With interest rates rising substantially from their lows, at least for now it appears that higher interest rates are here to stay. With the rapid rise in rates, annuity rates have also reached levels not seen in well over a decade. For instance, as of August 30, 2023, the monthly payout for a 65-year-old male increased by almost 25 percent to $592.18, from where it stood at around $475 in January 2022.1

In this current climate of declining defined benefit pensions, volatile financial markets and increasing longevity, the potential for stable income for life using an annuity may be an attractive option for more risk-averse investors.

What is a Life Annuity?

An annuity is a form of insurance that provides a stream of payments to an individual for life in exchange for a lump sum premium. For individuals who want a reliable flow of income or worry about outliving their assets, it provides the benefit of a stable income stream that is guaranteed until death.

In general, the best time to purchase an annuity is when interest rates are high and prospective inflation is low. This is because the amount of income paid to the holder is generally set at the time of purchase and based on prevailing interest rates. If an annuity is purchased in a period of lower interest rates, the payments will be less than if purchased when rates are higher. Since the annuity provides fixed payments, inflation will erode the purchasing power of future annuity payments.

While the fixed payments are guaranteed as long as the annuitant(s) is alive, the corresponding drawback is that the initial capital put into the annuity cannot be reclaimed as it has been exchanged for the ongoing stream of income. As such, the idea of locking up a substantial amount of retirement funds in an annuity may not be preferable for some due to the lack of liquidity. As well, annuities generally do not provide funds to be left within an estate after death, although an insured annuity strategy could be implemented if capital preservation is important.

An Annuity as Part of a Balanced Portfolio

Generally, a life annuity acts like an illiquid, permanent type of fixed- income instrument. It is considered “permanent” because, unlike traditional bonds, which fall in price when interest rates rise, the income generated by an annuity remains unaffected by changing rates. Many investors hold fixed-income investments to provide income and stability against stock market declines and an annuity can play a similar complementary role within a portfolio. Some investors choose to put a smaller proportion of savings into an annuity and increase the amount over time as a way of mitigating potential future rate increases.

Estate Planning with an Insured Annuity

An insured annuity provides the guaranteed stream of income of an annuity while maintaining capital available for transfer to the next generation. It consists of the purchase of a permanent life insurance policy and a life annuity, with the insurance policy death benefit equal to the amount of the annuity investment. This replaces the capital used to purchase the annuity in the estate for the benefit of heirs. The premiums for the life insurance policy can be funded by a portion of the annuity payments received, and insurance proceeds are paid to named beneficiaries. Since a portion of the payment is considered to be a return of principal, only the interest-income portion of the payment is subject to tax annually. When non-registered funds are used, the preferential tax treatment can be significant.

1. The figures are for a non-registered single life annuity with a premium of $100,000 and a 10-year guarantee, with payouts commencing one month after purchase. The figures are based on an average of the top three providers on August 30, 2023. https://www.investmentexecutive. com/newspaper_/insurance-guide/interest-rate-hikes-boost-annuities-sales-payouts/; https://www.cannex.com/public/antc03e.html

Harbourfront Wealth Management was one of Wealth Professional Magazines 5 Star Brokerages for 2022. Wealth Professional is a free online information resource for all Canadian advice and planning professionals. This is not a paid award Harbourfront Wealth Management is not a sponsor.

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