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.
However, only $2,050 is taxable because the CRA considers the remainder as a return of the client’s capital. In addition, he’ll pay an annual insurance premium of $3,039, meaning his after-tax income is $4,086. That’s an after-tax rate of return of 4% on the $100,000. The equivalent GIC interest rate would have to be 7.6% to provide the same return — but as of March 1, the highest rate in the country for a five-year GIC was 3.53%.
“A back-to-back [provides] non-registered money, and it sings so beautifully because of the tax treatment,” says Cumming. Moir agrees: as a result of the tax treatment on the prescribed annuity, some of her clients can reduce their annual taxable income so that it falls below the threshold where they would incur OAS clawbacks.
The prescribed tax treatment also allows back-to-backs to provide an alternative to the lower returns of other fixed-income vehicles. “The bane of [an advisor’s] existence is fixed income,” Cumming says. He points out many advisors tout an average annual portfolio return of 6%-to-8%. With only a 3.5% return on fixed income, equities and other investments have to outperform to compensate. “For the same level of risk, why not make 7%-to-8% [on] your dollars allocated to fixed income?” asks Cumming.
Advisors should note returns are highest if the client is in the highest marginal tax bracket. While the net income is higher under a lower marginal tax rate, the interest rate on the equivalent GIC (or other fixed-income product) required to make the same return is lower.
Leave it behind
The insurance aspect of the back-to-back works well for estate planning purposes since the client names a beneficiary of the insurance payout. “That avoids any probate fees. It can be credit-protected while the client remains alive, and it also goes directly to the named beneficiary,” says Crozier. “Therefore it cannot be challenged by anyone, like a will can. And the money gets settled quickly.”
The beneficiary also receives the funds tax-free. “It’s more of a wealth preservation tool than a wealth or estate maximization tool,” says Moir, since the client leaves the beneficiary the same amount as the purchase price of the annuity.
As Cumming alluded to earlier, this type of certainty is one of the strongest hallmarks of a back-to-back. “The greatest thing I can tell you about an annuity is you never have to look at the newspaper to see how it’s performing,” he says. “Once they’re in place, there’s no paperwork, no annual review, no dealing with minions and clerks. It’s great. And by definition, you can’t outlive your income.”
Still, back-to-backs aren’t for everyone. “They work for healthy seniors at the highest marginal tax rate who have over $100,000 and are willing to lock it up for the rest of their lives,” says Crozier. “The economies of scale don’t [exist] at smaller amounts. Even $100,000 is at the low end. The more you invest, the higher the rate of return on all of the money.”
And the trade-off for the certainty is inflexibility. Once the back-to-back is in place, you can’t change it, which makes some advisors and clients squeamish. “With a GIC you can wait the three-to-five years and get the money back, whereas there’s no opportunity to do so on the insured annuity,” Crozier explains. “What if interest rates go up?”
A matter of interest
Back-to-backs do look good in this interest-rate environment. But once long-term rates rise above 7%, back-to-backs become less attractive and clients may be hesitant to commit to a financial instrument that could last 25 years. So is this the wrong time to be recommending this strategy?
“Interest rates are going to rise at some point. By how much and how quickly, we have no idea,” says Moir. “You’re able to get a 7% return in a low-interest-rate market [now]. GIC [interest rates] would have to skyrocket for a client to fall behind.” She recommends putting only 25%-to-30% of a client’s portfolio into a back-to-back so not all of a client’s fixed-income assets are in one place, in case interest rates do shoot up. “Also, when we write our client proposals, we have a GIC- or a bond-fluctuation page that shows us how far ahead or behind a client would be [by locking into a back-to-back now] if interest rates go up.” This then lets the client make an informed decision.
“By saying it’s the wrong time, it’s like an advisor telling a client to time the stock market,” says Cumming. “If you can get a cash flow of 7%-to-8% today, that’s not a low interest rate. If you want to wait, you have to be making 7%-to-8% while you’re waiting. And you can’t get that. A safe investment where you won’t lose anything? I can’t get anyone 7%.”
Crozier agrees. “I’m really surprised why more don’t [purchase annuities]. But hey, I’ve been surprised about it for 25 years. Some things never change.”
Indeed. In the early 1990s, when interest rates started to drop from 11% to just below 10%, Crozier was promoting a back-to-back that would have given one particular client the equivalent of a 14% interest rate. Thinking rates would go back up, he only invested a relatively small amount into that annuity. “In subsequent years rates have continued to drop,” says Crozier. “Every now and again I see that client on the street, and he says to me, ‘I should have listened!’ ”
Though small, there are some risks associated with back-to-backs. The entire process hinges on the insurance proceeds being paid out upon death, which happens in the vast majority of cases. But the proceeds, cautions Crozier, “are not paid out in the case of suicide in the first two years, in the case of misrepresentation in the first two years, and in the case of fraud on the underwriting application regardless of when death occurs. While that risk is small, maybe +/- 1%, it still exists.”
Moir points out annuities used in back-to-back strategies are typically not indexed for inflation, another reason she recommends a less-than-30% allocation. “You can buy an annuity that increases with inflation, but the yield at the beginning isn’t as great, and then you’re getting an average yield over time,” she says.
Moreover, the favourable tax treatment of prescribed annuities may not last. “The issue on annuities is the amount of taxable income on a prescribed annuity is based on old mortality tables that assume people are going to die by an average of age 80, when in reality people are living longer than that,” Crozier points out. “What that means is less of the income is taxed than what should be coming out of the annuity.” Crozier says the risk of Finance changing the rules with detrimental impact for in-force cases is also low, and there are currently no motions before Parliament related to the tax treatment of annuities.
Despite the overwhelming benefits, some advisors are still wary of annuities. “I bet if you talked to 100 advisors, 90 would say, ‘Ugh, horrible time to be buying annuities,’ because that’s what they’ve always heard,” says Cumming.
And then there are the compensation implications: if a client locks up money in a back-to-back annuity, that money isn’t in play for investing. Commissions, while ongoing for mutual funds, offer a one-time payout for annuities.
Cumming says annuities will continue to grow in popularity for two reasons: lower-than-expected saving rates among clients, and advisors’ inability to deliver consistent, 8% returns. “The equity markets over the last 10 years have not allowed us to make any money,” he says.
Moir’s team has told its advisors that offering back-to-backs is in the best interests of clients. “What is better, getting 7%-to-8%, or 3%? A lot of our advisors realize this is a good fixed-income alternative,” she says. “And ultimately, if they’re not presenting it, someone else may. I’ve had clients call me up and thank me. I’ve had clients come back and buy more because they see how well it works.
“This is more of a holistic plan versus just a transactional business that a lot of [advisors] were used to 10, 15 years ago.”