Insured annuities – tax effective income and estate protection

Most retirees have several sources of retirement income. The largest contributor to this income is typically a portfolio of investments. Retirees spend decades savings for the future and trying to maximize returns to build the largest possible nest egg. When investors shift from the accumulation phase (saving for the future) to the decumulation phase (spending the nest egg) different investment objectives emerge.

The number one worry becomes, “will I outlive my money”? Secondary, but no less important concerns are how to reduce income tax and how to generate steady, guaranteed returns. Risk tolerance plummets in the decumulation phase of an investor’s life.

The insured annuity concept addresses all of these considerations.  The strategy maximizes after-tax income from non-registered savings and preserves capital for heirs and/or charitable bequests. An insured annuity involves the purchase of two contracts from insurance companies, a life annuity and a life insurance policy.  The objective is to provide a better return on investment than traditional, conservative, taxable fixed income investments like GICs. Additional benefits can include creditor protection and avoidance of probate fees that come with life insurance products that name the appropriate beneficiaries.

Here is how it works

A specified amount of non-registered savings is used to purchase a prescribed life annuity. The annuity pays a regular stream of tax efficient income for the life of the investor. A portion of that income stream is used to purchase a life insurance policy that is paid to the estate (or named beneficiary) upon the passing of the investor. The end result is higher retirement cash flow than alternative fixed-income investments while still leaving an estate for heirs.

The preferred tax treatment of prescribed annuities and the tax free nature of life insurance death benefits drive the higher after tax returns. Payments from prescribed annuities are considered a combination of interest and capital, therefore, only a portion of the income is taxable. 

There are risks to consider though 

An insured annuity is a strategy that cannot be undone with the exception of cancelling the life insurance.As such, it is prudent for a retiree to have other sources of capital that they can draw on in the event of an emergency or change of circumstances that requires a lump sum withdrawal of assets.Annuities are like pensions in that you cannot request more than the monthly guaranteed income that the contract guarantees.

Returns on alternative guaranteed investments may increase.If interest rates on GICs increased dramatically in the relatively near future, the relative advantage of the insured annuity begins to erode from a financial standpoint. The advantages of simplicity and tax efficiency remain however.

• Poor health – You must be in sufficiently good health to obtain the life insurance. Before committing to the annuity purchase, it makes sense to apply for the life insurance first and ensure that the policy is approved at the expected premium level.
• Both the annuity and life insurance contracts should be purchased from different insurance companies.If purchased from the same insurer, CRA could consider them “one contract” and that would have negative tax implications.

In summary

The insured annuity strategy is not well understood and consequently underutilized.  Speak with us or your financial planner to assess if it makes sense for you.