Financial Fitness: Annuities — the RRIF alternative

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When it comes to retirement income, Registered Retirement Income Funds (RRIFs) are by far the most popular choice for Canadians. About 80% 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 is a straightforward income solution. It will generate fixed monthly payments, without the need to worry about managing investments or making difficult financial decisions in retirement. A 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, which are 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. 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 rates, the more income you receive. 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. Other factors include 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 have grown 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, there are disadvantages. The primary drawback is that you have little control over your money or level of income.

With 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 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 a 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.

But before you decide, speak to a financial advisor who can help you determine whether an annuity is right for you.

Deborah Leahy is an Investment Advisor with Edward Jones. Deborah.leahy@edwardjones.comMember Canadian Investor Protection Fund

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