An annuity is a straightforward income solution. It will generate fixed monthly payments without the need to worry about managing investments in retirement.

An annuity is a contract with a financial institution that provides regular income in exchange for a lump sum of money. The regular payments, usually monthly, consist of a combination of the repayment of part of the principal of your original investment, plus income earned by the investment. Annuities are offered primarily by life insurance companies.

To better understand how an annuity works, think of it as a mortgage in reverse. With a mortgage, a lender gives you a sum of money that you repay through a series of regular payments over time. Interest is charged on the outstanding balance. With an annuity, you provide money to an institution that pays you back through a series of regular payments, along with interest or other income generated by your outstanding principal.

Annuity payments are usually fixed throughout the life of the contract and are established when you purchase the annuity. The level of payments is dependent on a number of factors.

Length of the annuity

Some annuities provide income until 90, while others provide an income stream for life (in some cases it can continue to your spouse). Longer periods of expected payouts reduce payments, if other factors are equal. An important element is prevailing interest rates at the time you buy the annuity. The higher the rates, the higher the income. This level of income does not change if rates change, because payments are fixed. For this reason, the purchase of an annuity is more attractive during times of higher rates.

Age and gender

When you purchase an annuity with funds from an RRSP, annual payments are taxable. Until that point, however, the money hasn’t been taxed because you received an income tax deduction for the original RRSP contribution and your investments grew sheltered from tax inside your retirement plan.

While annuities are a solution for those who need regular income and want a simple financial life in retirement, they have disadvantages. The primary one is that you have little control over your money or level of income. With investments in a RRIF, you can easily change your investment strategy and alter the amount of income you draw from the plan. You’ll need to establish what is most important to you before choosing your option. If you still want to retain some control over your retirement income, consider both an annuity and a RRIF. This way you’ll have the best of both worlds, a simple source of regular income and greater control over a portion of your portfolio. Before you decide, speak to a financial advisor to help you determine whether an annuity is right for you.

Deborah Leahy is an Investment Advisor with Edward Jones, deborah.leahy@edwardjones.com

Member Canadian Investor Protection Fund