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Page 1 of 5  So you've decided to buy a life fixed annuity (sometimes called a SPIA for single premium immediate annuity), and you want to know how? In this commentary (our fourth in a series about annuities), we look at the practical side of things, for example: whether it is better to buy with tax-exempt funds (in Canada, your  RRSP or RRIF) or from your regular, non-registered account; is it better to finance your purchase by selling your stocks or bonds or borrowing;
buying the annuity in one fell swoop or spreading your purchases over time; what bells and whistles to consider for your annuity; should you purchase directly or through a broker; what return can you expect; and how much will it cost you ? A lot of questions which we hope this commentary will help you with.
In the three previous commentaries in this series (which you find in our Archives ) we looked at:
• the annuities in general; see the commentary Longevity risk: are annuities the solution?
• reasons to buy an annuity; see the commentary Annuities: bought, not sold?
• and conversely, reasons NOT to invest in annuities; see the commentary Annuities: think before you leap .
In this commentary, we explore the practical aspects of buying an annuity. To get the most benefit, it would be preferable to have read the previous commentaries.
From tax-exempt (registered) or regular (non-registered) accounts
It is possible to buy an annuity from your registered accounts (in Canada, these are typically a RRSP until age 71 and after 71 a RRIF) or from your regular account (i.e. those with no tax benefit). Our general preference is not to unnecessarily initiate the wind-down of your RRSP because you lose the tax-free accumulation benefit; see RRSP accounts
on our site.
So if you have sufficient funds in both your RRSP and unregistered accounts, we believe it would be advantageous to purchase your annuity outside of your RRSP. This gives you two advantages: the first is to earn income tax free longer in your RRSP, the second is to receive a portion of the annuity tax-free because it is regarded as a return of capital (we discuss further below).
After the end of the year during which you turn 71 you must close your RRSP. Among other options, you can transfer the assets into a RRIF and continue to make the same investments, except that tax rules require you to withdraw annually from your RRIF a minimum amount. These withdrawals are fully taxable. The minimum annual withdrawal percentage starts at 7.38% at the age of 71 years, gradually increasing
to 20.00% by your 94th anniversary; in general on RRIFs, visit InvestorED.ca
; Taxtips.ca
; and Keith Betty's Shakesprimer
.
A recent article in a respected periodical indicates that the logic of mortality credits (see discussion on these credits in our previous commentaries) encourages the purchase of annuities between 60 to 90 years of age; see Ibbotson et al doc.1051 p.55, 71. If you take the average between the two extremes, you arrive at a target age of 75 years to buy an annuity:
Greater than 75-years-old mortality credits (additional return derived from pooling assets and giving up estate residual value) increase with age. At around age 75 the mortality credits appear to be sufficient to overcome the various costs of annuitization. The mortality credits are always positive, so theoretically (so long as you do not care about leaving an estate) for a given investment return you should always be better off with an annuity than without one, but in reality you must first exceed, and difficult to determine, embedded costs of the annuity before you see any net benefits. Peter Benedek www.retirementaction.com
.
Given the mandatory annual withdrawals from your RRIF, in the absence of high returns, if you wait until you are 75 years of age or older to purchase your annuity with funds from a RRIF, you will likely have less money available in your RRIF to invest. So if you intend to buy your annuity from a RRIF, you should consider this constraint.
Funding Source
The purchase of an annuity from a non-registered account may be made using your cash, if available, by selling investments or by borrowing.
Generally our site does not encourage borrowing by the typical independent investor; see Your Broker’s Margin Account Form .
Given the characteristics of an annuity (it is a non-liquid fixed rate irrevocable long-term investment), it is more prudent not to borrow to buy an annuity.
Between the sale of shares or of your debt investments (e.g. bonds) to fund the purchase of an annuity, the choice should be dictated by the Asset Allocation appropriate to your circumstances, in general, see Asset allocation
on our site. An annuity is akin to a debt investment for purposes of calculating your asset allocation. If your current asset allocation is appropriate, you should probably sell debt investments to not change your asset allocation. If your asset allocation is too aggressive (too much equity), take the opportunity to sell share investments to fund the purchase of your annuity. Tax considerations should also be considered and may affect the foregoing.
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