Non-Qualified Annuity

 

The difference between a non-qualified annuity and a qualified annuity is its tax treatment. This is a fundamental difference that you must speak with your life insurance advisor or your accountant about to make sure you use the right source of money to buy your annuity. You will see how a non-qualified annuity has a tax advantage over the qualified annuity.

 

A Non-Qualified Annuity is Purchased with After Tax Dollars

non qualified annuity

non qualified annuity

Put in simple terms, the non-qualified annuity contract is bought with a cheque coming from your bank account. This is why we use the term “non-qualified” as it is not qualified as an annuity bought from a registered account (pension). It may sounds counter intuitive, but non-qualified annuities show a strong tax advantage not only compared to qualified annuities but also compared to most investment vehicles.

 

What is the Tax Advantage of a Non-qualified Annuity?

 

Since your annuity contract has been purchased with after tax dollars, your taxable rate on the annuity payment will also be reduced. When calculating the applicable tax on an annuity payment, the contract stipulates that a part of that payment is in fact a return of capital.

 

In other words; non-qualified annuities reimburse you, with each annuity payment, a part of your (after tax) capital that was used to purchase the contract.

 

Obviously return of capital is not taxable as you already paid your dues on this money. You can’t really calculate what part of the annuity payment will be taxable as an investment return and the part that will qualified under return of capital. However, your life insurance advisor will be able to demonstrate it in the non-qualified annuity contract.

 

Non-qualified Annuity Tax Treatment Example

non qualified annuity tax treatment

non qualified annuity tax treatment

Let’s presume you have $100,000 in non-registered investments. You decide to deposit the money in your bank account and buy a non-qualified annuity with the proceeds. The contract pays an 8% return. This means you receive $8,000 annually. Remember, the $8,000 is not fully taxable as you purchased a non-qualified annuity.

 

The insurance company calculation (mainly based on life expectancy statistics) shows a portion of return in capital of $5,000. This means the Government agrees that you receive the first $5,000 from your non-qualified annuity tax free. The remaining ($8,000 – $5,000 = $3,000) will be taxed according to your marginal tax rate. If you are taxed at 30%, this means $900 in taxes ($3,000 * 30%). Therefore, you pay a total of $900 on a $8,000 non-qualified annuity payment. That’s the equivalent of an 11.25% tax rate.

 

If you had purchased your annuity through your registered fund (in a tax sheltered account), your contract would have been considered as a qualified annuity. In this situation, the full $8,000 would have been taxable. Instead of paying $900 in tax as is the case with a non-qualified contract, the qualified annuity tax payable would be $2,400 ($8,000 * 30%).

 

Therefore, if you have investments in both non-registered and registered accounts, using your after tax dollars to buy a non-qualified annuity is definitely the best solution tax wise. As you will pay tax upon withdrawals from your registered investments, you might want to postpone tax payable on your non-registered investments.

 

Non-qualified Annuity Investment Strategy

 

There is a very interesting investment strategy to be realized with a non-qualified annuity. If you join the annuity contract with a life insurance, you can protect both your pension income and your estate. In fact, if you purchase a non-qualified annuity and die two years later, your annuity payments will be lost.

 

However, if you buy life insurance for the same amount, your heirs will receive the capital you used to generate your pension. It’s like enjoying the investment return of your money while you live and giving your capital to your heirs once you don’t need it.

 

The non-qualified annuity payments are not fully taxed and the proceeds of a life insurance is 100% tax free. This makes this strategy very interesting in terms of both retirement and estate planning.  You can find more information on this strategy, also called the back-to-back annuity, here.

 

Where Can I Buy a Non-qualified Annuity?

 

Non-qualified annuities are sold by life insurance agents and directly from a life insurance company. You can contact a trusted life insurance agent by clicking here. He will walk you through all type of annuities and will help you chose what is best for you.

 

Non-qualified Annuity Video Explanation

 

While searching the web, we found this lengthy, but complete, explanation of a non-qualified annuity and its tax treatment.

Joint Life Annuities

 

 

From this day until the moment of our death…

 

Life annuities are generally a good product for an investor who is risk averse and doesn’t want to manage his portfolio. The annuity provides a steady income stream until the investor (also called the beneficiary) pass away. At this moment, depending on the type of contract, there may or may not be a remaining balances to be switched to the investor estate.

 

If you retire with your spouse, the perspective of losing a part of your money given to a life insurance company is definitely not appealing. What will happen to the surviving spouse? Will he/she be left with no revenues?

 joint life annuities

Joint Life Annuities

 

Life insurance companies are apparently very creative and try to meet every investors needs. A simple life annuity contract doesn’t cover for both spouses in the event of death of the beneficiary. In order to assure an income stream to both spouses, life insurance companies came up with a joint life annuity.

 

How the Joint Life Annuity Works

 

A regular life annuity stops at the investor death. Therefore, there are payments starting at the agreed date on the contract until the beneficiary passes away. The joint life annuity simply has two beneficiaries instead of one; the investor and his/her spouse.  Therefore, it enables payments to be made until the death of the second beneficiary.

 

Payments start according to the contract and it is made in the name of one or both beneficiary. Upon the death of the first beneficiary, the annuity continues its payment to the second person on the contract. The monthly payment is the same before or after the death of the first beneficiary since it’s a joint contract. It is the perfect solution for an aging couple seeking for a secure source of revenues for both parties.

 

Joint Life Annuity Cost

 

As any other annuity contracts, joint life annuities cost is on a case by case basis. Depending on your age, your health and the amount invested, the payment will vary. The joint life annuity is obviously more expensive than a standard life annuity contract. The reason being the payments must not last during the life of a single investor but during the last of two investors. This increase significantly the life expectancy of the contract as it will only ends once both beneficiaries are deceased.

 

Joint Life Annuity Advantage

 

The main advantage compared to a stand life annuity contract is the possibility to cover two investors with the same contract with the same terms. It is usually cheaper (e.g. you will receive more money from your annuity) than purchasing two individual policies.

 

Joint Life Annuity Disadvantage

 

Joint life annuities might not be a good product for couples who have different income stream needs. If one spouse already benefit from an important pension plan, there may no need to add retirement income through an annuity. In this situation, the spouse without the pension plan is maybe better off with a single life annuity that will finish upon his death.

 

How Do I Know If I Should Go For a Joint or Single Life Annuity?

 

Finding the best contract and annuity rates is often a numbers game. You need to meet with an adviser that will run multiple scenarios and offer you the best value for your money. If you haven’t found an adviser yet, you can click on the following link to contact a trusted representative that will answer all your questions:

 

Who Sells Annuities

Longevity Annuity

When things last forever…

 

The concept of longevity annuities is fairly new to the population as we all didn’t expect to live that long. In the United Stated, the life expectancy for a female is now 81 while male can hope to live up to 76. Nonetheless, it has become more frequent to see older people celebrating their 85th, 90th or even 100th birthday. It is surely awesome to see your children with their children and possibly grandchildren celebrating your anniversary. On the other side, this has a significant impact on your retirement plan if you haven’t think about it. This is where longevity annuity comes into play…

 

Longevity Annuity

 

What is a Longevity Annuity?

 

The longevity annuity itself is not really a new product. To be honest, it is only a new way some insurance companies had found to market an existing product. The longevity annuity is nothing more, nothing less than a deferred annuity contract. However, the usage of the product has another twist.

 

A New Purpose for Deferred Annuities

 

Deferred annuities are commonly used to build a pension plan. During several years, you accumulate money inside the annuity in the hope of building enough savings at retirement. The money is invested through a Life Insurance Company until you start withdrawing at retirement.

 

With longevity annuities, you purchase such products when you are already retired. The idea is to use a part of your retirement money, to make sure you have enough savings if you beat your life expectancy.  As opposed to an immediate annuity, the investor decides a future date where payments will start instead of entering in the distribution process within the same year. For example, an investor could decide to reduce his lifestyle at the age of 65 in order to purchase a longevity annuity that will start payment at the age of 85.

 

Such strategy could result in some hefty payments for the beneficiary. For example, a 65 years old investor with $200,000 could buy an annuity paying slightly under $14,000 today. But if he buys a longevity annuity until the age of 85, the payments could go up as high as $120,000. Most longevity annuity starts paying benefits between the age of 80 and 85.

 

Use it or Lose it

 

Are you ready to call an agent to enquire about longevity annuities? Wait! There is hick-up with the product. If you die before using the longevity annuity, your money is gone. No wonder those who live longer receive huge lump sum of payments, right?

 

While the payout could be very interesting, you may want to think twice before using an important sum to fund your longevity…

 

Who Sell Annuities

Qualified Vs Nonqualified Annuities

Annuities are definitely complex and their understanding comes with a few hours of researches along with learning new terminology. Another term you can hear from your adviser when discussing annuities is “qualified” vs “nonqualified”.  While immediate and deferred annuities relate to the timing of your payments, the terms qualified and nonqualified are linked to the source of money used to purchase the contract. More precisely, the term used is directly linked if you have used savings from your tax-deductible IRA or any other employer-sponsored retirement plan to buy the annuity. The different between the two types of annuities are fairly significant.

 

Qualified Vs Nonqualified Annuities

 

Qualified Annuities

 

A qualified annuity is purchased with money coming from a tax-deductible savings account such as an IRA or other employer-sponsored pension plan. The tax implication is crucial. Any annuity payments are subject to taxes. As opposed to regular annuity distributions which are only partially taxable, qualified annuities payments are fully taxable.

 

Many investors don’t want to bother with stock market fluctuations at retirement and prefer cashing their IRA’s to buy a qualified annuity where the stream of income is guaranteed. At that point, you lose control of your investment but receive a determine amount monthly instead.

 

At the age of 70 ½, a required minimum distribution (also called RMD) is applied on all IRA’s and other retirement account. This rule has been put in place so the Government receives taxes from your pension plan. The RMD rule applies also to qualified annuities. Therefore, if you think of avoiding taxes by switching your IRA account into a qualified deferred annuity, you will not pass the age of 71 without withdrawing at least the RMD and pay taxes on it.

 

Taxes apply as any other type of income on such contract. The annuity payment is added to your revenue declaration.

 

Nonqualified Annuities

 

As opposed to qualified annuities, nonqualified annuities regroup all contracts purchased with after-tax money. The main advantages of nonqualified annuities are the possibility to defer future taxed (through deferred annuities) and the tax efficiency on payments. In fact, annuity payments are partially taxable as a part of the distribution is considered to be a return of capital. Since you have paid taxes on the money used to buy a nonqualified annuity, it is only normal to not be double taxed.

 

What’s the Best Between a Qualified and Nonqualified Annuity?

 

Depending on your revenues and sources of income at retirement, you may or may not have the option to purchase one or the other. But if you have an amount in cash and you also have in an IRA type of account, you can certainly benefit from the nonqualified annuity tax efficiency since the money invested in your pension account is already tax-sheltered.

 

If you use your tax-sheltered money to purchase an annuity, your distribution will not only be fully taxable but you cash invested in other products will be taxable too. Therefore, it is preferable to use cash to buy an annuity in a tax perspective. Keep in mind that if you require lump sum withdrawals, you might not want to invest all your cash in an annuity.

Immediate Annuities Vs Deferred Annuities

The term “immediate” and “deferred” comes from the moment where you will start receiving the annuity payment. You can technically buy any types of annuities and make it an immediate or deferred contract. Let’s take a look at their main characteristics.

 Immediate Annuities Vs Deferred Annuities

Immediate Annuities

 

The immediate annuity is also called an income or single premium immediate annuity. The purpose of this transaction is to receive distribution within the same year the contract is purchased. Please note that the purchase of an immediate annuity is irrevocable. This means that one you have agreed to the contract, there are no way back.

 

There are two types of immediate annuities: Fixed and Variable.

 

Fixed Annuity

The fixed annuity provides a steady stream of income to the investor. The amount of the distribution is guaranteed. Read more about fixed annuity.

 

Variable Annuity

The distribution from this contract varies according to the value of its sub-accounts. The investor has the ability to manage his investment within the annuity. Read more about variable annuity.

 

Deferred Annuities

 

The definition of the deferred annuity is easy to remember as the money is invested in a tax deferred account. The investor accumulates money in a tax deferred investments until he starts the withdrawing process. As long as the money is in the account, there are no taxes charged. They apply only on distributions. This could be a great complimentary product to your savings if you have already maxed out your regular pension contributions.

 

Investors have the option between a fixed, variable or indexed annuity contract. Deferred annuities are by far more popular than immediate annuities as Americans are holding more than $1 trillion in them. Their tax advantage makes them highly attractive for any investors who is looking to build a pension and saves on taxes at the same time.

 

On the other side, immediate annuities might gain in popularity in the upcoming years as boomers are looking for more diversified ways to generate retirement income. Therefore, they are more likely to use a part of their investment and convert it into an annuity.

 

Who Sells Annuities

Insured Annuity Annuity

The insured annuity, also called back-to-back annuity, is a combination of two products: a life insurance and a fixed annuity. This product has been created for investors who seek both revenues and a guarantee of capital to be left to their heirs.

 insured back-to-back annuity

Back to Back Annuities Structure

 

As previously mentioned, the back-to-back annuity is a simple combination of a life insurance covering the amount used to buy a fixed annuity.

 insured back-to-back annuity structure

The idea behind this structure is to provide income to the investor while he lives and still protect his assets to be given to his heirs upon his death. The fixed annuity provides a steady stream of income to the investor. This distribution is used as a pension and also pays for the life insurance premium. Therefore, the net amount received by the beneficiary is smaller than a simple fixed annuity payment, but the capital used to purchase the contract remains intact upon his death. This strategy is used when the investor wants to make sure to leave something behind to his spouse or his children.

 

Main Advantages

 

Tax Efficient

As any other fixed annuity distribution, the insured annuity provides tax efficient revenue to the investor. Part of the annuity payment is considered a return of capital and therefore is not taxed. If an investor purchase an annuity at the price of $100,000 in exchange of payment worth of $7,000 per year, only a portion of this amount will be shown on his tax report as taxable revenue.

 

Income + Capital  are Guaranteed

The main advantage of this strategy is definitely to assure both a stream of income and the capital used at death. This product is 100% guaranteed from one way to another as both payments and amount at the end of the contract (death) are known in advanced and secured by the Life Insurance Company.

 

Better Return than CD’s

In order to appreciate the back-to-back annuity to its full value, an investor must compare it to a certificate of deposits where he would receive the interest but not the capital until maturity. In this case, the maturity is the death of the investor. The combination of the annuity return minus the insurance premium cost is considered to be the net annuity payment. Usually, the net distribution is higher than a certificate of deposit yield if both contracts are taken at the right age. There is a sweat spot between the actuarial calculation to price both annuities and life insurance premiums between the age of 65 and 75. This is always a case by case analysis you must do prior to enter into such contract.

 

Main Disadvantages

 

The Money is Locked-in

Once the annuity is purchased and the life insurance premium paid, it is not possible to withdraw more than the annuity payment (unless it is specified in the contract which would incur additional costs). You can always stop paying the life insurance premium and keep the fixed annuity, but you will lose the capital guarantee at the same time. While it is a good product to secure a part of your income at retirement, it is also wise to not invest all your money in a locked-in product.

 

Inflation Risk

If you purchase a sample fixed annuity, the payment will remain the same throughout the contract. If you happen to live a longer life than expected, inflation will gradually erode the value of your distributions. Since the money is not invested in the stock market, there are no ways for you to increase this payment.

 

Don’t Buy it Too Young or Too old

As previously mentioned, there is a sweat spot where the calculation for the back-to-back annuity is advantageous for the investor. If you buy it too young, the annuity payment will not be high enough to net a payment better than a certificate of deposit’s yield. If you buy it too old, the insurance premium will become too important to be paid by the annuity payment. Then again, your net investment return will fail to compete against a CD yield.

 

Final Thoughts on Back to Back Annuities

 

Since you have the option of securing both your pension payment and your capital you want to give to your heirs, the back-to-back annuity could be a great solution for a part of your nest egg. Its lack of flexibility makes the product inadequate to become the one and only source of income at retirement. Having said that, it is definitely worth it to have a talk with your adviser to see which scenario is best for your situation.

 Who Sells Annuities

Variable Annuity

You are looking to build your own pension plan with your hard earned money? Some advisers may talk to you about variable annuities. A variable annuity is an investment product where you accumulate your next egg in a tax deferred structure. At the time of withdrawal, you are allowed to buy an annuity generating a steady stream of income.

variable annuities

Variable Annuities Structure

 

Variable annuities are nothing like fixed annuities.  The value of payments you will receive at retirement is unknown and not guaranteed. In a variable annuity, the investor selects with the help of his rep a series of mutual funds into sub-accounts. The investment risk can range widely from conservative to aggressive portfolio. The money is then invested in those sub-accounts through mutual funds during the accumulation phase.

 

variable annuitiy structure

Accumulation phase

The accumulation phase is defined by the moment where you purchase your variable annuity contract and open you sub-accounts until the moment you start withdrawing. During that phase, you have the opportunity to contribute to your policy at any time with different amounts. Most likely, you will be suggested to invest a lump sum or periodically if you are building your savings.

 

The money is invested in mutual funds and this is why the investment returns vary greatly. The amount available for distribution at retirement is unknown as investments are not guaranteed. Therefore, it is similar to a defined contribution pension plan; you know how much you invest in it, but you don’t know how much you will get in return.

 

How is it Different from Indexed Annuities?

 

If you look at the indexed annuity structure, you will notice that there are two parts in the contract: a fixed annuity + call options on an index. This structure guarantees you a minimum payment from your annuity.

 

In the case of a variable annuity, there are no minimum payments guaranteed. Your future annuity payments will depend on how you invest your money during the accumulation phase. You can now understand how different the variable annuity is from the indexed contract. An investor seeking for guarantees should not consider variable annuities as a safe investment.

 

Main Advantages

 

Taxed Deferred

All after-tax money used to fund subaccounts will benefit from a tax deferral until you start your withdrawing period. This enables you postpone taxed paid on interest and dividend revenues which are usually paid the same year they are declared.

 

Annual Bonuses & Accumulation Phase

Some contract will add a bonus the investor’s contribution to the variable annuity. For example, for each an investor is in a variable annuity contract, he will receive a bonus on the future annuity value of 5%. The bonus is not real cash (e.g. you cannot withdraw this amount if you cash your policy) but it is calculated at the time of converting your investment in an annuity.

 

Consider an investor who buys a $100,000 variable annuity contract. The money is then invested in mutual funds for ten years and he doesn’t generate any returns (let’s assume he is very unlucky). If the investor receives a bonus of 5% per year based on his original amount, in ten years, the annuity will be calculated based on an amount of $150,000 even if his sub-accounts generated a 0% return. If the investor wanted to cash his investment and walk away after ten year, he would only cash his $100,000. However, if he stays and decides to take the annuity, the amount of the distribution will be calculated based his investments + his bonus of $50,000.

 

Capital Protection Option

Most contracts will protect the capital invested upon death. This means that if an investor dies during the accumulation period and mutual funds are showing negative returns, the Life Insurance Company will write a cheque to the Estate in the amount of the capital invested and not the current market value.

 

Locked-in Market Phase Option

In addition to potential bonuses offered by the Life Insurance Company, some contracts will allow the investor to “lock-in” the market value of his investments at a very specific moment during the contract. This enables the investor of capturing the peak value of his investments for his future annuity calculation even if mutual funds drop later on.

 

Consider an investor who buys a $100,000 variable annuity contract. After three years of gains on the stock market, the sub-account value is showing $150,000. The Life Insurance Company locks the value of his investment at that number. If the following year the market enters in a recession and mutual funds drop to $125,000 and the investor starts receiving his annuity; the payment will still be calculated on the amount of $150,000é

 

Main Disadvantages

 

You can imagine that with those “sizeable” advantages come “sizeable” costs as well. If you are getting excited about variable annuities, you want to read the following. It gives you a clear picture of what variable annuities truly are.

 

High Management Fees on Mutual Funds

Management Fees (also called MER’s) charged on subaccounts are substantially high. It starts around 2% but could reach up to 4% of your asset. It is definitely hard to show competitive net investment return when you start with an average MER fee of 3%. Therefore, most investments found in variable annuities are underperforming compared to similar portfolio outside such contract. Make sure to enquire about all fees before you purchase such contract.

 

Surrender fees

Similar to indexed annuities, surrender fees are often locked with a minimum of ten years. Therefore, once you sign-up the contract, don’t think about taking your money out of the subaccounts! There are not really any flexibility with variable annuities contracts. Once you purchase a variable annuity, you are also locked-in.

 

Misleading Usage of the Term Insurance

When a rep use the term “insurance” to be part of a variable annuity, he refers to the fact that you are guaranteed to receive at least the amount you invested from the contract if you die prematurely. This is not a life insurance per se. You only have the “assurance” you will get your money back if you pass away and your mutual funds are currently showing negative returns.

 

Final Thoughts on Variable Annuities

 

Personally, I’m not a big fan of variable annuities mainly because they cost too much to structure and they are not flexible. The marketing around those investment solutions are quite phenomenal, but the end result is deceiving. Ask your adviser to show you the difference in term of fees and investment return with a similar portfolio that is not included in a variable annuity contract. You will see him skating for a while…

 

Guess who truly likes variable annuities? Your adviser making a healthy 3-4% commission by selling them! Imagine if you are about to invest $300,000; this means at least $9,000 in your rep’s pocket. This is enough to push the sale a little, don’t’ you think? When a product is pushed down through your throat, maybe you should simply turn around and walk away…

 

Who Sell Annuities

Indexed Annuity

You are looking for a guaranteed stream of income but you are not willing on quitting the stock market returns yet? Indexed annuities may be part of the answer for you. By definition, an indexed annuity investment return is linked to a market index. The most common index is the S&P 500.

 

indexed annuities

How Indexed Annuities Are Structured

 

As opposed to fixed annuities, indexed annuities investment return is not known at the purchase time. Your initial investment is secured and you will not lose money through such contracts. There is also a minimum investment return included in indexed annuities. How can you be 100% sure to make money with an indexed annuity if the rate of return is linked to a market index? The answer to this question lies in the contract structure.

 

In order to provide a variable return linked to the S&P 500 for example, the indexed annuity contract  is separated in two parts:

 

indexed annuities structure

 

The fixed annuity inside the contract provides a guaranteed income stream as any regular contract. This is how the Life Insurance Company is able to provide you with a minimum investment return. The second part of the contract is invested in call options to buy the selected index (the S&P 500 for example). A Call option is a contract enabling the owner to purchase an index at a specific price.

 

If the index goes up, your annuity payments will be increased by the profit realized with the call option. If the index goes down, the call option contract will expire and no gains or losses will incur. Please note that the money used to purchase the call option is loss.

Main Advantages

 

Downside Protection

As explained previously, if the index goes down, you will not lose money on your investment. The fixed annuity included in your contract is your safety net against such events. An investor who bought a variable annuity at the beginning of 2008 still received payments after the crash and didn’t lose any money. On the other side, another investor who would have preferred to keep his money invested in the stock market and derive an income from it would have lost a fair chunk of his nest egg.

 

Better returns than CD’s

Since the stock market is reputed to outperform certificates of deposit and bonds, indexed annuities also offer better returns. Given the current interest rate market, your chances of outperforming safer investments such as CD’s with an indexed annuity are great.

 

Possibility of following / beating the inflation

One of the main risks for retirees is to be able to keep up with inflation. Since you stop working, your ability to increase your income is solely link to the return of your investments. Inflation is expected to be around 2.25% over a long period of time. This means that if you want to keep the same lifestyle you have today, your investments must at least generate 2.25% each year. Indexed annuities are built to follow and possibly beat inflation overtime in order to secure your investment.

 

Main Disadvantages

 

I’ve written many times that there are no free lunches in finance and indexed annuities are no exceptions. Security and potential higher income comes with a price.

 

Limited Upside with no dividends

If you look at the S&P500 returns over a year and you take your annuity statement, you will notice that your contract didn’t follow exactly the index. In fact, your investment return will trail behind. Since not all your money is invested in call options, you can’t expect to match the index perfectly. Also, keep in mind that call options don’t cash dividend paid by companies included in the index. Since 53% of the overall S&P500 return comes from dividend payment, you will miss a great deal with such contract.

 

Surrender charges and other fees

Surrender charges are particularly high if you want to cancel your contract. Most contracts include surrender charges over 10 years. Fees included in such contract are far from being low.

 

It’s pretty complicated to understand… even for the adviser!

Due to its duality (fixed vs call options), indexed annuities are fairly complex… even for some advisers. Do not hesitate to ask many questions to your rep to make sure you understand the product… and the he does too! Don’t let you blinded by some fluffy graphs and income projections.

 

Final Thoughts on Indexed Annuities

 

Indexed annuities were built a few decades ago with one goal in mind: compete against CD’s return. This is not a growth seeking product because the potential gain is limited. Indexed annuities could be used as a complimentary product within your annuity structure.

 

Buy an annuity

Term Certain Annuity

 

 

There are two types of what we call “fixed annuities”. The term “fixed” come from the payment of the annuity. Therefore, a fixed annuity is offering a fixed… payment. It is usually a monthly income stream that is paid during the time of the contract. This is where the two types of fixed annuities come: Life Annuity and Term Certain Annuity.

 term certain annuity

Life Annuity

 

The life annuity is paid to the beneficiary upon his death. Once the beneficiary passes away, the remaining part of the annuity is left to the Life Insurance Company. This is a good product for investors who are in good health and plan to live longer. For more information, we cover life annuities in this section.

 

Term Certain Annuity

 

The term certain annuity provides a steady stream of income to the beneficiary until the contract expires. Therefore, if an investor purchase a 10 year annuity at the age of 55 and die at the age of 58, the Life Insurance Company will keep the rest of the money.

 

***I’ve read on Canadian Insurance Company sites that some term certain annuities can pay a lump sum payment equal to the remaining benefit of the annuity to your beneficiary (similar to a life insurance clause).

 

Term Certain Contract Main Advantage

 

The main advantage of term certain annuity is its cost. Since the annuitant (the life insurance company) doesn’t have to pay you until you pass away, it will simply have to consider a conservative investment projection and pay you accordingly.

 

This could be a great product if you seek for a temporary stream of income and you are not looking to add any life insurance component to your contract (in order to guarantee your payment over time for example).

 

Main Disadvantage

 

Since there are no free lunches in finance, term certain annuities are cheap but not perfect. In fact, chances are that you will outlive the term of your annuity and be left with no money and no income stream after the maturity date.

 

Imagine a scenario where you purchase a 15 years term certain annuity at the age of 55 and blow your 70th anniversary candles? That’s right, you’ll be crying that you are still alive since you will not be receiving any more money from your contract.

 

When Should I Purchase a Term Certain Annuity?

 

A term certain annuity is a good product if you only need income for a specific period (to cover your most active period of your retirement for example) or if you can’t afford to pay for a better contract (with insurance or additional return included).

 

Since I’ve found term certain contracts offering the remaining benefits in the event the investor decease prematurely, I suggest you speak with an adviser to know which contract is good in your state/province.

 

If you have any questions about term certain annuities, you can speak with a trusted adviser for free here.

Fixed Annuity

The fixed annuity (also called a life annuity) contract is the most common type of annuity. The main purpose of this contract is to provide a lifelong income stream to the investor. The investor invests a lump sum of money in exchange of a set of periodic payments (mostly monthly) until the moment of his death.

 life annuity

Example of a Fixed Annuity

 

Mr. Rogers is about to retire. His house is paid and he has some savings aside to insure a great retirement. However, he doesn’t want to see his portfolio value going up and down all the time. He remembers clearly what happen in 2008 and certainly doesn’t want to feel unease at retirement. His investment currently shows $500,000. He decides to take off $250,000 from his investment and buy a life annuity.

 

The life annuity is purchased from a Life Insurance Company and the periodic payments are fully guaranteed. The company agrees to pay Mr. Rogers the sum of $17,500 per year, the equivalent to 7% of his $250,000. The amount of the payment was based on the age and overall health condition of Mr. Roger. In other word, the Life Insurance Company doesn’t expect M. Roger to live for another 40 years (which would equal to a sum of payments of $700,000).

 

Calculation of the Investment Return

 

The investment return on a life annuity is unknown as it all depends on the date of death of the beneficiary, Mr. Rogers. For example, if the investor were to die three years after purchasing his annuity, he would have received a total payment of $52,500 from an investment of $250,000. Please note that on a regular life annuity contract, the remaining of the investment stays with the Life Insurance Company. Therefore, the estate of Mr. Rogers would lose $197,500. This is definitely not a good investment return!

 

On the other side, if Mr. Rogers beat the odds and live for 30 years, he would receive the sum of $525,000. This is a total investment return of 110% or a 5.65% annualized return. If you were to invest money today for 30 years, it would be impossible for you to find an investment paying a guaranteed 5.65%. This is why the life annuity could be a very interesting option for retirees.

 

Main Flaw of the Life Annuity

 

The main flaw of the life annuity is that the capital used to buy the contract is not guaranteed. This is why is it very important to make sure you don’t invest all your money into a life annuity and that you have a great life expectation (no family record, good health, healthy habits, etc).

 

If you pass away like Mr. Rogers three years only after buying a life annuity, you will be wasting a lot of money. While included in a financial planning approach, it is common to find a life insurance combined with the life annuity in order to protect the capital in such situation. This is called a guaranteed life annuity.

 

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