Annuities: Managing the Risk of Living Too Long
Insurance and Risk Management – Part 7
What? There is a risk in living too long?
Imagine you are 65 years old. You have been reasonably diligent in saving for retirement. Now is the time to cash in. You are about to start receiving your Canada Pension Plan (CPP) and Old Age Security (OAS). The company you worked for provided a defined contribution pension plan. You also saved additional money in an RRSP. Based on some online research and a conversation with the financial advisor at your bank, you think you need to make your retirement savings last until age 90 or for 25 years.
Somewhere you read that you have the option to defer your CPP and your OAS up until age 70, increasing the amount you would receive by 0.7% per month that you wait to start CPP and by 0.6% for each month that you wait to start OAS. However, you are concerned that you might get sick and die too soon to enjoy your pension income, so you elect to start right at 65.
You also make the choice to convert your workplace pension plan into a Life Income Fund (LIF) and your RRSP into a Registered Retirement Income Fund (RRIF).
Time marches on. You withdraw money from your LIF and RRIF according to the government-prescribed schedule. Combined with your CPP and OAS you are doing okay. However, in your mid 70s the investments in your LIF and RRIF hit a bad patch. For a couple of years, you have to take out a larger percentage of your investment balances than you had anticipated in order to keep up your standard of living. This permanently impairs the capital remaining to support your lifestyle. At this stage, though, you figure you can handle it as you are getting older and are not as active as you once were. You cut back and it still looks like you can live reasonably well until age 90.
More time passes. Lo and behold, you are 90 years old and “feeling pretty spry for an old fellow.” Fantastic. It’s great to be a senior citizen. And the fact is, many of your friends from years ago are still going strong, too. However, despite cutting back on your spending several years ago, your assets have dwindled substantially. Now you are beginning to wonder whether living until age 95 or a 100 is such a great thing, if you don’t have enough money to cover your daily expenses. As you continue to age and your income dwindles, the Guaranteed Income Supplement (GIS) begins to kick in with a little bit of money, but it’s quite a bit less than you had anticipated, because you hadn’t expected to live this long. What to do?
This scenario describes longevity risk, that is, the risk of outliving your assets. Since this is a series on risk management you have to know that life insurance companies have a product to deal with this risk. Enter the annuity.
At its simplest an annuity is a series of payments made at equal intervals. Focusing the definition a little, an annuity is a contract between you and an insurance company. In return for a lump sum payment or a series of payments, you receive regular disbursements. These disbursements can begin immediately or be deferred until some time in the future.
In the situation I described in the first part of this post, the person had a defined contribution registered pension plan (DC RPP) and a registered retirement savings plan (RRSP). Both of these build up through a series of payments, but once you retire and wish to draw on them, you need to convert them into a source of income. Unlike a defined benefit registered pension plan (DB RPP), in which the payments to the pensioner are known (thus defined benefit) and the risk of adequate funding for the plan lies with the employer or union, with a DC RPP only the contributions are known (thus defined contribution) and the risk of adequate funding lies with the pensioner. A DC plan and an RRSP are in many ways quite similar in that you are setting aside money for retirement but the nest egg you are building up is not guaranteed to generate a consistent income month after month like a DB plan is.
Enter the annuity. Instead of converting your RPP into a LIF and your RRSP into a RRIF, you can use those accumulated assets to purchase an annuity and effectively “pensionize your nest egg.”* “Just a moment,” you object. “I have a registered pension plan. Why do I need to ‘pensionize’ my pension?” The answer is that your DC pension is not a true pension, at least as Moshe Milevsky defines it. It is not guaranteed for life. A DB plan is a true pension, as is CPP and OAS. These are sources of worry-free income.
How does an annuity work?
Let’s say that between your DC RPP and your RRSP you have accumulated $500,000. At age 65, you may want to take $100,000 of that nest egg and buy an annuity. There are various forms of annuities, some with guaranteed payments of 10 or 20 years, some with no guarantee at all. Others have inflation protection while others do not.† Once you have handed over that money to the insurance company they will start paying you, let’s say $500 a month, for the rest of your life. You can purchase another annuity at 70 and again at 75, and you now have a substantial portion of your expenses covered for the rest of your life. You don’t need to invest all of your assets into annuities to make a substantial difference in your income security.
Why are annuities not more popular?
Loss of control
I don’t have firsthand information about this, but there are anecdotes of people who have decided to purchase an annuity, only to become unwilling to hand over the large cheque required to the insurance company, no matter how rational the choice might be. When you buy an annuity, that money is no longer in your control and giving up control is tough.
Payments are too low
Factors that influence the payments you receive from annuities include your life expectancy at the time you complete the contract and the prevailing interest rates. Life expectancy has been increasing steadily and interest rates are very low. It just doesn’t seem like it’s the right time to buy an annuity. It should be noted, however, that if you have a shorter life expectancy due to health considerations, you are likely to get a higher payout.
Fear of an early death
The probability of living into your mid-80s is such that most people should not take CPP early due to the resulting permanent reduction in payments. Yet many people do. They’ve paid into the CPP for decades. They want it now while they can still have it. For much the same reason, people are also reluctant to purchase annuities. If you die within a year, your $100,000 annuity purchase may have only paid out $6,000.
I have two things to observe about this: 1. You can purchase an annuity with a guarantee payout period of 10 or 20 years, so even were you to die early, the payments could continue to be made to a designated beneficiary. If you are married, you may want to buy a joint and last to die annuity such that the surviving spouse would continue to receive payments after the first spouse died. 2. If you die, do you really care about money anymore?
No inheritance for heirs
Well I suppose you might care if you were hoping that some of the money you have will outlast you and go to your heirs. Any money used to purchase an annuity is no longer yours. The payments are yours and possibly to your heirs if you’ve made arrangements as described above. However, if it is a straight life annuity, or the guaranteed payout period has expired, or it is not a joint annuity, well, then, yes, the money is gone. In that case, if you want to arrange for an inheritance, you will need to look elsewhere.
Retirement experts like Moshe Milevsky, Alexandra Macqueen and Frederick Vettese make a compelling case to at least consider adding annuities to a portion of your retirement income portfolio. If you are approaching retirement, I encourage you to at least raise the subject of annuities with your advisor, preferably someone who does not have a vested interest in you either purchasing (insurance advisor) or not purchasing (investment advisor) an annuity.
My next and final post in this series will look at insuring the insurers.
*Pensionize Your Nest Egg is the title of a book by two recognized experts in the field, Moshe Milevsky and Alexandra Macqueen.
†Frederick Vettese, author of Retirement Income for Life, suggests that instead of buying an annuity with inflation protection, you stagger purchases of annuities over two or more periods.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, accounting or legal decisions.