If so, they have a big decision to make with their RRSP investments: cash them out, convert them to a RRIF or convert them to an annuity by the end of the year.
First off, what is an annuity? It is basically an insurance product (and thus only sold by life insurance licensed professionals). They come in all kinds of shapes and colours but a fixed life annuity looks like this: you hand over your hard-earned RRSP money, and the financial institution guarantees you a fixed monthly payment every month for the rest of your life.
Annuity payments are priced based on prevailing interest rates – in other words the payment afforded by the financial institution is guided by today’s interest rate environment. Currently, a 71-year old man can expect to receive about $630 every month for each $100,000 handed over. A 71-year old woman can expect to receive about $560 every month for each $100,000 (less than a man because they live longer on average).
So, if by the time you are 71 you have been able to save $500,000 in your RRSP, the resulting annuity payment might be about $3,000 a month in taxable income for life.
For those who prefer to receive a ‘paycheque’ in their later years, they may be better off with this option. Note that it puts a monthly cap on spending. It’s for those who do not want to concern themselves with investment returns, a stock market crash or running out of money. The risk of capital is no longer held by the individual, but rather with the financial institution contractually guaranteeing the annuity payments.
With an annuity, no matter how long you live, you’ll never run out of income. It is called a ‘safeguard against longevity risk’ for a reason. Remember, with a RRIF there is generally no maximum withdrawal rate, meaning you could easily draw down all of this financial bucket well before your last days on this earth. There is a minimum RRIF withdrawal rate starting at age 72, but many exceed these minimums early on in retirement which can result in more financially challenging times in their later years.
The value of the annuity must be balanced off with the fact that, with an annuity, generally there is nothing available for heirs. With the fixed annuity, when your life runs out, so do your annuity payments. Good legacy planning requires that you think through the implications of this – if you want to leave something for your grown children, it won’t come from the money tied up in an annuity. And that’s ok, if you just want to leave them the value in your family home, cottage or other investments.
Annuities are definitely not for everyone. For those in poor health or with a low life expectancy, they may be a terrible idea. For those with a sizable company-sponsored pension, they may not be recommended (since these are also life-long ‘paycheques’); those with significant wealth that they will never out-live also may not require the certainty of an annuity.
Don’t forget the tax implications of annuities. When purchased with registered funds, every dollar received from the resulting annuity will be considered taxable income. When purchasing an annuity with non-registered funds (a ‘prescribed annuity’), only the interest portion will be taxed.
It’s too bad annuities get a bad rap from many in the financial industry. One of the reasons is that they pay lower commissions than some of the alternatives. But I recommend taking another look and considering it for a portion of your retirement plan, if you fit the profile. It might just provide that additional level of financial peace in your later years, especially if you happen to live longer than most.