Posted on 28 December, 2009 | 58 Comments
As a derivatives trader, nobody more than myself enjoys coming up with sophisticated investment strategies. Yet, sometimes opportunities presents themselves in ways that don’t require a whole lot of complexity nor hours of research. And while I strongly believe there are no free lunches out there, sometimes you do find a $5 bill or even a $20 bill lying on the street. An insured annuity is one of those very simple, easy to understand products that complement the fixed income portion of one’s portfolio.
So, what is an annuity? It is a contract, usually between an insurance company and an “annuitant” who, for a lump sum payment, will receive from the insurance company, a stream of income for life — very similar to the benefits of owning a long term bond or perpetual preferred share.
So what is an insured annuity? An insured annuity is simply an annuity in combination with a life insurance policy. One of the disadvantages with owning an annuity without the insurance policy is that once you hand over the cheque to the insurance company, you don’t get your money back. An insured annuity solves this problem. Basically upon death, the annuitant’s estate receives the principal amount back — again very much like a bond that upon maturity pays back the principal amount.
Now, there are various types of annuities, and many factors that need to be considered in determining the appropriate type of annuity.
Single Life Annuity
A single life annuity will provide you with an income for as long as you live, ensuring that you will never outlive your money. It can also be guaranteed for a certain number of years. Should a premature death occur, the estate will continue to receive the funds at least up to the guaranteed period.
Joint and Last Survivor Life Annuity
This life annuity is payable while either you or your spouse (or common-law partner) are living. When one spouse dies, the survivor can continue receiving income payments as agreed upon when the annuity contract was established. As with the single life annuity, a guarantee period can be written into the contract.
Term Certain Annuity
This type of annuity can be useful for planning ahead when you will require a specific or additional income for a pre-defined period. A term certain annuity provides you with an income for a set period, or until a certain age.
How Life Annuity Payment Amounts Are Calculated
The life annuity payment amount is fixed and is based on:
• the amount of money used to purchase the annuity,
• the type of life annuity purchased,
• current interest rates,
• the ages of the annuitant and joint annuitant, if any,
• current long-term bond rates.
Tax Efficiency
Perhaps the greatest benefit for considering an annuity is for the tax efficiency of the prescribed annuity when using “non-registered” funds. The CRA recognizes that payments received as income from an annuity include both interest and principal. Since taxes have already been paid on the principal, the annuitant will not be taxed twice.
For example, if one purchases a life annuity for $1,000,000 and receives an annual income of $80,000, the amount that is taxable might be $18,000 (actual income and taxable amount will be based on conditions when an annuity is purchased). That leaves the investor with $62,000 on an after tax basis.
However, in order to complete the financial analysis, we have to factor in the cost of the insurance policy. Again, it will depend on the individual but for this example, let’s assume the cost of the insurance policy was $15,000. This would reduce the investor’s income from $62,000 to $47,000 on an after tax return basis.
In comparison, an affluent, wealthy investor would have to earn at least 8% from his bond portfolio in order to match the after tax return of an insured annuity. Given that most investment grade corporate bonds are paying closer to the 5-6% range, the insured annuity outperforms by a landslide.
In summary here is what an Insured Annuity can do for you?
• Provide a regular, guaranteed income stream for both you and your spouse for as long as both of you live.
• Create a tax advantage
• Ensure your principal is returned to your estate upon death
• Reduce market risk to investable assets by treating an annuity as part of the asset allocation strategy of the portfolio.
Are there any disadvantages to an annuity? It’s a non-cancellable contract, and technically you lose control of those funds. The contractual payments are fixed and will never increase — hence annuities are subject to inflation risk which is why we at Frontwater believe they are a complement to a portfolio weighted towards fixed income.
Certainly, as stated above, if for no other reason than continuing market volatility, and your expectations of a long life, a look at including an annuity within your overall investment strategy might be worth a consideration.
Whenever, I speak about insured annuities, I am reminded of the story with Leonardo da Vinci and the Pope. The story goes that the Pope requested that Leonardo da Vinci submit a piece for a new commission. Leonardo drew, freehand, at arms length, a perfect circle on a sheet of paper and sent it to the Pope, who promptly gave him the commission. For those who don’t know, to draw a perfect circle, freehand and unsupported is one of the hardest things possible to draw — all the more reason to admire beauty in simplicity.
To find out more about insured annuities, please contact Warren Blatt at 416-319-8172.
Author: Jeff Kaminker
www.fwcapital.ca
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