The article “How annuities work in Canada” was originally published in MoneySense on July 17, 2023, reposted April 18, 2024.
Annuities have faced headwinds over the past 40 years. But as interest rates climb and baby boomers retire, they’re gaining interest from Canadians.
Annuities are life insurance products that pay a regular income to a purchaser. When you buy an annuity, it’s like buying a pension plan with a lump sum premium paid from your savings. The payments you receive include a return of your original capital and interest income on that capital. It may also include the remaining capital of others who purchased an annuity who died before their life expectancy.
Annuity payments can be paid to you monthly, like with a pension. They can also be paid quarterly, semi-annually or annually.
When payments begin right away, you have what’s called an immediate annuity. Payments can also be deferred and begin in the future. This type of annuity is called a deferred annuity.
How are annuity payments determined?
Annuity payments depend on a variety of factors, including:
- Your sex: Women are statistically more likely to live longer than men, so they receive lower payments.
- Your age: The later your annuity payments begin, the higher the payments since less payments are likely to be made between the starting age and your life expectancy.
- Your health: A provider may consider the impact of serious health conditions on life expectancy that could increase your payment amount.
- The type of annuity: A fixed annuity has a set payment that does not change. Indexed annuities are adjusted for inflation, and they have lower payments initially than a fixed annuity. Variable annuities may have a base payment amount and a variable amount that can change depending on the return of a basket of investments. Companies like Purpose Investments and Guardian Capital have introduced tontine-like products that provide income for life, which can increase significantly for those who live well past their life expectancy. It pools the capital left behind by those who died at a younger age for those who live longer than expected.
- The term of the annuity: Some annuities—called term-certain annuities—are payable for a pre-determined term, like 10 years. Most annuities are life annuities that continue for the lifetime of the annuity holder. An annuity purchaser may elect to have a minimum guaranteed period for the annuity payments so that if they die before the end of that period, their beneficiaries or estate will continue to receive payments. A couple can buy a joint and survivor annuity using non-registered retirement savings plan (RSP) or non-registered retirement income fund (RIF) savings with payments continuing until the second of their deaths. Annuities with guarantees or based on the life expectancy of two purchasers will have lower payments than an annuity with no guarantees or based on a single life.
- Interest rates: The higher interest rates are when an annuity is purchased, the higher the payments. Ten years ago, a 65-year-old woman buying a $100,000 annuity with no guarantee might have received $482 per month in payments. Today, the monthly payments might be $539. For a 65-year-old man, those same payments would be $539 and $576. The increase in payments over the past decade may not be as much as you would expect given how much interest rates have risen, but annuity calculations make assumptions for long-term interest rates regardless of current rates.
How annuities are taxed in Canada
If you buy an annuity with registered funds from an RRSP or RRIF, the subsequent payments are fully taxable just like an RRSP or RRIF withdrawal. Although most RRSP account holders convert their RRSP to a RRIF, you can purchase an annuity with RRSP or RRIF savings.
If you use non-registered savings to buy an annuity, the subsequent payments consist of a tax-free portion and a taxable portion. The tax-free portion is your return of capital or principal, while the taxable portion is the interest income. You can elect to have a non-registered annuity paid as a prescribed or non-prescribed annuity when you buy.
A prescribed annuity allocates the taxable income from the annuity equally to each payment. A non-prescribed annuity has more income taxable in the early years and less in the later years. This is similar to a mortgage, which has more interest payable by a borrower initially, or a savings account being drawn down that has more interest income earned on a higher balance in the early years. A prescribed annuity can result in tax deferral.
What are the benefits of an annuity?
One of the primary benefits of an annuity is that it protects you against the risk of outliving your money. It is like life insurance in reverse. Another benefit is the simplicity. Many people are envious of retirees with defined benefit pensions, but anyone can buy their own pension by buying an annuity. Unlike stocks and bonds, annuities are not volatile, and with the exception of variable annuities or indexed annuities, the payments are pre-determined.
A self-directed DIY investor may benefit from actively managing their portfolio in their 50s and 60s but considering an annuity in their 70s. The result is less reliance on their portfolio management and more guaranteed, predictable income.
An annuity can also be considered to replace part of an investor’s fixed income allocation within their portfolio. Or to cover some or all of a retiree’s fixed expenses along with Canada Pension Plan (CPP), Old Age Security (OAS), and workplace defined benefit pension income, with investments used for variable expenses.
Are annuity payments protected?
Most insurance companies in Canada are members of the not-for-profit organization Assuris, which protects policyholders in the event a member company fails. Annuity payments are guaranteed up to $5,000 per month or 90% of the monthly benefit, whichever is greater.
As an example, a $5,000 monthly annuity payment would be fully guaranteed if a member provider failed. A $6,000 monthly benefit would have $5,400—90% of $6,000—as the protected benefit amount. Prior to May 29, 2023, the Assuris guarantee was only $2,000 or 85% of an annuity payment.
Minimum investment requirements and fees for annuities
The minimum investment to purchase an annuity may range from $10,000 to $50,000, depending on the insurance company. A financial advisor needs to have a life insurance license to sell annuities. Their one-time commission is typically 1% to 3% of the total annuity purchase. By comparison, investment management fees are typically 1% to 3% of the assets under management every year.
Can you insure an annuity?
One of the biggest hesitancies to buying an annuity is the potential of dying soon after buying it, having handed over a lump sum to an insurance company. Adding a guarantee rider with a minimum number of payments payable to your beneficiaries or your estate is an indirect way to buy a life insurance policy on an annuity.
Some annuity holders take things a step further by buying a life insurance policy at the same time as buying an annuity—a concept called an insured annuity. If you buy a life insurance policy with a face value equal to the amount of money used to buy the annuity, it is similar to buying a guaranteed investment certificate (GIC). Both have regular payments and a principal guarantee (albeit on death for an insured annuity).
What are advanced life deferred annuities?
Advanced life deferred annuities (ALDAs) were proposed in the 2019 federal budget and received royal assent in 2021. An ALDA would allow an RRSP/RRIF holder to take up to 25% of their account, to a maximum of $160,000 as of 2023, and buy a deferred annuity to begin no later than age 85. The problem is no insurance companies are offering ALDAs yet.
Annuities: The non-pensioner’s pension
In closing, annuities provide an opportunity to a non-pensioner to buy a pension plan. Annuity income can insure a retiree against outliving their money. Annuities may appeal to DIY investors who are getting older or who don’t have a workplace defined benefit pension, and conservative investors may find them more attractive than stocks and bonds. They may also interest investors with smaller savings who have difficulty meeting the minimum investment requirements of an investment advisor.
However, annuities are not for everyone. They’ve not been popular with the past generation. Regardless, higher interest rates and an increasing population of investors in the decumulation phase of their lives are sure to bring more attention to annuities as a retirement income option.
About Jason Heath, CFP
Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever.
