Annuities might be the best retirement product that few Canadians buy. This is surprising as they provide guaranteed income for life, just like defined-benefit pensions which are considered the gold standard of retirement income plans.
Retirement experts who study annuities confirm these are an effective safeguard against longevity risk, or the possibility of outliving your wealth. Plus people with annuities tend to be more content, so there are many good reasons for retirees to give annuities more consideration. The concept is simple; you hand an insurance company a lump sum of money in return for predictable cash flow. But first you need to determine whether an annuity fits your circumstances and income requirements.
Are annuities right for you? While annuities have many attractive features, they’re not for everyone. If there’s no chance you’ll run out of money, annuities are probably the wrong choice. They make little sense if you have an ample employer pension, since you already have the assurance of an income for life. Nor are they attractive if you’re in poor health because the best payoff from an annuity comes from living longer than average. And if you’re very wealthy, outlasting your money probably isn’t a concern either.
People tend to avoid annuities because of their finality. Once you give your cash to the insurance company, you’re locked in it for life. By contrast, most other investment provide growth potential and the flexibility to tap your nest egg for extra cash if needed. And if leaving money to your heirs is a top priority, annuities preclude that option because the payouts generally end at your death.
Think of them as one part of a larger retirement income plan: As such they can work very well in a portfolio alongside stocks and bonds or GICs. The goal is to figure out the right allocation to each of these assets based on the trade-off between guaranteed income, access to cash and growth potential.
How much do you need? If you rely solely on a portfolio of stocks and bonds for retirement income, you should set a conservative withdrawal rate in case markets perform poorer than expected or you live exceptionally long, or both. A common rule of thumb if you retire at 65 is to plan on withdrawing 4% of your initial portfolio every year, plus inflation adjustments. But you should have a backup plan in case this withdrawal rate turns out to be unsustainable. Building annuities into your retirement strategy is one of the best backup plans, because they assure a relatively high level of withdrawal with no risk of depletion. Plus if you are investing unregistered funds they can be very tax efficient.
A popular strategy is to use annuities together with government pensions to meet your non-discretionary spending needs. That provides peace of mind that your basics are covered. Plus you can afford to take more risks with the rest of your portfolio, although there’s no perfect formula. For example a typical recommended mix might be 40% equities and 60% bonds, which could potentially increase the amount you leave your heirs should you live a long time and markets perform well.
Annuities can replace bonds for retired people who don’t have an employer pension plan. And because their basic living expenses are now covered, the recommend mix for the rest of their portfolio might be closer to 60% equities and 40% bonds.
To find out if an annuity is right for you, seek out a trusted financial advisor.
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