Annuities Explained: What They Are and Why You Should Care

Annuities. What are they and why should you care? Did that make them sound intriguing?

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What is an annuity? I find a lot of people kind of know… but not really. It’s a contract with an insurance company where you give them a lump sum, and in return, they promise to pay you a regular income, often for the rest of your life. But you’re thinking, “What if I give them a big lump sum and then I walk out of their office and get hit by a bus?”

Ah, you’re gone. The money’s gone. Don’t laugh — actually, hope you didn’t laugh at that — it’s not particularly funny. That fear very much affects annuity sales. We’ll talk more about ways around that risk in a moment. And, yes, look both ways is always a good strategy. Now, you wonder, how is it determined how much income I get each month for each dollar I put in?

More or less, common sense. Your age is a factor — the older you are, the higher the monthly payout because of course, statistically the expected payout period is shorter. If my dad buys an annuity, he’ll get a big monthly payout because he’s like 126 years old. Interest rates at the time of purchase really matter.

The money you buy the annuity with is going to be invested primarily in Federal and Provincial bonds and high-quality corporates. When rates are higher — payouts are higher. You can see why annuities weren’t at all popular when rates were ultra-low from 2010-2021 ish. Other mortality assumptions also play a role.

For example, men die younger on average, so they get bigger monthly cheques. I can see that some of you devious people have your gears turning: “Hey, if they’re gonna give me more money if they think I’ll die younger, I’m gonna tilt my answers.” When they say, “Do you smoke?” I’m gonna say, “Like a chimney.” “Any dangerous hobbies?”

“Alligator wrestling. Strike that. Drunk alligator wrestling.” Not gonna work. For the most part, no detailed underwriting here. Though, there are some “impaired risk” annuities in special cases, if someone legitimately has a documented reduced life expectancy. Legitimately, not “like a chimney.” You can buy a joint life annuity and the payouts will continue until the second person dies. But, of course, the payments will be smaller.

You can add a guarantee period, say 10 years, and if you die before that the payments continue until the 10th anniversary of the purchase. Obviously, the longer the guarantee period, the lower the monthly payout. Makes good sense. Now, what do I like about annuities? 1) They’re simple. 2) They provide protection against outliving your money.

They limit longevity risk. 3) There’s no market risk. 4) Psychologically, they can really benefit people — lots of research on this. Knowing you have a certain amount of money coming through each month forever is soothing. For some people who don’t have a defined-benefit pension plan,

annuity income added to CPP and OAS makes them more comfortable. Happier even. So, why don’t we see them used more? Canadian consumers really don’t seem to like them. 1) We mentioned the “bus” fear. It is real. Guarantees can help but it still weighs on some buyers. 2) Interest rates are relatively low,

taking payouts down. 3) Control is given up and that’s often psychologically hard. 4) Many wanna leave as much money as possible to beneficiaries. And 5) Inflation fears — this is a big one! That $2,000 a month seems great now but in 22 years its purchasing power could be whacked.

Remember the people who would be buying annuities now (65+) — lived through the 70s. Are there indexed-to-CPI annuities? I’m not sure they’re still around, I probably should have Googled that, but even if they are, be very careful. Being the complete social loser I am, I once studied these carefully and the conclusion was this:

The actuaries, to limit the company’s risk, had baked in very high inflation assumptions — I don’t blame them — and that the odds then therefore turn great against the product being a wise purchase for people. 6) Another potential reason they’re not too popular is that they pay a smaller commission to the advisor than most other routes

he/she may recommend. You hear that criticism a lot, but honestly, I’m not sure it’s fair. Consumers seem almost afraid of annuities even when a good advisor says they’re a strong fit. So what do I think of all this? I may surprise you here. I’ve seen many situations where I think annuitizing a percentage, often a relatively small percentage, of a person’s portfolio makes sense.

The peace of mind, minimize the longevity risk. Hey, there are negatives, but those two positives are underweighted in too many analyses. But hey, I don’t have an annuity, and I’m not saying run out and get one. They are a tool though that has some very good use cases. No doubt. Annuities Explained What They Are and Why You Should CareStay open-minded.