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Invest Style

Annuities: High returns, but at a stiff price

You get a hefty yield over bonds, but your income eats into your capital

Annuities: High  returns, but at a stiff price

By Andrew Allentuck
Globe Investor Magazine Online, March 16, 2009

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 certain cash flow for life.

The annuity concept is a bet on how long you will live - your money for an income stream that will last for the rest of your life. You give money to an insurance company, which pays it out to you as a combination of interest income on underlying assets and as well as capital. When you die, the insurance company gets what is left.

"People are living longer, and most don't have defined-benefit plans. So, there is an increasing market for income certainty," says Kevin Strain, senior vice-president for individual insurance and investments at Sun Life Assurance Co. of Canada in Waterloo, Ontario.

Men tend to die before women, so insurance companies pay men more from each dollar of capital because they assume the payout period will be shorter. Men get closer to 8 per cent, while women tend to get about 7 per cent, says Josef Frank, director of fixed products at Manulife in Toronto.

Ill health can boost returns. The sicker you are, the higher the potential payout, since you're likely to die sooner and leave the insurance company with a bigger pot of cash.

The prospect of premature death means most people prefer to buy a minimum guarantee period with their annuities, such as 10 years, Mr. Frank says. That ensures that if you and your partner both die before 10 years are up, contractual payments can continue to be made to a designated beneficiary.

But once your lives or minimum payments end, there is nothing left, and that can leave heirs in utter dismay, says planner Daniel Stronach, head of Stronach Financial Group Inc. in Toronto.

"There have even been lawsuits against financial advisers whose clients have bought annuities," he explains. "The claims come from aggrieved children who have lost their inheritances when parents have died and left their money to insurance companies."

Caroline Nalbantoglu, a financial planner with PWL Advisors Inc. in Montreal, agrees. "The biggest drawback to the annuity is that it dies with you if you pass away after the guarantee period," she says. Annuities appeal to investors who are prepared to eat into their capital to bring in an attractive income. A poll of three large insurance companies for a 65-year-old with a spouse also aged 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 4 per cent yield to maturity would produce no more than a $333.33 monthly cheque.

But 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 2 per cent for the next 30 years, 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 to inflation, but only at a high cost.

There are other ways to buy into annuity-type income. For example, a Registered Retirement Income Fund will pay a rising fraction of its capital, increasing from 4 per cent per year at age 65 to 20 per cent per year beginning at age 94.

An RRIF does not provide the protection from creditors as an annuity does. Nor does an RRIF guarantee income for life. But the RRIF is not final - amounts taken out above statutory minimums are easily changed, and the RRIF investor can have both upside gains and downside losses of underlying investments. The RRIF usually requires management and asset adjustment from one year to the next, while an annuity is a one-time decision and purchase for life.

Just how safe is your money? The failure of insurance companies is not unknown - witness the 1994 death of Confederation Life Insurance Co. from a combination of management and investment issues.

"The underlying soundness of any company's annuity income stream is ultimately reliant on its underlying assets," says Bruce Corneil, senior vice president and chief operating officer of fund manager Beutel Goodman Co. Ltd. in Toronto.

However, Assuris, the life insurance industry's guarantee fund, will replace 85 per cent of defined-income benefits or $2,000 per month, whichever is greater. Prospective investors who would be exposed to the loss of the remaining 15 per cent of pensions over $2,000 per month can shop their business among as many companies as they need to stay under the $2,000, 100 per cent coverage limit, Mr. Stronach notes.

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