How Do Annuities Work?

Have you been wondering what is an annuity in Canada? An annuity is a financial product that guarantees a set amount of money on a monthly basis. It is typically used after retirement and is sold by an annuity provider, such as a life insurance company. You deposit a lump sum and in return receive a fixed income for a certain number of years or until the end of your life. An annuity’s main purpose is to provide you with guaranteed income payments during your retirement years. Annuity payments are issued monthly, quarterly, semi-annually, or annually.

Annuity vs. life insurance

You can use both an annuity and life insurance company to fund your retirement, but they are not the same. An annuity is more suitable for this purpose, while life insurance’s main purpose is to provide your family with a payout when you die.

Here are the key differences between them:

How does an annuity work?

An annuity can help you ensure you do not outlive your savings. It provides you with a predictable stream of income in your retirement years to help cover basic expenses.

Some of the main features of annuities are:

• Predictable payments – An annuity pays fixed guaranteed income payments for a predetermined period or your entire life or until the death of your spouse or other-named beneficiary.  
• Tax-deferred growth – Tax-deferred means you do not pay taxes until you make a withdrawal. Also, you will pay taxes only on the amount you withdraw. The remaining amount will continue to grow on a tax-deferred basis. Since an annuity allows investment gains to accumulate tax free, it can grow at a faster rate than a taxable product.
• Death benefits – In case of a death-benefit provision, you can name a beneficiary. The designated person will receive the remaining fixed annuity after your death.

Different types of financial companies offer annuities, including banks, investment brokers, and insurance companies. Depending on the type of annuity you buy, you can pay the premium in one go or as regular payments over time. This period is called the accumulation phase. During this period, you make deposits into your annuity to build up its cash value.

The accumulation phase is followed by the distribution phase or payout phase. It begins when the provider starts issuing you annuity payments. How long the payout will last depends on the type of annuity you have bought and its terms.

Depending on your policy, you can choose the income stream to last your entire life or for a specific period (15 years, for example). If you have bought a joint-and-survivor annuity, it will continue to pay your spouse or beneficiary for years after your death.

How frequently you receive payments depends on the annuity type you have purchased. Generally speaking, you can choose to receive payments once a month, every three months, every six months, or a year.

Depending on the type of annuity you signed-up for, you may choose to receive the fixed annuities immediately or at a later date. Your annuity retirement income depends on many factors, such as:

1. Current interest rate

The size of your annuity payment is directly related to the interest rate at the time of purchase.

2. The amount you deposit

The more money you invest in an annuity, the higher your retirement income will be.

3. Age

Your annuity income is inversely related to your remaining life expectancy. So, the older you are when you sign-up for an annuity, the higher your retirement income.

4. Gender

Statistically speaking, women live longer than men. In Canada, the average life expectancy is 84 years for females and 80 years for men. Therefore, women receive less money than men of same age, assuming other things are the same.

5. Guarantee period

The shorter the payout period, the more you will receive for monthly payments. Annuities typically issue payments for a specific period or until you pass away. In the case of a life annuity, you can also arrange for the payments to continue for a minimum period — say 5 or 10 years — after your death. The longer this period is, the smaller the monthly payments.

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Types of Annuities

There are three basic types of annuities: life annuity, term-certain annuity, and variable annuity. These three types are based on two main factors:

• how long you would like the provider to issue regular payments

• how you would like the annuity to grow over time

Let’s discuss each of the three main types of annuities in detail.

1. Life annuity

A life annuity is an insurance company product that pays you a guaranteed income for your lifetime. No matter how long you live, you will not outlive your annuity income.

For example, if you purchase a life annuity for $240,000 at age 60 with an income of $1,000 a month, you will receive your principal amount by the time you turn 80. The monthly payments from your annuity, however, will not stop at age 80. You will continue to receive $1,000 every month for the rest of your life.

So, the longer you live, the more money you get back from your annuity. Generally, life annuities pay for as long the as the annuitant remains alive. Once you die, the provider stops issuing payments.

However, some providers offer various options that ensure the payments continue after your death. These options are:

• A guaranteed option: If you buy a life annuity with a guaranteed option, your beneficiary or estate will receive the payments if you die within a certain period. For example, let’s say you sign up a life annuity with a guaranteed benefit period of 10 years, but die two years later. The provider will continue to issue payments to your beneficiary or estate for 8 more years (that is, until the guaranteed benefit period ends).

• A joint and survivor option:  In this case, the annuity makes regular payments as long as one of the annuitants is alive. Depending on terms of your contract, the provider may pay 100% of the fixed annuity to the surviving annuitant or a lower percentage — usually 75% or 50%. The higher the percentage the second annuitant receives, the lower the monthly payments will be.  

• A cash-refund option: Your estate or beneficiary receives a lump sum if you pass on before receiving the original investment account. This lump sum is equal to the difference between the amount you paid and the total amount you received.

You can pick one or more of these options to make sure your spouse, beneficiary, or estate receives income payments from your annuity after your death. However, keep in mind that each feature will reduce the size of the annuity payment.

2. Term-certain Annuity

It guarantees payments for a certain period, as opposed to your lifetime. If you pass away before the term ends, your beneficiary or estate receives the remaining payments. Depending on your provider, your beneficiary may have the option to receive the remaining amount as a lump-sum payment. The longer the payout period, the lower your regular payment will be.

3. Variable Annuity

In the case of a variable annuity, your account balance and annuity payments are tied to the performance of an investment portfolio. If the latter does well, your will receive higher annuity payments. The opposite is also true — your regular payments will reduce if your portfolio loses value. So, while a variable annuity gives you an opportunity to earn higher returns, the payout is not guaranteed.

Pros and Cons of Annuity Types

Each of the three annuity types comes with its own set of advantages and disadvantages.

Life annuity

With a life annuity, you receive a predetermined amount until your death.

Pros:

• You receive payments for as long as you live.

• Gives you peace of mind knowing your investment income will not change.

• You can ensure your spouse will have fixed income after your death by choosing the joint and survivor option. (This can be a good option for married retirees, especially if your partner does not have other sources of retirement income).

• Additional options (like the guaranteed option or the cash-refund option) can ensure your beneficiary or estate receives a lump sum or periodical payments for a certain period after your death.

Cons

• You might not live long enough to receive all of your money back.

• Additional options will reduce the size of your annuity payments.

Term-certain annuity

A term-certain annuity issues guaranteed income payments for a selected period.

Pros

• You receive payments for a fixed period. If you die before this period ends, your beneficiary or estate will receive the remaining money either as a lump sum or periodical payments.

• Because your payments are fixed, they are secure from both market and interest rate risks.

Cons

• You receive payments for a limited period, as opposed to your entire lifetime. If you outlive the annuity term, you will not have any money coming in. For some people, particularly those without sufficient retirement funds, this could pose a problem.

Variable annuity

A variable annuity is a financial product whose value is tied to the performance of an investment portfolio.

Pros

• Gives you an opportunity for long-term capital growth. If your portfolio performs well, you will receive more money than you would have with a non-variable annuity.

Cons

• No guaranteed payout. You may earn little or no interest on your investment if the market performs poorly.

• Variable annuity plans can be complex, especially if you are not a seasoned investor.

• High administrative fees. Generally, these plans have higher administrative costs than non-variable annuities.

Who should get an annuity?

Whether an annuity is right for you or not depends on your age and financial situation.

An annuity does what other investments do not — provides a steady guaranteed income payments stream for your entire lifetime. If you are young and healthy and want to make sure you do not outlive your money, buying an annuity can make a lot of sense.

An annuity can also be a good option for high net-worth individuals who have maxed out other tax-advantaged retirement investment vehicles. There are two reasons why this is so:

• An annuity grows on a tax-deferred basis

• There is no contribution limit, which means you can save as much as you want

However, just like any other financial product, annuities might not work for everyone. If you do not expect to outlive your savings, you do not need an annuity.

How to purchase an annuity?

You can buy an annuity pretty much the same way you buy any other insurance company product.

• In person from a licensed broker, insurance company agent, or a financial advisor with a valid license to sell insurance products

• Over the phone or online from an insurance company or a licensed broker

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FAQ

How do I know if an annuity is right for me?

When considering whether an annuity is right for you, there are a number of factors to take into account. First, you need to consider your financial goals and objectives. Do you need income for retirement? Are you looking for a way to grow your wealth over time? Are you looking for a death benefit for your beneficiaries?

Next, you need to consider your financial situation. What is your current income? How much money do you have saved for retirement?

Where does the money in an annuity go?

When you purchase an annuity, you are essentially making a deal with an insurance company. You give them a lump sum of money (or make periodic payments) and in return, they agree to make regular payments to you for a set period of time – usually for the rest of your life. The payments can be made monthly, quarterly, or yearly, and they can be for a set amount of time (such as 20 years) or for as long as you live.

Conclusion

In exchange for an investment now, annuities provide you with a lump sum or a stream of payments in the future. It is a good choice for people who want to receive a steady income in their retirement years. There are different types of annuities, each with its own pros and cons. Consult an experienced insurance company broker, like Dundas Life, to pick a product that is right for your needs.