What is an Annuity?

What is an Annuity? Should you get one?

The shift by employers from traditional defined-benefit pension plans, which typically guarantee income for life, to ‘over-to-you’ defined-contribution arrangements, has put more responsibility on employees for making their savings last through an unknown number of retirement years.

Lacking the knowledge or ability to choose from the investment strategies available to them, many such retirees would be better off converting a significant portion of their retirement savings into an annuity, according to a recent report entitled Retirement Income: Ensuring Income throughout Retirement Requires Difficult Choices.

Life Insurance In Reverse

Annuities are often described as life insurance in reverse. You buy an annuity policy with a lump-sum payment and in return the life insurance company pays you a guaranteed amount for a certain period of time, or for the rest of your life, depending on the option you choose.

The amount you get depends primarily on your age and the current level of interest rates. For a slight cost, you can also add inflation protection to the mix, thus creating your own version of the indexed defined-benefit pension plans many public sector workers enjoy.

Also read: Are Target Benefit Plans the Answer?>

The catch, of course, is that you’ll never be able to touch that money again, apart from receiving the monthly income. And therein lies the problem for most Canadians.

According to a recent report from the BMO Retirement Institute, only a small portion of those planning to retire in five years are willing to give up control over some of their retirement savings in order to receive guaranteed income for life.

Matching Income And Expenses

While annuities are useful for matching fixed expenses with income and preventing people from compounding any previous poor decisions, they do little for those who need some liquidity or want to leave a substantial estate, critics say.

But don’t rule them out too quickly, says Moshe Milevsky, a professor at York University’s Schulich School of Business and author of Pensionize Your Nest Egg: How to Use Product Allocation to Create a Guaranteed Income for Life.

Although the amounts vary, it’s important that buyers understand that their monthly annuity cheque is made up of three things: their savings, interest, and some other people’s money.

Mortality Credits Change The Equation

Insurance companies know that some annuitants will die young. They build such survivorship data into their annuity pricing which means that buyers are implicitly making a bet that they will outlive the average Canadian. If they lose the longevity bet, the balance of their savings will go to the winners — the insurance company and, to a certain extent, its other annuity holders, instead of their heirs.

But that’s the upside, Milevsky argues, highlighting the two main variables that affect life annuities: interest rates and mortality credits. While prospective buyers may be cool to the idea of annuities because interest rates are so low right now, these mortality credits –— the ‘other people dying’ factor — can work to your benefit the longer you live.

Arguing that most retirees want stability as they age, Milevsky makes a compelling argument for why annuities could form the foundation of many a home-grown pension plan.

 Would you consider getting an annuity as part of your post-work retirement income plan? Tell us in the comments, or visit us on Facebook and Twitter.

Related Topics

Life Insurance 101 / Saving For Retirement / Savings / Savings News

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