regardless of CPI inflation. These do not offset inflation risk. Risk refers to the unknown. These products only help you manage your rising cash flow needs.
• Inflation protected products do not qualify for the preferential tax treatment of Prescribed Annuities. A higher tax may wipe out any additional benefits from inflation protection.
• Product pricing is said to be ‘not worth it’. Just like for RealReturn Bonds, the buyer pays a premium for the risk reduction that may be larger than the rest of the population values it.

In the box below are some Canadian quotes for a $100,000 purchase by a 65 and 71 year old male . Using the most up-to-date mortality tables (CPM2014) the expected mortality at 65 is age 86. At 71 it is age 87. At the time, Canadian inflation is roughly 2%, and the growing annuities increase at a pre-set 2%. The “Equate Flat Pay to Indexed Annuity” spreadsheet shows that issuers may price in no returns (or even negative returns) on the lower premiums they pay at the start. They will be pocketing all that income themselves.

However, from your personal POV you must assume a long life to age 100. You could not earn those 10% returns necessary to fund a worst-case scenario. The growing annuity is worth the reduction in starting benefits.

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When married couples buy joint coverage they face the decision whether the surviving spouse’s benefits should decrease, remain the same, or increase. In most cases they should increase, unless you have inflation-proofed the benefits.

• By the time of the first spouse’s death inflation will have eaten into the value of the original benefits. An increase would partially rectify the situation.
• A presumption is commonly made that one person can live cheaper than two. But will that be true? Other than food and medicines what expenses will be reduced? And what about the additional costs to the survivor of paying people to do some of the (eg) repair chores previously done by the now dead spouse?
• Consider the costs of health care. Chances are that the first-to-die was cared for gratis by the spouse. The second spouse will have to pay for care.

Taxes on Annuity Benefits

The decision to buy an annuity, also the decision to defer purchase, should be made on an after-tax basis, like all financial decisions. Annuities are taxed under four different systems.

1. Annuities are not ‘Qualified Investments’ for TFSAs, so the tax treatment of TFSAs is not relevant. The wording of the TFSA rules (section 1.48) require that the owner be able to surrender the contract at any time for fair market value. Normal annuities don’t allow this.
2. Annuities bought with RRSP money are taxed as the benefits are received. Both immediate pay and inflation indexed policies qualify. The value of the contract is not included in the calculation of the Minimum Required Withdrawals (Revenue Canada section 146(3)(b)(iii)). Inflation-indexed annuities with smaller payments can materially delay tax, but since the reduction in RRIF Minimum Required Withdrawals in 2015, that benefit is mostly deleted. Deferred-benefit annuities historically did not qualify inside an RRSP, but will starting 2020. They must pay annual benefits by age 85 and nothing will be taxed until then. Their use is limited to 25% of your account and $150,000. Pre-set benefit increases are limited to 2% per year.
3. Annuities purchased in taxable accounts may qualify to have a simple formula determine the portion of the benefit that is taxable. In Canada these are called Prescribed Annuities. The portion of the payments that are taxable is set and can be calculated ahead of time. Start with the 1971 Mortality Tables for annuities purchased before 2016 or the 2000 Mortality Tables for annuities purchased after 2015. These are prescribed by the Tax Act. Look up your age (when purchasing) and the life expectancy for that age. Divide the annuity’s purchase price by that longevity, to determine the yearly amortization of cost. Subtract that amortization from the yearly benefits. The rest of the benefits are taxable income. This means that both the actual income earned AND the mortality credits are eventually taxed. For every year after, the taxable income will be that exact same $$ amount. ExampleA 60 year old male buys a $ 100,000 annuity with benefits of $ 5,475 yearly in year 2017.Look up in the 2000 Table, the line for age 60 shows life expectancy of 24.5 years. The purchase price $ 100,000 divided by 24.5 years = $ 4,082 amortization yearly The taxable income = 5,475 benefit less the 4,082 amortization = $ 1,393 or 25.4% of the benefits The change of Mortality Tables (from 1971 to 2000) at the end of 2015 drastically increased the portion of Prescribed Annuity benefits taxed – because the Principal Repayment was spread over more years. But offsetting that was the drop in market interest rates and annuity yields – which increased the portion of benefits coming from Principal Repayment.
   There is a difference between US and Canadian taxes after you live longer than your life expectancy at purchase – when the sum of all the non-taxed benefits you have received equals the original cost of the annuity. In Canada nothing changes. The tax-free return of principal portion continues as always. In the US 100% of the payments now become taxable. So the graph below reflects Canadian taxes only.
4. In Canada, annuities may have bells and whistles that prevent them being classified as Prescribed. The taxation of these Non-Prescribed Annuities is a lot more complicated. So complicated that you will not be able to tell ahead of time what your taxable income will be. It varies over time (getting smaller) and depends on the issuer’s proprietary mortality table – which they will not publish. But essentially you get taxed on the yearly interest earned. Asking a salesman what your first few years’ taxes will be won’t give you a useful number because the sales commission the issuer pays reduces taxable income in the early years. Before 2017 it was generally accepted that Prescribed annuities were taxed at lower rates than non-Prescribed – by quite a lot. After 2016 the combination of low interest rates and the lower mortality table has made the opposite true. While the mortality credits are eventually taxed in Prescribed Annuities, they are never taxed in Non-Prescribed Annuities. And the interest earned is miniscule. The graph above reflects a 60 year old male at Jan 2017. For purchases later in life the Non-Prescribed line drops below the Prescribed line at all times. Use this Taxable Income of Prescribed vs Non-Prescribed Life Annuity spreadsheet to calculate taxes for a Non-Prescribed annuity. It is not a guaranteed calculation, but the best available estimate. Changing your age at purchase requires some editing.

Buy with RRSP or Taxable Accounts?

When you hold assets in both RRSP and Taxable accounts, you must decide which account to use for the purchase. Here is just one scenario assuming …..

• $20,000 fully taxed income from other sources.
• $200,000 wealth in each of an RRSP and a Taxable account. Gross up the RRSP by the 22.5% bottom tax bracket –> $258,065
• One account buys an annuity quoted for a 60 yr. old at 5.475% creating a $10,950 benefit if bought outside, or $14,129 if bought in the RRSP.
• In a Taxable account the annuity’s taxable benefits would be $2,787 for Prescribed vs. $4,372 (but falling) for Non-prescribed.
• The other account holds investments earning 3% dividends = $6.000 and 2% capital gains = $4,000.

All three outcomes are very similar. Increasing RRIF withdrawal rates will cause taxable income to rise over time. In contrast the taxed portion of Non-Prescribed annuities falls over time. Changing the age at purchase from 60 to 70 years old would tilt in favour of a Non-prescribed annuity bought with Taxable savings.

There are other issues to consider.
a) Annuities purchased for RRSPs may have lower benefits than those purchased for Taxed accounts, because the issuers have higher maintenance costs.
b) Securities invested in Taxable accounts may be held for many years without selling – delaying capital gains taxes and lowering the effective tax rate.
c) If not all the annuity payouts are spent – e.g. with some reinvested to take care of inflation – the marginal tax rate on the income from those reinvested assets may be different in each option.
d) If you worry about taxes reducing the value of your estate because the whole RRSP balance is taxed all at once, then buying the annuity in the RRSP would be your choice because its value drops to zero on death regardless.
e) The simplicity of converting all the RRSP into an annuity, and forgetting about required RRIF draws, may outweigh any tax considerations.

Buy with Pension Payout

When employees with Defined Benefit pensions quit their job, they are given choices for their accrued pension benefits. These commonly include (a) stay in the pension and receive monthly benefits after retirement, (b) take the payout as cash where it will all be taxed as income, or (c) transfer a portion into a self-directed Locked-In account (like an RRSP but with more restrictions) with the remaining funds being taxed as income.

The longer you have been in the pension, and the more generously it was funded, the larger the pot of cash on which you must pay tax, all in one year. Here is a good article explaining the taxed portion. The government is facing pressure to reduce that portion of the payout. But for some there is a way to avoid tax on any of the payout.

A ‘copycat annuity’ is bought directly with payout funds, from normal annuity providers. It is structured to provide the same guarantees and benefits as your corporate pension. Its two benefits are (a) the risk of the annuity-provider going belly-up may be less than the risk of the corporation under-funding its pension, and (b) none of the pension payout become taxed.

This option is little discussed in the media, so be confident in the advice you get before choosing this path. The important sentence in the article is “If the annuity does not replicate the rights under the RPP, the tax consequences can be catastrophic.”