Globe and Mail: How A Back-To-Back Annuity Can Boost Cash Flow In Retirement

Jan 9, 2015

What if you could increase after-tax investment income by a third with virtually no risk? This would be especially appealing for retired people with a low appetite for risk who rely on taxable interest income to cover their expenses.

Depending on your circumstances, you might be able to do just that, thanks to a tax-smart investment strategy known as back-to-back or insured annuities. It works best for people in their 70s who are in the highest marginal income tax bracket with more than $100,000 to invest – the more the better – but who want to preserve their wealth for their children or favourite charity.

You buy an annuity that gives you a fixed, guaranteed income for life, backed by an insurance policy that allows you to pass on that same amount to your beneficiaries.

The key is to buy what is called a prescribed annuity, which offers a substantial tax advantage over guaranteed investment certificates for taxable accounts, or savings not held in a registered plan.

"Many people today are looking for guarantees," says Warren MacKenzie, a principal of HighView Financial Group in Toronto. The strategy also has the virtue of being simple, Mr. MacKenzie says. "Nothing is simpler than an annuity. It's like having a pension."

The problem with annuities, Mr. MacKenzie says, is that when you die the money is gone and there is nothing for your heirs. That's why the strategy bundles an annuity with an insurance policy.

Having a fixed, guaranteed income may look more attractive as the years go by and people no longer want to bother making investment decisions, planners say. In some cases, they may not be capable of doing so.

"As people get older, they sometimes lose the ability to make good investment decisions," Mr. Mackenzie says. So annuities of one type or another may be suitable for a portion of their savings. "You would never want to put all your money into an annuity because they offer no inflation protection."

With most annuities, the taxable portion of the payout is greatest at the outset. With prescribed annuities, in contrast, the taxable portion remains constant throughout the life of the contract so investors end up with more in their pockets after tax. Prescribed annuities are bought with funds that are not held in a registered account.

The effectiveness of the strategy varies with age, health and interest rates, planners note. With interest rates so low, annuities make the most sense for people in their 70s, when insurance can be costly and tough to get. At 75, for example, interest rates account for a third or less of an annuity's pricing, with age (life expectancy) being the main determinant. The proportions are reversed for people a decade younger.

"Always apply for the insurance policy first to make sure you can get it," says Jason Pereira, a financial planner at Bennett March/IPC in Toronto. The type of insurance policy chosen will vary with a person's circumstances, with the least expensive being term to 100. Other people may prefer whole life or permanent insurance.

"The benefit [on the annuity side] of being older outweighs the additional cost of the insurance policy," Mr. Pereira says. Annuity payouts rise in line with a person's age.

The strategy makes sense only for people who want to leave a legacy, Mr. Pereira adds. It works despite the insurance costs because of the favourable tax treatment afforded prescribed annuities.

A useful illustration of the strategy's mechanics can be seen on the Sun Life Financial website. The case study looks at a couple, ages 64 and 68, who have work pensions, registered retirement income funds and substantial non-registered savings in the form of guaranteed investment certificates and Canada Savings Bonds.

Although they have enough savings to last a lifetime, they want as much risk-free income as possible so they can travel more and still leave their capital intact for their children.

So they take $500,000 of their $800,000 in non-registered savings – interest on which is fully taxable – and buy a back-to-back annuity and a $500,000 joint and last to die universal life insurance policy. That way, they still have $300,000 available for increased spending or emergencies.

Even after paying the insurance premium, they end up with more after-tax income. The example uses a marginal tax rate of 45 per cent and a 4 per cent GIC rate.

With their GICs, they earn $20,000 a year. After $9,000 in income tax, this shrinks to $11,000 net. With the insured annuity strategy, they get $27,209 a year. Income tax is only $2,603, leaving $24,606 net. Subtract $9,816 in insurance premiums and they still have $14,790 a year – 34 per cent more than with the GICs, equivalent to a 5.4 per cent GIC rate. The $500,000 insurance policy is paid to their beneficiaries when they die.

With interest rates at historic lows, insured annuities don't offer the same bang for the buck as they used to, Mr. Pereira says. Super-low interest rates affect both annuity returns and insurance costs, he notes. Not only are annuity payouts lower, insurance policies are pricier.

"The reality is that in the current marketplace, this strategy is not as attractive as it used to be."

Even so, it may make sense in certain circumstances. Mr. Pereira offers the example of a 75-year-old woman with half a million dollars invested in GICs yielding 2.5 per cent and a 40 per cent marginal tax bracket. After-tax, the GICs would net her $7,500 a year. With the insured annuity, she would get $10,308 a year after tax and insurance premiums.

"That works out to the equivalent of buying a GIC paying 3.4 or 3.5 per cent," Mr. Pereira says.

Apart from increasing income, prescribed annuities can help avoid potential clawbacks of Old Age Security benefits because the taxable portion of the annuity is lower than the GIC interest would be, advisers say. As well, the annuity payments qualify for the pension credit.

The strategy is not without weak spots, planners say. Inflation will erode the value of the annuity payouts over time, and rising interest rates in the future will make existing payouts look skimpy. If, 10 years from now, GICs look more appealing, you can't change your mind. The money is gone.