Following our third market meltdown in the past decade, the fashion maxim “everything old is new again” may apply to annuities as well.
As baby boomers approach and enter retirement from DC plans, there is a strong argument in favour of allocating a portion of assets to an annuity—yet we see few members elect this option. The industry needs to collectively change the negative perceptions of annuities and help retiring plan members implement wise strategies.
Protection against investment risk is just one of the often-overlooked advantages of annuities. They also address the risks that capital accumulation plan (CAP) members face of outliving their savings, losing the ability to manage their own assets, getting bad advice from untrustworthy sources or seeing their asset base eroded by high investment management fees.
So why do annuities continue to get a bad rap, and what can the industry do to change it?
Improving member understanding
Part of the solution is better member education. Individuals tend to place more emphasis on the chances of dying early and losing out on annuity income than they do on the chances of living beyond their expectations and having a guaranteed income for life. Plan members need to understand that annuities come with a range of optional death benefits that provide continuing income to a spouse or beneficiary and can be purchased with various guaranteed periods of payment. They also need to be kept up to date on recent developments—for example, annuities that guarantee, at a minimum, the return of the original principal amount or that allow more flexibility and access to future payments. Better communication and understanding of the available options will help to foster the use of annuities among retiring CAP members.
Compensating advisors
Advisors also need education to ensure that they understand how to design an effective de-accumulation strategy for their clients, including the potential role of an annuity. The current compensation structure for advisors is problematic and does little to promote the use of annuities. Commissions on annuities (generally around 3%) are paid upfront, with no potential for additional future commission. Mutual funds, which can be resold when deferred sales charges expire, are far more lucrative.
One of the key advantages of membership in a group plan is that members can, in most cases, purchase an annuity on a commission-free basis, saving 3% of their capital. Even if there is a one-time 3% commission, the member is still better off than with an ongoing annual management expense ratio of 2.5%.
Comparing options
There is no question that the same level of annuity income costs more in a low interest rate environment than it does when interest rates are up. However, the current interest rate for pricing annuities is generally between 3% and 4%. Compare that to the interest rate you’ll receive on other products with the same level of guarantee (currently 2.25% for a 10-year GIC, as per the Royal Bank, or 2.3% on a 10-year Government of Canada bond), and you’ll soon realize that annuities provide the best bang for your buck for each dollar of income provided. Why? Because the longevity risk is spread across all annuity holders, thereby providing a higher income to all for the period during which it will be collected.
Graphs 1 and 2 compare the income streams from a life income fund (LIF) and an annuity. Both tables are based on Ontario LIF drawdown rates for 2011, a beginning balance of $100,000 and a non-commissioned male single-life, 10-year guaranteed annuity quote obtained from LifeAnnuities.com.
With a 4% net rate of return, the annuity provides the highest level of income across all ages—and the LIF will be exhausted by age 90 if the member takes the maximum payments each year. With a net rate of return of 6%, the annuity provides a competitive annual income, with the advantage of ensuring that it continues for life.
Satisfying the need for greater stability of retirement income means extending the principles of diversification beyond traditional investment products to include various methods of receiving income. Deciding what portion of a member’s savings should be applied to the purchase of an annuity will depend on each individual’s unique circumstances. However, one simple strategy that will work for many retirees is to buy sufficient annuity income so that basic retirement needs are “insured,” with any remaining savings invested in the market.
There is also the question of when to buy an annuity. Although the tax treatment of annuity income in Canada can be quite favourable, members of registered plans can’t delay starting their payments past the end of the year in which they turn 71.
Baby boomers’ needs for a safe, predictable retirement income could fuel the growth of the annuity market for many years to come. Now it’s up to plan sponsors to step up annuity education—and the pension industry to find new ways to evolve the product.
Janice Holman is a principal with Eckler Ltd. jholman@eckler.ca
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