Another Retirement Income Tool

Many people profess to hate life insurance.  Many of those also hate life annuities because if they died soon they would lose their capital.  Strange as it seems, you cannot rationally hold both beliefs.

Suppose someone has some money and they have it very conservatively invested in gilt-edged bonds.  A bond is effectively a series of promises.  For a 10-year bond with interest payable semi-annually there are 21 promises.  20 of them are the promise to deliver a small check each six months and one larger promise to return the capital 10 years hence.  A 30-year bond is the same but with 61 promises instead.

People buy bonds like this because they value the promises.

On the downside the interest is taxed at high rates and the value of the remaining promises fluctuates in value.  For those that intend to hold the bond to maturity, the fluctuation is irrelevant.

From a future income viewing point, bond income is unknowable beyond the maturity date.  For many people that is not important but for some, those of advanced age, predictability is a value and the uncertainty may not be pleasing.

For those, two bad things may make a good thing.

If they own both a life annuity and life insurance they will have created a lifetime bond.  Think it through in terms of the promises.

In the beginning they invest capital, just like buying a bond, but in this case they acquire a life annuity with no guarantee period.  (Only for simplicity here.  Many companies won’t even issue one)  At the same time, (actually slightly before) they arrange life insurance for the same amount as the capital in the annuity.

The result is a series of promises again.  Payments from the annuity at regular intervals net of payments to pay for the insurance.  Just like interest from the bond.  At death, the insurance returns the capital, just like a bond at maturity.  The insurer is neutral in all this.  The total of their reserve for the annuity and the reserve for the insurance is a constant.

This structure is taxed advantageously and the after tax, after premium, spendable cash will be higher than it would be using a bond.  Sometimes quite a lot higher.  I had a client die recently and her after-tax gain compared to a bond or investment certificate over the 25 years or so she owned the structure exceeded the capital employed in the beginning.

More income for given capital works for many, but there are other advantageous situations.  It is a way to free some capital without affecting cash flow.  It is a way to protect a second spouse.  It is a way to increase an estate.

It is not for everyone and it is not for all of one’s capital.  When it is workable, it provides a secure, predictable, relatively high yield stream of spendable income.

In Canada there is a change coming in 2017 to the “prescribed annuity” rules and that will affect some of the new plans.  Adversely of course; after all it is a tax thing. 

If predictability and yield matters, you might want to give it some thought now.

Don Shaughnessy is a retired partner in an international public accounting firm and is now with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.


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