Life annuities: Consider liquidity risks

In the 1980s, investors benefited from sky-high interest rates. But now, it’s harder to help clients plan for retirement and draw from their portfolios as they age, says Richard Johnson, CFP, an advisor at Assante Estate and Insurance Services in Antigonish, Nova Scotia.

“This is true whether people are in a tight [financial] situation or not,” he adds. “But where [someone is] on a fixed-income and strapped for cash, liquidity is extremely important.”

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It’s also key to help clients get as much income as possible while cutting down on risk. One way to achieve this is through using products like GICs and annuities.

But say a client only has $100,000. In that case, Johnson says, “I’d be less inclined to look at GICs. And while you can back up annuities with insurance policies, you’re likely not talking about doing something like that with a [cash-strapped client].”

Planning analysis: Life versus term-certain annuities

Rather than focus on GICs and life-only annuities, Johnson suggests looking at term-certain annuities. Here’s his analysis of how such annuities could be used.

Male client, aged 70

“I looked at the best rates for an annuity for a male aged 70 and found [such a client] could receive $604.99 per month with a $100,000 life annuity, and that’s with no guarantee. That would mean about $7,259 per year, or a 7.25% running yield on the annuity.

“But if he died after getting his first payment, then his money would be gone. Most people don’t like that scenario,” he adds.

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“Instead, [this client] could look at a term-certain, 10-year annuity,” says Johnson–although it’s key to remember that such annuities must end before an investor’s 91st birthday. Over the 10 years, this client could get the same income per month as with the life annuity (about $605 a month, with no guarantee) for a total cost of only $67,147.

Then, he’d have $32,853 left over, meaning he’d have liquidity, Johnson adds. And, “If he invested this money at 3% over the 10 years—using a conservative, balanced portfolio with dividends and a tax-efficient vehicle—he could get about $44,000. He could choose a balanced fund or mutual fund that invested in banks, for example, rather than go buy individual stocks.”

At age 80, this client would be nearing his life expectancy. And at $600 per month, his remaining $44,000 could last about another six years, provided he doesn’t have unexpected or additional costs, says Johnson (this calculation doesn’t account for inflation, for simplicity).

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Female client, aged 70

Men get more money out of annuities because they have shorter life expectancies, says Johnson. “A woman’s payment for a $100,000 life annuity would be $536.39 per month because of her longer life expectancy. So she would get about $6,436 per year, or 6.4% running yield.”

Still, a term-certain annuity could be a preferable option if she’s low on cash but wants low-risk income. With a term-certain annuity, she could get the same monthly income as with the life annuity (about $536) for 10 years at a total cost of only $59,897, he adds.

By choosing the term-certain annuity, “This client would have $40,012 left over [that] she could invest at 3% for 10 years in the same manner as the male client. Then, she’d have $53,772 at age 80.”

He adds, “The negative side is this woman would then be 80 years old and her income from the annuity would stop.” So, he says you’d have to decide what to do with her remaining $54,000 to ensure she continues to have reliable cash flow—without investing the money, she’d have enough income for about eight years (this calculation doesn’t account for inflation, for simplicity).

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His conclusion

Term-certain annuities aren’t the perfect answer, says Johnson. “But with seniors, there are so many things that can happen where they need access to money, including medical emergencies. Liquidity must be considered.

“[Both] life and term-certain annuities have their place, but the latter shouldn’t be overlooked,” he adds. Overall, he finds clients are reluctant to lock in their money at low interest rates, especially since “annuity payments are matched, in some degree, to bonds. You may want to lock in your mortgage payments, but not your investments.”

Still, fear of the unknown is a big issue, Johnson notes. “That’s why the annuity seems comfortable. But if you don’t have liquidity, then that’s a risk. Buying a life annuity at this stage requires some hard thinking,” even though people are living longer.

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