Unlocking the Annuity Puzzle: Why Canadians avoid what seems to be the perfect retirement vehicle

Financial planner Robb Engen recently tackled this puzzle in his Boomer & Echo blog, “Why Canadians avoid one of retirement’s most misunderstood tools.” Engen notes that experts like Finance professor Moshe Milevsky and retired actuary Fred Vettese believe “converting a portion of your savings into guaranteed lifetime income is one of the smartest and most efficient ways to reduce retirement risk.” Vettese has said the math behind an annuity is “pretty compelling,” especially for those without Defined Benefit pensions.

Milevsky and Alexandra Macqueen coined a great term applicable to annuities when they titled their book about the subject Pensionize Your Nest Egg, which I reviewed in the Financial Post in 2010 under the title ”A cure for pension envy?”

Engen observes that a life annuity is “the cleanest version of longevity insurance … You hand over a lump sum to an insurer, and they guarantee you monthly income for life. If you live to 100, the insurer pays you. If stock markets collapse, you still get paid. If you’re 87 and never want to look at a portfolio again, the income keeps flowing.”

In other words, annuities neutralize the two big risks that haunt retirees: longevity risk (the chance of outliving your money) and sequence-of-returns risk, the danger of suffering a stock-market meltdown early in retirement and inflicting irreversible damage on a portfolio. 

Despite all the seeming positives about annuities, Engen notes that “almost nobody buys one.” He cites a Vettese estimate that only about 5% of those who could buy an annuity actually do so. Engen suggests there is a behavioural hurdle: fear of losing liquidity and control of the underlying assets. He cites research by the National Institute of Ageing’s Bonnie-Jeanne MacDonald on pooled-risk retirement income, where she wrote that such retirees are  “strongly opposed to voluntary annuities, as they want to keep control over their savings.”

A chance to lock in recent portfolio gains?

Even so, the new Retirement Club created by former Tangerine advisor Dale Roberts earlier this year (see the blog posted on my own site in June) recently featured a guest speaker who extolled the virtues of annuities: Phil Barker of online annuities firm Life Annuities.com Inc. 

Barker said many clients tell him they’ve done really well in the markets over the last 20 years and now they’d like to lock in some of those gains. They may be looking for fixed-income strategies, and many were delighted with GIC returns when they were a bit higher than they are now (some in the range of 6-7%). But they are less happy with the new rates on GICs now reaching maturity. Meanwhile, annuities have just come off a 20-year high in November 2023 so the time to consider one has never been better, Barker told the Club in August. 

With annuities, you can lock in a rate for the rest of your life—so if your timing is good, it may make sense to allocate some funds to them.  

Related reading: GICs vs. annuities

Barker said eight life insurance companies offer annuities in Canada: Desjardins, RBC Life Insurance, BMO Life Insurance, Canada Life, Manulife, Sun Life, Equitable Life and Empire Life. All are covered under Assuris, a third-party organization that guarantees 100% of an annuity up to $5,000 per month. So if one of those companies failed, the annuity would be honored by one of the other firms via Assuris. 

Barker described an annuity as simply a “personal-funded pension.” To set one up you can take registered or non-registered funds and send the capital to an insurance company. In return, they give you an income stream for as long as you live: this is the traditional life annuity. Unlike annuities in the U.S., you cannot add funds to an existing annuity, Barker told the club, nor can you co-mingle funds from for example RRSPs and non-registered funds. 

However, you can buy a new annuity each time you need to. There is no medical underwriting for annuities, unlike life insurance. Joint annuities for couples are a great value, he said, but the tax slips are sent to the primary annuitant. Nor is income splitting possible under current CRA rules. 

When annuities shine

Annuities shine when you are confident about your health and prospects for living a long time. Having $X,000 a month assured income to live on means your other sources of income that fluctuate with stock markets can be weathered, Barker said. “We’re seeing people getting 6.5% to 8.5% a year for the rest of their lives, depending on their age.” 

As Dale Roberts commented during Barker’s talk, having enough to live on just from the pension bucket (annuities, pensions, CPP/OAS etc.) frees you up to take some risk in other areas, like stocks and equity ETFs.

Funding by registered vs. non-registered accounts

Registered funds transfer to an annuity tax-free; that’s because money is not being deregistered, but rather going from one registered environment into another registered environment. It will be fully taxed when it comes out. The monthly income from the annuity is then fully taxable in the year it is received. 

If you fund with non-registered money, the taxation is considerably different. For one, if your non-registered account has unrealized capital gains you’ll have to realize them and pay tax on them. Other than that, so-called prescribed annuities are relatively tax-efficient. The capital that is used to fund the annuity is not taxed, only the gain is, Barker says. “Therefore, the taxable portion of the annuity income is a very small amount. Prescribed means that the taxation is the same or level for the entire life of the annuity.”

The Club has also covered other retirement income products that may resemble annuities in some respects: the Vanguard Retirement Income Fund (VRIF) and the Purpose Longevity Fund, both of which I have small chunks in. Dale adds that the Longevity Fund has the potential to be a “nice complement to annuities,” as it “is designed to increase payments quite nicely in the later years thanks to the mortality credits. Those with very long lives are subsidized by those who pass away much earlier.”