What Is an Annuity?

When planning for retirement, one of the biggest questions is how to turn your savings into a reliable source of income. An annuity is one potential solution.

An annuity is an insurance product that can provide regular income in exchange for a lump-sum payment or, depending on the product, a series of payments. Some annuities provide income for a fixed period, while others can provide income for as long as you live.

For retirees, the biggest attraction is often longevity protection: the ability to receive guaranteed income for life and reduce the risk of running out of money because you live longer than expected.

However, annuities are not automatically right for everyone. Once you purchase many types of annuities, your capital can become difficult or impossible to access. Inflation, fees, beneficiary provisions, taxation and the terms of the contract all need to be considered before purchasing one.

What Is an Annuity?

An annuity is a contract with an insurance company. You provide money to the insurer, usually as a lump sum, and in return the insurer agrees to provide income according to the terms of the contract.

Depending on the annuity, payments can begin immediately or at a future date. They may continue for a fixed period or for the rest of your life.

The amount of income you receive depends on factors such as:

• Your age when the annuity is purchased
• The amount of money used to purchase the annuity
• The type of annuity
• Interest rates when the annuity is purchased
• The length of the payment period
• Whether payments continue to a spouse or beneficiary
• Whether the payments are indexed or otherwise adjusted
• The insurance company providing the annuity

An important feature of a life annuity is that the insurer assumes much of the longevity risk. You may live to age 90, 100 or beyond, and the contractual payments can continue for life even if you have received more than the amount you originally paid.

How Do Annuities Work?

Suppose you use $250,000 of your retirement savings to purchase a life annuity. The insurance company calculates a regular payment based on the terms of the contract and factors such as your age, the amount invested and prevailing interest rates.

You might then receive a monthly payment for the rest of your life.

The payment is not simply a return of your original $250,000. The economics of a life annuity also reflect investment earnings and the pooling of longevity risk among many policyholders.

Someone who dies earlier than statistically expected may receive fewer payments, while someone who lives considerably longer can receive payments for many years. This pooling of mortality risk is one of the fundamental features that makes a lifetime annuity different from simply withdrawing money from an investment account.

Types of Annuities

There are many types of annuities, and the terminology can vary between Canadian and U.S. financial markets. The most important distinctions for retirement planning are whether payments are guaranteed for life or a fixed term, when payments begin, whether the amount can vary, and whether the annuity includes protection for a spouse or beneficiary.

Life Annuity

A life annuity provides guaranteed income for as long as you live, subject to the terms of the contract.

This can be particularly valuable for retirees who are concerned about outliving their savings.

For example, someone could use part of their retirement portfolio to purchase a life annuity and use the resulting income to cover essential expenses such as housing, food and utilities.

The trade-off is that you generally give up access to the capital used to purchase the annuity. Depending on the contract, there may also be little or no value payable to your estate after death.

Joint-and-Survivor Annuity

A joint-and-survivor annuity can provide income for two people, typically spouses or common-law partners.

Payments can continue to the surviving spouse after the first person dies, depending on the percentage and terms selected in the contract.

Choosing survivor protection generally results in a lower initial payment than a comparable single-life annuity because the insurer expects payments to continue for the surviving person.

For couples, this can be an important consideration because the death of one spouse does not necessarily eliminate the household's financial needs.

Term-Certain Annuity

A term-certain annuity provides guaranteed payments for a specified period rather than for your entire lifetime.

For example, you might purchase an annuity that provides income for 10 or 20 years. Depending on the contract, payments may continue to your estate or beneficiary if you die before the end of the guaranteed period.

The major difference from a life annuity is that the income can end while you are still alive if the guaranteed term expires.

Immediate Annuity

An immediate annuity begins making payments relatively soon after you purchase it.

This can be useful for someone who is already retired and wants to convert a portion of their savings into predictable income.

A single-premium immediate annuity, or SPIA, is one example of this type of arrangement.

Deferred Annuity

A deferred annuity is designed to begin payments at a future date. The deferral period can allow the money to remain invested or accumulate according to the contract.

Deferred income annuities can also be used as a form of longevity insurance. For example, someone might purchase future income that begins at age 85 rather than immediately at retirement.

Variable and Investment-Linked Annuities

Some annuity products have payments or values that are linked to the performance of underlying investments or indexes. These products can have significantly different risks and fee structures from traditional guaranteed life annuities.

It is important not to assume that every product called an "annuity" provides the same type of guarantee. Read the contract carefully to determine exactly what is guaranteed and what can fluctuate.

Why Consider an Annuity?

The primary reason retirees consider annuities is guaranteed income.

Unlike an investment portfolio, where withdrawals depend on the amount of money remaining in the account and the performance of the investments, a qualifying life annuity can continue making contractual payments regardless of how long you live.

This can help address several retirement risks.

1. Protection Against Longevity Risk

Longevity risk is the possibility that you will live longer than your savings last. A life annuity transfers much of this risk to the insurance company.

This can be particularly valuable for someone who expects to live well into their 80s, 90s or beyond.

2. Predictable Cash Flow

An annuity can create a predictable income stream that can be used to cover essential retirement expenses.

This may make it easier to manage the portion of your retirement budget that must be funded regardless of market conditions.

3. Reduced Dependence on Portfolio Withdrawals

If an annuity covers some of your essential expenses, you may not need to withdraw as much from your investment portfolio every year.

That can potentially reduce the amount of investment assets exposed to market fluctuations during retirement.

4. Peace of Mind

Retirement planning is not only about maximizing wealth. For some retirees, knowing that part of their income will continue for life is valuable in its own right.

What Are the Drawbacks of Annuities?

Annuities also have significant disadvantages. A lifetime income guarantee comes at a cost, and the decision can be difficult to reverse.

Limited Access to Capital

Once you purchase many types of annuities, you cannot simply withdraw the original investment whenever you want.

Some contracts provide limited withdrawal or surrender options, but these can come with restrictions or charges.

Inflation Risk

A fixed monthly payment can lose purchasing power over time.

For example, an annuity paying $2,000 per month today will still pay $2,000 per month if the contract is not indexed, but that $2,000 may buy considerably less 15 or 20 years from now.

Some annuities offer payments that increase over time or provide inflation-linked features, but those features can reduce the initial income or increase the cost of the contract.

Death-Benefit Trade-Offs

A simple life-only annuity may provide a higher monthly income but offer limited protection for your estate if you die soon after purchasing it.

Adding a guarantee period, joint-and-survivor provision or death benefit can provide more protection for beneficiaries, but these options generally reduce the initial income payment.

Fees and Contract Restrictions

Annuity costs vary substantially by product and provider. Some products have relatively straightforward pricing, while others can contain multiple layers of fees, commissions, administrative charges or surrender restrictions.

Before purchasing an annuity, ask the provider to explain all fees, commissions, surrender provisions, guarantees and conditions in plain language.

How Is an Annuity Taxed in Canada?

The tax treatment of an annuity depends on the type of annuity and the account or funds used to purchase it.

Registered and non-registered annuities can have different tax consequences, so it is important not to assume that all annuity income is taxed the same way.

For example, payments from an annuity purchased with registered retirement funds can generally be taxable as pension or retirement income. The tax treatment of a non-registered annuity can be different because part of each payment may represent a return of capital rather than taxable income.

Your tax result depends on the specific contract and how it was purchased. A tax professional or qualified financial planner should review the details before you make a large annuity purchase.

How Are Annuity Payments Determined?

There is no universal annuity payout rate. Two people investing the same amount can receive different payments depending on their circumstances and the contract they choose.

Important factors include:

• Age at purchase
• Health and underwriting information, where applicable
• Interest rates
• Single-life or joint-life coverage
• Guarantee period
• Inflation protection
• Death-benefit provisions
• Payment frequency
• The insurance company and its pricing

This is why it is important to compare quotes from multiple providers rather than assuming that the first annuity quote you receive is the only available option.

Are Annuities Protected If an Insurance Company Fails?

Canadian life insurance companies are required to belong to Assuris, an organization that provides protection to eligible policyholders if a member insurer fails.

For eligible annuity income, Assuris currently provides:

• 100% protection for monthly income payments up to $5,000
• 90% protection for the portion of monthly income above $5,000

Assuris protection is subject to its rules and limits, so it should not be treated as the same thing as a government guarantee of the entire annuity contract.

Annuities and Your Retirement Portfolio

An annuity does not necessarily need to replace your entire investment portfolio. In many retirement plans, it can be used alongside other assets.

For example, consider a retiree with:

• CPP and OAS
• A workplace pension
• RRSP and RRIF savings
• TFSA investments
• Non-registered investments
• A potential annuity purchase

CPP, OAS and a workplace pension may already provide a foundation of guaranteed income. An annuity could potentially fill part of the remaining gap between those guaranteed sources and the retiree's essential expenses.

This approach can allow the investment portfolio to remain available for discretionary spending, emergencies, large purchases and legacy goals.

Annuity vs. Investment Portfolio

An annuity and an investment portfolio solve different problems.

Feature	Annuity	Investment Portfolio
Lifetime income	Can be guaranteed with a life annuity	Depends on withdrawals and portfolio performance
Access to capital	Often limited after purchase	Generally more flexible
Market risk	Depends on the type of annuity	Directly exposed to investment markets
Inflation protection	May be available depending on contract	Can potentially grow with inflation over time
Estate value	Depends on contract provisions	Remaining assets generally belong to the estate
Income predictability	Can be highly predictable	Withdrawals can vary with portfolio value

The goal is not necessarily to choose one or the other. A retirement plan can use both guaranteed income and investments to address different financial needs.

When Might an Annuity Make Sense?

An annuity may be worth considering if you:

• Want more guaranteed lifetime income
• Are concerned about outliving your savings
• Have limited pension income
• Prefer predictable cash flow
• Want to reduce dependence on portfolio withdrawals
• Are comfortable giving up some liquidity
• Have enough remaining assets to cover emergencies and discretionary spending

When Might an Annuity Not Be Appropriate?

An annuity may be less suitable if you:

• Need substantial access to your capital
• Want maximum flexibility over your investments
• Have already secured enough guaranteed retirement income
• Are primarily focused on leaving assets to heirs
• Are uncomfortable with the restrictions in the contract
• Need significant inflation protection that the proposed annuity does not provide

The right decision depends on your overall financial situation rather than simply the headline monthly payment.

How Annuities Can Fit Into a Retirement Plan

Annuities are best considered as one component of a broader retirement-income strategy.

A well-designed retirement plan might combine guaranteed income from CPP, OAS, employer pensions and an annuity with flexible withdrawals from RRIFs, TFSAs and investment accounts.

The key question is not simply whether an annuity produces a high monthly payment. Instead, consider what role the annuity would play in your overall plan.

For example, if CPP, OAS and a workplace pension already cover your essential expenses, purchasing a large annuity may provide less additional value than it would for someone with very little guaranteed income.

Conversely, someone with substantial savings but very little guaranteed lifetime income may place a higher value on converting part of those savings into predictable lifetime income.

Conclusion

Annuities can be a powerful retirement-income tool because they can convert a portion of your savings into predictable income and, with a life annuity, protect against the risk of outliving your money.

But an annuity also involves important trade-offs. You may give up liquidity, flexibility and some estate value in exchange for guaranteed income. Inflation, taxation, fees, beneficiary provisions and the financial strength of the insurer should all be considered.

For many retirees, the most useful question is not whether an annuity is "good" or "bad," but whether purchasing one improves the balance between guaranteed income, investment flexibility and longevity protection in their specific retirement plan.

Retirementize can help you model your retirement income from CPP, OAS, pensions, investments and other sources so you can understand how different income strategies may affect your retirement plan.

Build your retirement plan with Retirementize and see how guaranteed income and your investment savings can work together throughout retirement.

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