It’s getting to be almost impossible to get a low risk return in bonds or stocks. Treasury bills and bankers acceptances (unsecured IOUs, in fact) pay less than half a per cent, give or take and depending on the day. Bonds due in three to five years pay a couple of percent before tax and barely one per cent after. You could buy a bond with a four per cent or better annual interest rate due in 20 to 30 years, but if interest rates go up, those long bonds will plummet in value as new bonds with fatter interest payments are issued. For even more risk, you can pick stocks with terrific dividends, yet many payouts are at risk of being cut. Preferred stocks, which are like bonds save that they give the holder no contractual right to be paid, often have double-digit yields. Considering that preferreds rank behind junk bonds in priority to be paid, their high yields are no free lunch.
So what can you do to get a decent and safe yield on your cash? Remember, if you give up and just leave your money in the bank in a liquid but low interest account, you could wind up eating your capital.
Annuities could be the cure for investment income blues in this time of troubled markets. They offer a large boost over the yields on safe government bonds and they guarantee a known cash flow for life. And for folks over the hump of middle age and able to see retirement in their sights, annuities can make a good deal of sense.
The annuity concept is a bet with an insurance company. You put your money down to buy an income stream for as long as you or a spouse or partner live. The insurance company juices up underling bond interest with some return of capital and boost based on the idea that the time for payout is finite. At the death of the person(s) getting the money, the insurance company gets what is left.
Betting on death (or long life, if you prefer) sounds like an investment plan cooked up in Vegas, but it is as solid as finances of the insurance company selling the plan and as sure as the concept that you get income for life and therefore can never run out of money.
Men tend to die before women, so they get more from each dollar of capital than do women. The payout range on annuities these days is between seven per cent and eight per cent per year, depending on gender. Men, who tend to die before women, get closer to eight per cent, while women, with the gift of relative longevity, tend to get closer to seven per cent. Ill health can boost returns. The sicker one is, the higher the potential payout, though it may be necessary to take a medical exam to satisfy the insurance company that one’s ills are mortal.
In spite of the complexity of annuity payment structures, the totals that can be paid are potentially attractive. A poll of three large insurance companies for a sample annuitant at age 65 with a spouse age 65 with a 10-year minimum pay guarantee produced quotes of $569.18 per month, $573.63 per month and $587.85 per month.
In comparison, a blend of mid to long-term government bonds with an average four per cent yield to maturity would produce at most a $333.33 monthly cheque. The annuity idea has some appeal to someone who is prepared to allow capital to be consumed as a flow of income.
There are problems: premature death or, if you like, death before demographic averages, can mean that the insurance company wins big. For that reason, most people shopping for annuities prefer to buy a minimum guarantee period — 10 years is common.
The minimum pay period ensures that if you or you and your partner both die before 10 years is up, contractual payments can continue to be made to a designated beneficiary. But once the lives or minimum payments end, there is nothing left. That can leave heirs in utter dismay.
There are other issues: live too long and inflation can erode the buying power of what, at time of purchase, seemed a tidy sum. For example, if you have a $1,000 a month annuity starting at age 65 and inflation runs at two per cent for the next 30 years to your age 95, then in the last year of this example, the purchasing power of the monthly stipend will be about $500. You can index some annuity contracts, but only at a high cost.
RRIFS VS. ANNUITIES
You have other ways to buy into annuity-type income. For example, a Registered Retirement Income Fund will pay a rising fraction of its capital rising from four per cent per year at age 65 to 20 per cent per year beginning at age 94. The RRIF does not provide the protection from creditors that the annuity, which is an insurance product, does nor does a RRIF guarantee income for life. But the RRIF is not final. Amounts taken out above statutory minimums are easily changed, and the RRIFee can have both upside gains and downside losses of underlying investments. An annuity is a one time decision and purchase for life. The RRIF usually requires management and asset adjustment from one year to the next.
So what’s best? Keeping money flexible and trying to get a good return from assets or going with a single decision to buy income for life at the certainty of eventual forfeiture of capital? The biggest problem with the annuity is that your cash flow will die when you or your partner pass away. Die at the end of the guarantee period and there is nothing left for your children or other heirs.
That income can be made more certain. Failure of insurance companies is not unknown. Witness the 1994 death of Confederation Life Insurance Company from a combination of management and investment issues. However, Assuris, the life insurance industry’s guarantee fund, will replace the greater of 85 per cent of defined income benefits or $2,000 per month. Prospective annuitants who would be exposed to the 15 per cent loss of pensions over $2,000 per month if their insurance company were to fail can shop their business among as many companies as they need to stay under the $2,000, 100 per cent coverage limit.
Bottom line: there is logic in making the one time annuity decision. Market turmoil is showing some of the wisdom of buying a guaranteed income stream. As well, people are living longer and most don’t have defined benefit pension plans. So there is an increasing market for income certainty. Inflation can wreck the value of annuity income, so committing your money to an annuity anytime before age 50 or 55 for people in good health is foolish. But once you can see retirement in your sights, it can pay to look at the pros and cons of buying an annuity. Then compare that with the alternative of hunting for good deals in capital markets.
Andrew Allentuck’s latest book, When Can I Retire? Planning Your Financial Life after Work, was recently published by Penguin Canada.