So you are going to buy an annuity. With what?

Preparing for life after work. RRSPs, RRIFs, TFSAs, annuities and meeting future financial and psychological needs.
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Shakespeare
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So you are going to buy an annuity. With what?

Post by Shakespeare »

In this post:
parvus wrote:Great points on GMWB, in theory. :wink:

You've probably seen the work of one of Moshe's students -- Jason Pereira. He suggests bonds and balanced funds aren't really worth the GMWB premiums. Equities, however, if you can get them ...

OTOH, we may now be on the verge of a true longevity derivatives market.

OK, so bonds aren't worth the guarantee. So, you have a 50:50 equity bond split [we'll assume you have pension/OAS income so don't need to put your age in bonds] and it's time to annuitize - say, you are early 70's (male) or mid 70's (female). You calculate that a 50% annuitization is appropriate - half your money. What should your portfolio look like after annuitization? Consider three simple cases:

1. The same : 50:50 bonds/equities.
2. Buy the annuity with bonds - 100% equities.
3. Buy the annuity with equities - 100% bonds.

Well? And does it make a difference if you can get an indexed annuity?
Sic transit gloria mundi. Tuesday is usually worse. - Robert A. Heinlein, Starman Jones
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ghariton
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Re: So you are going to buy an annuity. With what?

Post by ghariton »

I'm planning to buy my annuity with 100% bonds. I view the annuity as fixed income. The annuity will have roughly the same risk characteristics as the bonds (except for slightly increased default risk), so I will be replacing like with like. Finally, the annuity will give me enough to cover the basics of life, the same way that my bonds will be doing until I annuitize.

Since I plan on using RRBs to purchase an inflation-indexed annuity, inflation is not an issue. If inflation-adjusted annuities were not available, I would probably keep my RRBs and not annuitize. (I don't think my wife and I will be alive much beyond 80, let alone 90. If we do nevertheless make it past 90, we'll move in with whichever child is the richest. :wink:)

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Re: So you are going to buy an annuity. With what?

Post by Nowhereman »

Why do you have to buy an annuity if the Interest paid from a 100% Bond Portfolio meets your needs.

Lately there have been 5% + Bond Issues, and if 4% is the safe withdrawal rate, why not live on the interest.

Frankly, I do not believe anyone who can generate enough pure interest to live on should be in the stock market, except for dividend shares.

I just put a $1,000,000 portfolio into 70% bonds, 30% Dividend shares, that is all the owners need to meet their needs.

They are 62, about $3,000 a month in Indexed Pensions, no debts, mortgage free $450,000 home, Grade 11 education.

They don't even spend their Pension monies, why risk for cash they won't consume?

Yes, they had a small businesss and drove 10 year old cars.
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Re: So you are going to buy an annuity. With what?

Post by adrian2 »

Nowhereman wrote:Why do you have to buy an annuity if the Interest paid from a 100% Bond Portfolio meets your needs.
Because an annuity is guaranteed to last a lifetime, a bond is not.
Nowhereman wrote:Lately there have been 5% + Bond Issues, and if 4% is the safe withdrawal rate, why not live on the interest.
4% is annually indexed for inflation, the 5% bond coupon is not. Plus, you're comparing apples to oranges, SWR calculations are for a mixture of equities and bonds, using data from one of the most successful markets in the 20th century - it is not carved in stone like the Ten Commandments.
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Re: So you are going to buy an annuity. With what?

Post by Nowhereman »

I assume that when you die, the annuity dies, unlike the ownership of the bonds, they are what the next generation inherits, after taxes??

I am a total neophyte with annuities, I have never learned anything about them because I have no need for them, however this will change in the immediate future due to a large inheritance, and how best to allocate these monies.

The couple whose monies I allocated for them do not even spend their pension monies and leaving an Estate to their only child is of paramount importance, sounds like an annuity would not work for them.???

I am going to learn more, thanks for stimulating my interest. :thumbsup:
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Shakespeare
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Re: So you are going to buy an annuity. With what?

Post by Shakespeare »

I assume that when you die, the annuity dies, unlike the ownership of the bonds, they are what the next generation inherits, after taxes??
The simplest annuity dies, but a minimum guaranteed payout can be purchased and joint annuities are also possible.

The advantage is that it is a guaranteed payout for life (however long) with a higher %payout than bonds.

The disadvantage is that the capital is lost - the guaranteed payout- say, five years - means that if you croak after 3 years the estate gets 2 years. (Assuming it isn't a joint annuity).

It's a lottery: if you live for a long time you win. If you die early the insurance company (and long-lived annuitants) win.
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Re: So you are going to buy an annuity. With what?

Post by Flights of Fancy »

You also give up liquidity with an annuity, so DCA-ing into annuities is a way to mitigate that risk.

Back to the original question: I've looked at this question solving for the sustainability of a portfolio. The answer largely hinges on your spending level (all other factors held constant). As you increase spending, the only way to maintain sustainability is to increase equity allocation. (Or perhaps I'm answering a different question.)

I'm using the methods outlined by Milevsky et al. and can provide you with specific references if you need them. PM me for details.
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Re: So you are going to buy an annuity. With what?

Post by c emptor »

I recently received an annuity quote from an insurance company which stipulated that the quote was offered "Assuming your marginal tax rate is 50%". Why does the recipient's tax rate influence the quoted amount? I got a quote from another insurance company that didn't mention this qualification.

I asked for a "prescribed" quote and found that about 25% of the money received was taxable. The rest would be return of capital. Is this prescription amount influenced by the recipient's marginal rate?
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Re: So you are going to buy an annuity. With what?

Post by Shakespeare »

Flights of Fancy wrote:You also give up liquidity with an annuity, so DCA-ing into annuities is a way to mitigate that risk.

Back to the original question: I've looked at this question solving for the sustainability of a portfolio. The answer largely hinges on your spending level (all other factors held constant). As you increase spending, the only way to maintain sustainability is to increase equity allocation. (Or perhaps I'm answering a different question.)

I'm using the methods outlined by Milevsky et al. and can provide you with specific references if you need them. PM me for details.
I'm not sure what you mean, but it may be that my original post was phrased poorly.

ISTM that, once you have annuitized, if your goal is to balance capital preservation and longevity you should retain a balanced portfolio. If your goal capital preservation only you should have a high bond allocation and use the equities to buy the annuity. If your goal is to maximize your remaining portfolio you should use bonds to buy the annuity.

(I intend to use nominal bonds to buy an unindexed annuity: spending decreases with age except for the last 6 months and CPP, OAS, and my (very small) pension are all indexed.)
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Re: So you are going to buy an annuity. With what?

Post by Flights of Fancy »

The specific tradeoff is between expected financial legacy (which you need to discount to today's dollars, not using an insurance payout in the future for example) and sustainability.

We are talking about the same thing. Mathematically, though, the optimal asset allocation will vary based on your spending rate for x dollars. Milevsky has released a couple of calculators which solve for lifetime ruin probability and expected discounted bequest in different annuity/SWIP and asset allocation scenarios. Here's a screenshot of one. This is the puzzle you are solving, yes?
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Re: So you are going to buy an annuity. With what?

Post by Shakespeare »

This is the puzzle you are solving, yes?
Yes, that's correct. Also, my "gut feeling" is that the portfolio after annuitization should still be roughly balanced - say, 40:60 to 60:40 - to best cover the probabilities.
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Re: So you are going to buy an annuity. With what?

Post by brucecohen »

c emptor wrote:I recently received an annuity quote from an insurance company which stipulated that the quote was offered "Assuming your marginal tax rate is 50%". Why does the recipient's tax rate influence the quoted amount? I got a quote from another insurance company that didn't mention this qualification.

I asked for a "prescribed" quote and found that about 25% of the money received was taxable. The rest would be return of capital. Is this prescription amount influenced by the recipient's marginal rate?
A prescribed annuity is a tax-driven creature. It can be purchased only with non-registered funds. And it can't be inflation-indexed.

Every life annuity payment received is a blend of taxable interest and tax-free return of capital. Think of it like a home mortgage. In the early years there's a lot of interest. As each year goes by, the level of interest falls as the level of principal repaid goes up. So, with an annuity that's NOT prescribed -- such as one bought with RRSP/RRIF money -- there's a lot of taxable interest early on.

Under the prescribed annuity rules, CRA lets the issuing insurer level the interest-RoC split over your life expectancy. So in the early years there's a lot less taxable interest and a lot more tax-free RoC. At some point, the table turns and the levelling pays out more taxable interest and less RoC than you'd get with a straight annuity. But many/most people die before then. Or are too infirm to care.

Thanks to this levelling, a prescribed annuity can usually produce more spendable income than GICs or bonds. But unlike GICs or bonds, it's a lifetime contract with no access to the underlying capital.

The financial industry norm is to use a 50% MTR for generalized illustrations. That goes back to when the top bracket MTR was about 50%. And the math is easy. Any financial advisor who sells annuities can easily produce an illustration using your actual MTR. BTW, a life annuity is an insurance contract and can be purchased only from a licensed advisor. BTW#2: It's important to shop the market for a life annuity quote. At various times an insurer might not want new annuity business, but instead of withdrawing from the market it just gives lousy quotes.
Nowhereman wrote:I assume that when you die, the annuity dies, unlike the ownership of the bonds, they are what the next generation inherits, after taxes??...The couple whose monies I allocated for them do not even spend their pension monies and leaving an Estate to their only child is of paramount importance, sounds like an annuity would not work for them.???
Before this couple considers annuitizing, they should ask these questions:
1. Does our pension income cover our normal living expenses?
2. If so, how secure is the pension promise? IOW, what are the odds that the plan sponsor will go bust and leave an unfunded liability?
3. How well is our pension protected from inflation? Few private sector pensions are indexed at all. Indexing is common for public sector pensions, but often not full indexing.

If the pension meets their normal living expenses, the sponsor is public sector, and there's full inflation indexing, they have no need for an annuity. If there's not full inflation indexing, can they reasonably generate enough investment income to cover that gap? If so, they have no need for an annuity.

If, for some reason, they really want to annuitize but also want to leave an estate, they can look into a "back to back." Here, the advisor matches a life insurance policy to the annuity. Let's say the annuity costs $100,000. The life insurance would be placed for $100,000. So mom and dad get to spend their cash flow and the original capital amount is still available at death thanks to the insurance payout. This is most often done with a prescribed annuity that can only be purchased with non-registered funds. The idea is that part of the extra cash flow relative to after-tax GIC/bond interest will be used to pay the insurance premium.* Whether this works will depend on the age and health of the couple.

The life insurance premiums really should be paid by the estate beneficiaries since they'll get the benefit. But one of Canada's top financial advisors told me years ago that he had almost no retiree clients who went for that. Even if the parents were willing, the selfish kids weren't.
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Re: So you are going to buy an annuity. With what?

Post by Flights of Fancy »

There are intuitive paths through this. Generally speaking, with low income requirements and a high starting portfolio value, there's no additional sustainability (or expected financial legacy) with an increased equity allocation.

With a moderate portfolio and relatively high withdrawals (think: "average" case), you need some equity allocation.

You can plot the optimal curve for various spending, asset and product (annuity vs. SWIP) allocations to find the peak.
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Re: So you are going to buy an annuity. With what?

Post by Shakespeare »

SWIP
:?:
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Re: So you are going to buy an annuity. With what?

Post by Flights of Fancy »

Systematic Withdrawal Plan. Where you get your cash from a portfolio in retirement, usually by selling either a fixed number of units or a varying number of units giving you a monthly stable allotment.

Too many acronyms. That's one from my advisor days.
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Re: So you are going to buy an annuity. With what?

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c emptor wrote:I recently received an annuity quote from an insurance company which stipulated that the quote was offered "Assuming your marginal tax rate is 50%". Why does the recipient's tax rate influence the quoted amount? I got a quote from another insurance company that didn't mention this qualification.

I asked for a "prescribed" quote and found that about 25% of the money received was taxable. The rest would be return of capital. Is this prescription amount influenced by the recipient's marginal rate?
"Assuming your marginal tax rate is 50%" influence the illustrations made by the insurance company boasting that you pay less tax, sort of like "$1 in eligible Canadian dividends is worth $1.40 in bond interest", so the $30k annually from the annuity is like $42k from GIC's.
Bruce Cohen wrote:So, with an annuity that's NOT prescribed -- such as one bought with RRSP/RRIF money -- there's a lot of taxable interest early on.
I hate to try to correct a pension expert, but my understanding is that a non-prescribed annuity is 100% taxable income.
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Re: So you are going to buy an annuity. With what?

Post by Shakespeare »

Systematic Withdrawal Plan.
I guessed that - but why "SWIP" and not "SWP"?
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Re: So you are going to buy an annuity. With what?

Post by Flights of Fancy »

Easier to say? I have no idea. I'm a decade into using that term by now.

Editing to say that when I'm being fussy about spelling/typing, I will spell it SWiP.
Last edited by Flights of Fancy on 02 Mar 2010 14:05, edited 1 time in total.
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Re: So you are going to buy an annuity. With what?

Post by Pickles »

Since the topic has been broadened a bit, I would like to know why an annuity purchased from registered funds has a lower monthly payment than a non-registered annuity. I understand how a prescribed annuity works and why one can't buy it with registered funds but why will Manulife pay $739.84 to a 70 year old woman who purchases a non-registered life annuity with a 15 year guarantee but only $626.09 if she buys it with registered funds? Aside from the tax treatment, isn't it the same product?
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Re: So you are going to buy an annuity. With what?

Post by Flights of Fancy »

Because of the increased administrative burden on the issuer. They have to have a whole department coordinating with CRA, and that's how they fund it.
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Re: So you are going to buy an annuity. With what?

Post by Pickles »

Thanks FoF. It seems inconceivable that the administration of an annuity could justify a 15% reduction in payout. Just what do they do with CRA? Deduct and remit the taxes? How do these fees compare with fees charged for investments in a RRIF?
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Re: So you are going to buy an annuity. With what?

Post by Flights of Fancy »

Yes....but that form of annuity has to bear the entire burden for adhering to the tax rules: the cost is not amortized over the company as a whole. It gets even more complicated when RRIF minimums are taken into account (as they would be in the case you posted, I presume).
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Re: So you are going to buy an annuity. With what?

Post by Pickles »

So each annuity bears the entire cost of administration? There is no economy of scale? Does anyone buy registered annuities anymore? It would seem to be a really bad deal.
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Re: So you are going to buy an annuity. With what?

Post by c emptor »

Thanks Bruce and adrian2 for explaining the language that the insurance agent was using.


I am trying to figure out how much frictional costs there are in the purchase of a single life,no guarantee,male 65 years old, non-registered annuity such as shown in this table from Cannex. for example, BMO Insurance offers $675.33.

I used gummy's calculator and another one to get an idea of the friction-less payout.

in each case there are two inputs that must be estimated. These are the number of years until there is no more money in the annuity after it has all been paid out to the annuitant, and the internal rate of return the insurance company obtains by investing in GOC bonds.

Gummy says that the length of the annuity is calculated by first determining the number of years between the age of the annuitant and 90, although he uses 95 in his calculator. So 95-65=30 years. So he states the annuity will be exhausted in 30/2=15 years, or when the annuitant is 80 years old. After that he will get other people's money.

For the internal rate of return I used the 10 year bond rate obtained from the BOC. This was 3.75%.

Using these two estimated inputs the monthly return from one calculator is about $725 and from gummy's it is $8838 per year or $ 736 a month. The average is about $730/month.

So from $ 730/month the insurance company in my example would give you $675 keeping $55 or 7.5 % for itself.

Do my calculations make sense? Is there a better way to calculate the MER? For some other insurance companies with quotes at Cannex the MER is a lot higher. For example Sun Life would payout $623.18 keeping $ 107 or 14.6 % for itself.
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Re: So you are going to buy an annuity. With what?

Post by Flights of Fancy »

I'm not totally sure what you mean when you say MER in an annuity context, but there are a couple of ways to calculate the value of mortality credits. Check Chapter 6 of this CFA institute monograph.
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