In the continuing low-interest-rate environment, your clients could be waiting for interest rates to rise before they consider investing in fixed-income investments and insurance products providing guaranteed lifetime income.
Do they know that interest rates affect payout annuity (including life annuity) income, but aren’t the only factor? For example, an interest rate increase to 2.5% from 2% does not mean a 25% increase in income.
To understand why, look at the three components making up each life annuity income payment:
- return of premium, and
- insurance credits.
Now consider the following graph illustrating a 65-year-old man investing a $100,000 lump sum into a registered life annuity. He’s guaranteed an annual $5,659.00 (after-tax) income payment for life:
With Canadians living longer,1 more of your clients could benefit significantly from owning a life annuity in later years, since insurance credits make up most of the income. In earlier years, interest and the return of premium make up most of the income.
It’s important your clients understand the insurance company guarantees future payments from life annuities, for as long as they live. They’ll be more confident those payments will last, if they come from a strong, stable, well-capitalized, and well-established organization.
When waiting isn’t wise
Life annuities can provide great value. So why aren’t they part of more Canadians’ retirement income portfolios?
Your clients may be thinking, “Interest rates are too low — I want to wait until they improve.” Some economists have dubbed this dichotomy the “under-annuitization puzzle … It is easy to blame low interest rates, which depress the amount of annuity income one can buy these days. But annuities were not in vogue even when interest rates were much higher” many years ago.”2
If some of your clients require a guaranteed level of income from their investment portfolio, leaving investments exposed to market volatility while waiting for interest rates to move could be detrimental to their financial well-being.
Example – a 65-year old-male client with $100,000 of registered money thinks interest rates will go up 1% over the next five years, so he decides to delay the purchase of an annuity for five years.
A $100,000 registered life annuity purchased now would generate $4,750 of after-tax income every year (assuming a 30% tax rate).
If the client instead chose to invest the $100,000 in a portfolio split 60/40 – equity/fixed income, and take $4,750 of after-tax income, the portfolio would have to generate at least 3.9% every year to ensure the client could purchase an annuity at the end of five years that would generate $4,750. Looking at past market performance, there’s an 8 out of 10 chance the client would achieve this, but if they didn’t, the average impact on income would be a decrease of $350 per year.
If the client uses non-registered money instead, the impact could be greater. The $100,000 would generate $6,400 of after-tax income with a life annuity.
The 60/40 – equity/fixed income portfolio would have to return at least 6.8% every year. The likelihood of the portfolio achieving that is 4.5 out of 10, and the average impact on income would be a decrease of $850 a year.
You can help your clients gain a better understanding of the benefits and risks of interest rate changes by creating your own analysis with the Buy now, buy later tool. Sign in at sunlife.ca/advisor and access the Money for Life web app from the Quick links menu.
Could interest rates rise? Of course they could, even though they haven’t increased significantly in the past few years. Instead of waiting until they do, as a good place to start the guaranteed income conversation, look at allocating 25% of their retirement savings to purchase a life annuity, and then adjust according to their income needs.
“Consider creating a retirement portfolio with a combination of products across life, health, and wealth to enable clients to maintain their financial well-being throughout retirement,” said Rocco Taglioni, Senior Vice-President, Individual Distribution and Marketing, Sun Life Financial. “On the income and investment side, a life annuity — along with CPP, OAS, and any pensions your clients have — can create a guaranteed income stream to cover basic expenses. Then you can add products such as a diversified portfolio of mutual funds to address the growth and inflation aspects.”
Many Canadians don’t understand how annuities work. In a survey released this year, more than 6 out of 10 Canadians said they don’t understand what life annuities are, or how they can anchor a retirement portfolio.3 “There’s a real opportunity here for advisors to educate their clients about the benefits of purchasing a life annuity now, rather than waiting for interest rates to rise,” said Taglioni.
1 Jean-Claude Ménard, Canada’s Chief Actuary, reports many Canadians will live longer than age 90. “Canadians face more years of saving, work as chief actuary increases life expectancy,” Financial Post, April 16, 2014.
2 Fred Vettese, “Annuities: The best financial product no one really wants,” Financial Post, September 4, 2012.
3 2014 Sun Life Canadian Unretirement Index. When asked, “How well do you understand how life annuities work?”, 62% of respondents answered, “not at all well.” 61% of respondents were not sure if they would consider buying a life annuity at any stage of life as a guaranteed retirement income option.