When it comes time to convert your RSPs or other accumulated savings into steady retirement income, the choices primarily come down to transferring funds into a RIF, or purchasing an annuity. Both can provide a reliable source of income for your retirement years, but there are important differences between the two.
We’ve previously looked at some of the features of a RIF. In this discussion, we'll review the pros and cons of annuities to help you understand how these two products differ.
Annuities and interest rates
Financial institutions invest the money they receive from you to earn income. Therefore, the amount you receive from the annuity is directly impacted by current interest rates.
An annuity is a contract set up with a financial institution that's authorized to sell insurance products. An annuity pays a guaranteed amount to the purchaser, and comes in two main forms - fixed rate, and variable rate. For now, we'll look at fixed rate annuities which pay a prescribed amount for the lifetime of the person holding the annuity.
The main advantage of a fixed annuity is that it offers a high level of security, and the reassurance of knowing that you'll receive the contracted amount as income for as long as you live. It’s like insurance against running out of money. Indeed, you can only buy annuities from a sales representative with an insurance license, so the analogy is not far off the mark.
Is an annuity right for you?
If you have sufficient money set aside for your retirement and will not likely outlive your savings, or if you have an adequate pension, you can stop reading now – an annuity probably makes very little sense for you. However, if you're concerned that you could run out of money during your retirement, then you may want to take a closer look at annuities.
Because payments are guaranteed for as long as you live, the calculation to determine your payout is based on the amount you invest initially and the current interest rates, as well as how long you can be expected to live. For a fixed rate annuity with no guaranteed payment period, the younger you are when you purchase the annuity, the longer it will likely have to pay, and insurance companies will factor this into the calculation. This means that a 75-year-old with $100,000 to put towards an annuity will likely receive a higher monthly payout than someone with an equal amount purchasing an annuity at 65 years of age.
The limitations of annuities
While you may find the guarantee of payments for life reassuring, there are other aspects of an annuity that could be troubling for you. For instance, unlike a RIF where you can withdraw funds at any time over and above the required minimum withdrawals, once locked into an annuity you no longer have access to funds beyond your scheduled payments. There's also the matter of what happens to your annuity once you die.
Unless you've made specific arrangements, any funds remaining in the annuity upon your death are retained by the financial institution. There are two typical ways to prevent this, but both cost an additional fee to arrange.
The first involves establishing a guaranteed period that ensures payments for the duration of the contracted time period. For example, if you arranged for a 10-year guaranteed period and then died after 7 years, your beneficiary would continue to receive payments for another 3 years. At the end of this 3 years, payments would then cease and any remaining funds would revert to the financial institution.
The second option is specifically intended to provide for a spouse, and is referred to as a joint annuity. This arrangement comes at a considerable cost, but does ensure that you and your spouse will continue to receive payments until you both die.
One last thing to point out - that's especially relevant given the current era of low interest rates - is that establishing a long-term annuity when interest rates are unusually low carries extra risk. This is because interest rates could rise considerably over the course of 20 years or more, resulting in lost opportunity as inflation increases.
As with any investment choice, investors have different needs, and an annuity addresses the specific fear of outliving your investments. For those concerned about this possibility, an annuity may provide the peace of mind that outweighs other limitations.