How an insured annuity can increase your retirement income

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For many people approaching or in retirement, their asset allocation will look different than during their working years. They become more cautious and favour safety over growth. It’s easy to understand since a significant downturn in the financial market like 2008 can wreck the retirement plans they worked their whole life for. But while their investments are more conservative, they still want to maximize their after-tax return. At the same time, it’s important for them to leave behind a legacy to their children, grandchildren or charity.

How do they go about achieving this without taking on additional risk? A simple but effective strategy to accomplish all of this is by using a concept called an insured annuity. If you break down the two words into separate components, you will see that this strategy makes use of a life insurance policy and an annuity.

Most people know that a life insurance policy pays out a lump sum amount in exchange for a stream of payments to the insurance company. You can think of an annuity as the reverse: you pay the insurance company a lump sum amount in exchange for a stream of payments until you die. With that in mind, you may begin to realize how combining the two concepts can provide you with lifetime income while leaving a legacy.

Comparison between an insured annuity strategy and GIC

Let’s look at a simple case study of a couple, John and Mary, ages 68 and 65. We will assume they currently have $500,000 in a non-registered account. Because of their conservative profile, it’s currently invested in GICs (Guaranteed Investment Certificates, the Canadian equivalent of term deposits) at 3%, which pays out fully taxable interest income. They are at a 45% tax bracket and are risk averse. They plan to live off of the interest from the GIC, and transfer the full $500,000 to their children when they pass away.

Now let’s compare it to the insured annuity strategy. They can use $866 to make the first monthly payment of a joint last-to-die universal life insurance policy with a $500,000 death benefit (1). Then they use the remaining $499,134 to buy a joint life prescribed annuity with no reduction on the first death and a 5 year guarantee period. The numbers in the example were calculated using software provided by a Canadian insurance company and hasn’t been optimized for the best rates.

First, the assumptions:

Capital$500,000
GIC interest rate3%
Marginal tax rate45%

Let’s see the difference:

 GICInsured Annuity
Annual Income$15,000$30,408
Return of capitalNIL$21,987
Interest$15,000$8,421
Less: tax payable-$6,750-$3,789
Net income$8,250$26,619
Less: insurance premiumsNIL-$10,393
Disposable income$8,250$16,226

And the analysis:

 GICInsured annuity
Difference in income-$7,976
Percent increase of insured annuity over GIC-97%
Pre-tax return3.00%4.00%
After-tax return1.65%3.25%

Benefits of an insured annuity

As you can see from the case study, the insured annuity strategy provides an increase in income of 97% compared to the GIC strategy. The payment from an annuity is a combination of return of capital and interest. Return of capital is tax-free so only the interest portion is taxable. With a prescribed annuity, return of capital comprises the majority of the annuity income. This is the main reason why the tax payable with an annuity is so much lower than with a GIC. As mentioned above, the whole payment from a GIC is taxable as interest income.

The 5 year guarantee period on the annuity provides peace of mind because even should both of them die within the first 5 years, their children will receive a death benefit from the annuity. While in this example, the couple achieved a 97% increase using the insured annuity concept, keep in mind it wasn’t optimized for the best rates. This means that other carriers may offer a lower premium for the life insurance policy and also a higher payout for the annuity. Also, since insurance premiums and annuity income depends on the age(s) of the individual(s), the actual advantage can differ from the example.

Drawbacks of an insured annuity strategy

An insured annuity is not without its drawbacks though. The lack of flexibility is the main concern. Annuity payments are received until death and can’t be commuted into a lump sum. Therefore, you can’t take out your capital once the strategy is implemented. Individuals with poor health may have a harder time qualifying for life insurance. Even if they do qualify, a rated policy would affect the potency of this strategy. This is especially meaningful if the GIC is tied up for a long period of time and the applicant(s) are showing signs of poor health.

Conclusion

A review of the couple’s financial goals will show that they were able to achieve all of them. They were able to shelter their investments from the volatility of the stock market. They were also able to maximize their after-tax return to almost double the income from a GIC. Lastly, they preserved all their capital for their beneficiaries. As an added bonus, if you name a beneficiary on the life insurance policy, the proceeds will bypass the estate. By going directly to the beneficiary, the death benefit is not subject to the probate fee, which in British Columbia is 0.6% of the estate between $25,000 and $50,000, and 1.4% above $50,000. The GIC will pass through the estate and be subject to the whole probate fee. The couple would have had to pay $6,450 in probate fees. To conclude, an insured annuity strategy vastly outperforms the GIC strategy.

To find out how much the insured annuity strategy could benefit you, head over and grab a quote here.

1. Rates are current as of February, 2014.

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