Financial Fitness: What the heck is an annuity anyway?

Photo courtesy of stock.xchng.

When it comes to retirement income, registered retirement income funds (RRIFs) are by far the most popular choice for Canadians.

About 80 per cent of us convert our registered retirement savings plans (RRSPs) to RRIFs. But while RRIFs are suitable for most retirees, they aren’t for everybody. For some, an annuity may be a better choice.

An annuity will generate fixed monthly payments without the need to worry about managing investments or making difficult financial decisions. An RRIF, on the other hand, requires you to continue to manage investments in much the same way you did with your RRSP. This can be as simple as regularly renewing GICs or as complex as managing a portfolio of individual securities.

An annuity is a contract with a financial institution that provides regular income in exchange for a lump sum of money. The regular payments 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.

One is the length of the annuity. Some annuities provide income until age 90, while others provide an income stream for life (and in some cases it can continue to your spouse). Longer periods of expected payouts reduce payments, if all other factors are equal.

Another important element is prevailing interest rates at the time you buy the annuity. The higher the rate, the more income you receive. This income does not change if rates change, since payments are fixed, so the purchase of an annuity is more attractive during times of higher rates.

Other factors include age and gender.

When you purchase an annuity with funds from an RRSP, annual payments are taxable. Until that point, 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 good solution for those who need a regular income stream and want a simple financial life in retirement, they have disadvantages. The primary drawback is that you have little control over your money or level of income. With an 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 about your income stream before choosing your retirement option. If you still want to retain some control over your retirement income, consider both an annuity and an RRIF. This way you’ll have the best of both worlds—a simple source of regular income and a portion of your portfolio over which you have greater control.

Deborah Leahy is an investment adviser with Edward Jones, member of the Canadian Investor Protection Fund.

Mine the knowledge of our columnists

The Senior Times will host an information session with columnists
Bonnie Sandler, Joyce Blond Frank and Deborah Leahy on October 4 from 1 to 3 pm at the offices of the newspaper, 4077 Décarie.
Those who wish to meet with them should make an appointment by calling 514-484-5033 or emailing with Consultation in the subject. Individual, 15-minute consultations will be provided.

Be the first to comment on "Financial Fitness: What the heck is an annuity anyway?"

Leave a comment

Your email address will not be published.