GUARANTEED INCOME IN A LOW INTEREST RATE ENVIRONMENT

 
Interest rates in Canada rose fairly steadily from 1957 to 1981* with the prime lending rate reaching an all-time high of 22.75% in August of 1981. From that point on, Canadians experienced a declining interest rate environment from 1982 to 2012. While this has been a boon for those holding mortgages and debt, it has negatively impacted retirees relying on fixed income investments for their retirement income and conservative investors who have opted for higher fixed income and GIC holdings in their portfolios to reduce risk and exposure to stock markets. The ten year government of Canada bond yield stood at 2.16% at the end of September 2014 and 5 year GIC paid an interest rate of 2%.

While there is talk about interest rates starting to move up in 2015 once the Federal Reserve in the U.S. starts hiking rates, this is more likely to impact short term interest rates. Given the fact that inflation rate in Canada is low (2.10% at the end of August 2014) and is expected to stay low for an extended period of time, the low interest rate environment with regards to long term rates could continue for the foreseeable future.

So what should investors seeking yield do to get higher rates of return without exposing themselves to undue risk? Understanding how a low interest rate environment impacts your retirement income and putting in place proper asset allocation and guarantees in place to manage the risk of outliving your money in retirement are key issues to be considered in your financial planning at this juncture.

One of the instruments overlooked by many Canadians that can be useful in this kind of environment, are life annuities. Even in a low interest environment like today, life annuities can provide the highest level of guaranteed income for as long as you live, in the most tax effective manner.

Annuity income is made up of three components: interest rates, insurance credits, and return of premium. The greatest portion of annuity income over time could be made up of the insurance credits. This is particularly true for those who live beyond their normal life expectancy and since life expectancy has been steadily on the rise in Canada in the last few decades, this could be true for many Canadians.

While many people think that interest rates have the greatest impact on the income they receive from life annuities, it is in fact not true. Interest rates actually affect the income you can receive from a life annuity less than you may have expected. You may be surprised to learn that a rise in interest rates from 2% to 2.5% will not result in a proportional increase of 25% in the income you can expect from a life annuity.

The improvement in the after tax income from an annuity compared to investing in a GIC or bond can be dramatic. For example a 77 year old female, who purchases a $100,000 life annuity with no guarantee (i.e. if she passes away the insurance company would keep the balance of the funds), can receive $8818 after tax income per year or 8.81%. If she is in the highest marginal tax bracket of 46.4%, she would have to earn $16,451 per year from a GIC or bon, or 16.45% per year equivalent before tax interest to equal the results of the life annuity.

Of course, if she invested her money in a GIC or bond, then her heirs would inherit the balance left in her account upon her death but if she purchases a life annuity with no guarantee then her heirs will receive nothing. To remedy this she can purchase a life insurance policy with a $100,000 death benefit that would replace the principal amount that she had paid to purchase the life annuity upon her death and this way her estate would not shrink.

In the example above, the cost of a $100,000 life insurance policy for a healthy 77 year old female would be $5930 per year. Therefore, the net income from the life annuity would be $2888 ($8818 – $5930) or 2.88% net of taxes. To earn 2.88% net of tax, she would need an annual rate of return of 5.39% in a GIC or bond. Therefore, purchasing a life annuity combined with a life insurance policy to guarantee the principal for heirs on death, could improve the after tax return by 115.53% in this case. The older you are the more significant the improvement would be over investing in bonds or GICs.

The following table shows a comparison of the life annuity backed by a life insurance policy with a GIC or bond with 2.5% annual rate of return.

 Insured

GIC                   Annuity

Deposit Amount                                                               $100,000           $100,000

Annual income from investment*                                $2,500                $8,818

Taxable income from investment                                 $2,500                $0

Marginal tax rate                                                              46.40%              46.40%

% of income that is taxable                                            100.00%            0.00%

Tax due                                                                              $1,160                $0

After-tax income                                                              $1,340               $8,818

Cost of insurance                                                             $0                      $5,930

Net income                                                                        $1,340              $2,888

Net return                                                                          1.34%               2.89%

Gross equivalent rate**                                                   2.50%              5.39%

% improvement over GIC                                                                         115.53%

 

The downside to investing in life annuities is that once you have committed your money you would no longer have access to your funds. In effect you will be exchanging your cash with a guaranteed pension-like income and your decision is irreversible. Therefore, this is a strategy that works best when used in combination with other types of investments and income sources to ensure that you have the desired flexibility and liquidity in your retirement years.

The life annuity part of your income mix will give you a guaranteed lifetime income while your investment portfolio can provide you with liquidity and market exposure, therefore creating a more balanced and sustainable investment portfolio.

Including a life annuity in your retirement income mix will also help you limit your market exposure and minimize the sequence of returns risk – the risk of depleting your portfolio by starting to withdraw funds in a dropping market environment.

Most importantly, with the higher income generated by a life annuity you can protect yourself against longevity risk, or the risk of outliving your money.

Therefore, be sure to look at life annuities as a viable alternative to be considered for your retirement income mix and discuss the pros and cons with your financial advisor.

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