What is an annuity and how does it work

Could you explain how an annuity works. What happens to the money when the person dies? If one were to purchase an annuity today, how would it compare to a RRIF? What would you recommend. Amount of investment would be $250,000.

An annuity is an exchange of a lump sum of money for a monthly payment of interest and principal.  It is similar to a mortgage only in reverse.  When you wanted to buy a house, you borrowed money from the bank (because they had the money and you didn’t) and you had to repay the loan with (usually) monthly payments of interest and principal.  By the end of the amortization period (quite often 25 years) the loan was paid off.

With an annuity, you have the money and you can lend it to the bank.  They will have to pay you monthly payments of interest and principal for the length of time you agree (could be 25 years).  If the amortization period is shorter (15 or 20 years) then the monthly payments will be higher (more principal paid each month).  If the amortization period is longer (30 to 35 years) then the payments will be smaller.

Life insurance companies can sell life annuities, but the concept is the same.  You give them a lump sum and they pay you a monthly amount until you die (they pay for the rest of your life).  What is different is that nobody knows how long you are going to live to calculate the exact amortization period.  (How many months are you going to live?)  So, insurance companies use life expectancy tables to estimate how long you will live.  Generally, the younger you are, the longer you will live.  Generally, females of the same age live longer than males.

The interest rate that is in effect at the time you “buy” the annuity has an impact on the amount you will receive.  When interest rates are higher, the monthly payments are higher.  When interest rates are lower (like they are now), the monthly payments are lower.  Once the annuity is purchased, the interest rate is fixed for the length of the term (specific number of months or the rest of your life).

If you purchase a term annuity from the bank, they will continue to pay the monthly amount until the term is up (60 months to 300 months).  If you live beyond the term of the annuity, the payments will stop.  If you die before the end of the term, the bank will pay a lump sum equal to the amount left owing (just like paying out a mortgage before it is completely paid off).

If you purchase a life annuity from the insurance company, they will continue to pay the monthly amount until you die.  That may be for 45 months or for 450 months.  When you die, there will not be any money left for you or your estate.  If, at the time you purchased the life annuity, the insurance company thought that you would live 20 years (240 months) and you died after 45 months, then they got to keep some of your money (bad for you, good for them).  However, if you died after 450 months (37 ½ years), you got back more than just your principal and interest.  Where did the rest of the money come from?  It was from people who died early!

If you had $250,000 in your RRSP, you could transfer the money to a RRIF or you could buy a life annuity.  If you are a male aged 65, your annual life annuity payment according to RBC Insurance would be $17,936.44 as of August 29, 2023.  (As a comparison, the same amount would have purchased an annuity of $14,784.67 on September 8, 2020).

The annual minimum payment from your RRIF would be $10,000.  You could take more from your RRIF, but you could not take less.  If you earned a 4% return on the investments in the RRIF (buying GICs for instance), then the payment would increase from $10,000 at age 65 to $12,813.41 at age 71.  After that age, the annual income would increase a little each year.  At age 90, the payment would be $15,361.63.  After age 94, the payment would begin to decline.

If you chose a RRIF and you died at age 85 (the average life expectancy or a male aged 65), there would be $164,369.12 left in the RRIF (compared to $0 in the annuity).

It is unlikely that the investment return of your RRIF would be exactly 4% for 25 years (age 90).  If interest rates went down so that the average GIC rate is 3% then the payment at age 71 would be $12,077.05 and at age 90 it would be $11,867.23.  If you died at age 85, there would be $140,474.62 left in the RRIF.

You could invest your RRIF in mutual funds (or other fluctuating investments).  If the average return on the RRIF mutual funds was 5%, then at age 65, the minimum payment would start the same at $10,000.  At age 71, the minimum payment would be $13,443.84.  At age 90, the payment would be $18,226.37.  If you died at age 85, there would be $199,039.57 left in the RRIF.

Recognize that mutual funds and other investments do not provide exactly the same return each year.  When markets go up (more than average) then the minimum withdrawal will be larger.  When markets go down, the minimum payment may decrease year over year.  If you are drawing out just the minimum payment, then your RRIF will last your lifetime (although the payments will be quite small after age 100).  However, if you are taking out more than the minimum, then it is possible that the market fluctuations combined with higher withdrawals may deplete your funds before age 85.

Be cautious in comparing annuity rates with GICs rates.  When the bank quotes a rate of 4% on the GIC, that is the interest you will earn (so $10,000 on a $250,000 GIC RRIF).  The annuity provider may suggest that the annuity above yields 7.17%.  However, this “yield” is a mixture of principal and interest (it could be 4% interest plus 3.17% principal).

When you went shopping for a mortgage, you were looking to get the lowest interest rate.  If you got a quote for a mortgage of $250,000 amortized over 25 years at an initial rate of 5%, the monthly mortgage payment would be $1,461.48.  This interest and principal payment works out to be a yield of 7.02%, yet we all talk about it as a 5% mortgage rate.

So, an annuity is good if you are concerned that you will live a long time and you are a conservative investor (buying GICs in your RRSP/RRIF).  An annuity is good if you are not concerned about leaving an estate (you don’t have kids or you don’t want to leave them money from your RRSP).  An annuity gets better the longer you wait to buy it (because your life expectancy gets shorter as you age).  An annuity gets better as interest rates increase.  An annuity is good for someone who does not want to manage or worry about their investments.

A RRIF may be better than an annuity if you can invest your money to get a higher return than the interest calculated on an annuity.  A RRIF may provide a larger estate if you die early.  (But with the same interest rate as an annuity, the larger estate comes with a smaller monthly income.)

A drawback of buying an annuity when interest rates are low is that you may be able to get a higher annuity payment sometime in the future (when interest rates are higher).

You could transfer your RRSP to a RRIF in the meantime to create some monthly income.  If interest rates go up more, you could use the money in your RRIF to purchase a life annuity later (at age 70 or 75).

If you are willing to take risks with the investments in your RRIF, then it is likely that you will get more money from your RRIF and leave a larger estate than with a life annuity at today’s rates.  However, with fluctuating investments, it is possible that the RRIF payment may be smaller next year (instead of larger).  The following year (when the market recovers), your payment may increase again.

Given today’s interest rates and my ability to accept risk with my investments, I would use a RRIF over an annuity.  For a person with little means and no risk tolerance that is concerned about running out of money, an annuity may make some sense.

Ron Graham, CPA, C.A., R.F.P., CFP

Ron Graham and Associates Ltd.