Set it up and leave it alone. That’s the dream of every investor: a low-risk, high-yield investment that provides a guaranteed payment. Thanks to prescribed taxation, the power of arbitrage, and low interest rates, there is such an investment: the back-to-back annuity.
“In a world that’s gone mad with volatility, isn’t it nice to be able to offer an exact amount of money and know it’s not going to change?” asks Bruce Cumming, president of Cumming and Cumming Wealth Management in Oakville, Ontario.
And that amount isn’t too shabby: right now, a healthy 65-year-old male can get 7%- to-8% return using a back-to-back. “If a bank offered you a 7% GIC for the rest of your life, would you be interested?” says independent actuary Ashley Crozier.
A back-to-back annuity, also known as an insured annuity, combines a life-only annuity with a guaranteed life insurance policy (usually term-to-100 or whole life). The face value of the life insurance is the same amount used to purchase the annuity, which provides monthly fixed-dollar payments to the annuitant. (If the annuitant dies sooner than expected, the insurance company doesn’t have to pay out as many monthly payments, so the overall value of the annuity becomes lower.)
Regardless, the life insurance policy guarantees a tax-free return of the annuity’s purchase price to a beneficiary.
The advisor has to be insurance-licensed to sell a back-to-back, and the client must be healthy enough to be eligible. “Procedurally, we always [apply] for the life insurance first to make sure the client qualifies,” says Cumming. But this separation of the two contracts actually leads to the inherent benefit of the back-to-back. Since different mortality tables apply to the annuity and the life insurance, an arbitrage situation exists. “Because of underwriting, the life insurance company thinks the person is going to live longer than the annuity insurer does,” says Crozier.
The older the client, the higher both the fixed monthly payment for the annuity and the life insurance premium. Cumming says the sweet spot, age-wise, for maximizing the benefits of single-life back-to-backs is when a client is between 65 and 75. “That’s where it’s magic,” he says. Since males have a lower life expectancy, their insurance premiums are higher, but so are their fixed monthly payments, and they get the better after-tax rate of return than their female counterparts.
If both spouses are healthy, they can obtain a joint-life back-to-back annuity. This has the best rate of return: the annuity fixed monthly payments are lower, and the insurance premiums are even lower.
Beverley J. Moir, Investment Advisor and Financial Planner with The MoirTEAM, ScotiaMcLeod, says her younger clients — that’s 60-year-olds — for whom a single-life back-to-back annuity would offer too low of a return can buy joint first-to-die annuities in order to take advantage of back-to-backs. “That way, you’re only locking in the money until the first death occurs, which could be in 20 years [instead of 30],” she says. “And you get a higher yield.”
Other types of back-to-backs include joint last-to-die annuities, which allow for ongoing fixed monthly payments after the first spouse’s death. “We do that for our older clients, because the yield is better for them,” says Moir, due to lower premiums than single-life policies. Also, if one spouse has health issues that would make him or her ineligible for single-life, the healthy partner can carry the policy.
Moir says back-to-backs are extremely popular with her clients. “Eighty percent of our business last year was insured annuities. They’re a hot item right now.”
Tax treatment means high returns
Back-to-backs involve prescribed annuities, which receive favourable tax treatment. Cumming gives the following example: Based on January 28, 2011 annuity and insurance rates, if a 65-year-old male in the highest marginal tax bracket purchases a $100,000 single-life back-to-back, he’ll receive $8,076/year in annuity payments.