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Aug 02, 2022
11 min read

Could your years be more "golden" with an insured annuity?

Retirement is often referred to as “the golden years.” Life is thought to be calm and idyllic. This, of course, assumes a sense of confidence around one’s finances. Unfortunately, that’s not always the case.

Kim’s more than 25 years in the financial service industry has given him extensive experience with life and living benefits insurance, including expertise with concepts and sales strategies, as well as tax and estate planning considerations.

Author's Note: Given the recent rise in interest rates, the following is an update to the numbers around annuity income, life insurance pricing, and rates of return of GICs.

 

A recent survey by RBC Insurance polled 1000 Canadians aged 55 to 75, and found that 60% of them are concerned they’ll outlive their retirement savings. Further, 45% don’t feel confident they’ll be able to afford the kind of retirement lifestyle they desire.  

The dilemma

Retirement plans tend to rely on investment portfolios which are heavily weighted toward fixed income assets such as GICs. The intent is to provide a stable income while preserving capital. If the capital is preserved and only the interest earnings are spent, this enables retirees to leave an inheritance on their passing. The problem with this strategy is that, despite the recent rate increases, the current and prolonged low interest rate environment provides significantly less income than it used to, which means it requires significantly more assets to produce the same income.

For example, if $60,000 of before-tax retirement income is needed, it can be produced from a capital amount of $1,000,000 if interest rates are at 6%. But if interest rates of just 4% are available, $1,500,000 of capital would be required to generate the same $60,000 before-tax retirement income. Further, interest income is taxed at the top marginal rate, which means that less of the $60,000 will be available for spending than if it had been generated from a more tax-efficient asset class.

An alternative way forward

So, is there a way to get tax-efficient, guaranteed lifetime income that will also leave an inheritance to loved ones? The solution might lie in an insured annuity strategy.  

This strategy is twofold. It involves investing your capital in a life annuity to create lifetime guaranteed income and purchasing a permanent life insurance policy on the life of the annuitant to replace the capital on death. Even after paying the insurance premiums, the net after-tax spendable income under the insured annuity concept often exceeds what’s available through buying GICs and only spending the interest income. Both strategies leave behind the same estate to heirs, but the insured annuity strategy offers higher and more tax-efficient income. 

Let’s discuss the details of this insured annuity strategy.

What is an annuity?

An annuity is an investment vehicle offered by insurance companies wherein capital is traded for a guaranteed income stream. Once purchased, it’s usually not possible to return the annuity to cash. There are two types of annuities: term and life.

A term certain annuity provides a guaranteed income stream for a defined length of time. For example, a 20-year term certain annuity will provide a guaranteed income stream for 20 years. At the end of the 20 years of income, the capital is gone.  

A life annuity will provide a guaranteed income stream for the life of the annuitant. It will also guarantee the income for a set number of years, so that if the annuitant were to die before the end of the guarantee period, the beneficiary would receive the balance of the guaranteed income stream. If the annuitant dies after the guarantee period is over, the income stream stops and the capital is gone.

Annuity sources and taxation

Annuities from RRSP or RRIF assets are fully taxable income. Annuities from non-registered assets may result in a prescribed annuity. A prescribed annuity has preferential tax treatment in that only a small portion of the income paid out is taxable, while the remainder is considered to be return of one’s own capital and, therefore, is not taxed. The mix of taxable and non-taxable income from a prescribed annuity remains constant for the life of the annuitant.

The insured annuity concept usually involves the use of non-registered funds as the source for the purchase of a life annuity. This provides guaranteed lifetime tax preferential income. It may save your OAS from being clawed back and it may increase eligibility for other income-tested benefits.

 

Is there a downside?
There are a few downsides to using capital to purchase an annuity: 

  • Once purchased, the annuity is usually not cashable 
  • If death occurs after the guarantee period, the capital is all gone and there is no inheritance available for heirs 
  • Even if death were to occur during the guarantee period, the amount of capital available to heirs from the balance of the guaranteed income will be significantly less than the original capital  

 

However, these downsides can be compensated for through the purchase of a permanent life insurance policy on the life of the annuitant. In practice, the life insurance is applied for and put in place prior to the purchase of the annuity. This is because sometimes the insurance on the annuitant is not available due to lifestyle or health issues. 

If the annuity were purchased and life insurance was unavailable, the goal of capital replacement on death would be thwarted. Ideally, the life insurance purchased will be the lowest cost permanent policy available. This will likely be a minimum funded level cost Universal Life or a Term 100 policy.

Insured annuity strategy vs. GIC strategy 
Let’s assume that a couple, both age 65, desires lifetime income while preserving capital to benefit their heirs. If they have initial capital of $500,000 and a GIC paying 4% is available, this would create an income of $20,000 annually, all of which is taxable. Assuming a 36% marginal tax rate, this would result in income tax of $7,200, leaving $12,800 of net spendable income. If they only spend the interest income, their heirs will receive $500,000 when both spouses have passed on.

If they were to invest that $500,000 into a joint prescribed life annuity instead, this would create annual income of $30,747.96 with only $11,654.16 of that being taxable. This results in income tax of just $4,195.50. Joint last-to-die life insurance to provide for the replacement of the $500,000 upon the death of the second spouse would take up $10,170 annually. This results in $16,382.36 of net spendable income. On the passing of the second spouse, their heirs will receive $500,000 from the life insurance proceeds.


The chart below breaks these figures down at a glance. 

 

$500,000 Invested

GIC at 4%

Prescribed Annuity, Insured 

Income Generated

 $20,000

 $30,747.96

Taxable Income

 $20,000

 $11,654.16

Tax Payable (assumes 36% MTR)

 $7,200

 $4,195.50

Annual Life Insurance Premiums

 -

 $10,170.10

Spendable Income

 $12,800

 $16,382.36

Amount to Heirs

 $500,000

 $500,000

$ Improvement vs GIC Strategy

 -

 $3,582.36

% Improvement vs GIC Strategy

 -

 28%

Source: Desjardins Financial Security Quote for prescribed joint life annuity with 10-year guarantee period and BMO Life Insurance 

Joint Last-to-die Universal Life policy (minimum funded, level cost).

Current as of June 5, 2022.

 

Final considerations 

Some might argue that today’s low interest rate environment would be the wrong time to purchase an annuity and lock in the income stream based on the current rates. However, what’s misunderstood is that the amount of income generated by the annuity, especially in older ages, is driven as much by age as rate. This is because the older one is, the more compressed the time period over which the annuitant’s capital and earnings are paid out, thus increasing the monthly income.  

There’s a sweet spot age group for this concept. It’s from about age 60 to 75, and perhaps even a bit older for females or for joint and last-to-die situations. This is because the older one is, as described above, the higher the monthly income. The flip side is that age also increases the cost of the insurance.

Given that some of life’s expenses are lump sums coming at uneven and sometimes unplanned intervals, it wouldn’t be prudent to tie up all of your capital into this concept. But you may want to consider placing enough of your capital into this strategy so that your monthly fixed expenses are covered.

Your Wealth Preservation Advisor can analyze your situation to see if this strategy is a fit for you.

This blog is for informational purposes only. It is not intended to provide legal, accounting, tax, investment, financial or other advice and such information should not be relied upon as advice. Please contact your lawyer, accountant or other advisor for relevant advice. CWB Group takes reasonable steps to provide up-to-date, accurate and reliable information but is not responsible for any errors or omissions contained herein. Information obtained from third parties is believed to be reliable, but no representation or warranty, express or implied, is made by CWB Group or any other person as to its accuracy, completeness or correctness. CWB Group reserves the right at any time and without notice to change, amend or cease publication of the information. Click here to view the full disclaimer.