Salting away money in a registered retirement savings plan is a popular way for Canadians to save for retirement. The 2016 census found that 35% of all Canadian households contributed to RRSPs. For those in peak earning years, the rate was even higher: nearly half (46.4%) of households with a major income earner aged 35 to 54 contributed. In 2015 alone, RRSP contributions totalled just over $39 billion, according to Statistics Canada.
Eventually, all this RRSP money will need to find a new home. An RRSP must be closed down by the end of the calendar year that the plan holder turns 71. At that point, the holder has three main options.
The most popular option is to convert the RRSP to a registered retirement income fund. RRIFs are flexible. Holdings can usually be transferred directly from an RRSP. The plan holder decides on the investments, and manages the cash flow. The amount withdrawn can be varied as long as the mandatory annual minimum is met.
Another alternative is to withdraw the RRSP assets. This is not a common choice because income tax will be due on the entire amount taken out in the year of withdrawal.
The third option is to use the RRSP money to buy an annuity. This is an insurance product which provides a regular guaranteed income for a specified period, usually the rest of the annuitant's life. Various features allow the annuity to be tailored to individual circumstances. For example, those with reduced life expectancy may be able to purchase an "impaired" annuity which provides higher income. Once purchased, annuities are irrevocable.
Both RRIF withdrawals and income from a registered annuity are taxable.
RRSP funds are not often used to purchase an annuity. Financial advisors tend to recommend RRIFs because they receive an ongoing stream of income for overseeing a client's RRIF instead of a one-time commission for selling an annuity, or no compensation at all if the client buys elsewhere. Yet, an analysis of the pros and cons of annuities suggests that an annuity may be the best way for retirees to deploy at least some of their RRSP funds.
One of the most useful attributes of an annuity is its capacity to address longevity risk, which is the risk that you will outlive your money. This is a real concern for retirees, given that Canadian life expectancies are long and continue to rise. At age 65, the average life expectancy is 86.9 years for women and 84 years for men, according to Statistics Canada data for 2011-2013. Centenarians are the fastest-growing population in Canada, according to the 2016 census.
Members of a defined-benefit pension plan or those in line to receive a healthy retirement income from other sources may not be concerned about longevity risk. However, most Canadians have no pension, or belong to a defined-contribution plan which has no pension guarantees. Their other sources of income are likely to be limited to Old Age Security/Guaranteed Income Supplement and perhaps a partial Canada Pension Plan. These retirees could outlive their retirement savings. Using RRSP funds to buy a life annuity solves their dilemma.
A life annuity helps simplify your life and give you peace of mind. There are no further decisions to make, and your income will arrive regularly for as long as you live.
Even so, some retirees balk at buying an annuity because the income received per dollar paid to the insurance company seems too low, because of today's interest rates. Instead, they set up RRIFs and manage their retirement money themselves.
There are two main reasons why an annuity may be a better choice than a RRIF. Some equity investments are likely to be necessary to generate sufficient income from a RRIF in this low-interest-rate world. With equities, there are normally no guarantees regarding rates of return or preservation of capital. You get to worry about making the right investment decisions, whether stock-market volatility will ruin your retirement plans, and whether you will run out of money before you die.
You may continue to be confident in your ability to manage your retirement funds, but research suggests that the risk of making a bad financial decision increases with age. A research paper by U.S. academics Michael Finke, John Howe and Sandra Huston found a consistent decline in financial-literacy scores after age 60, but no decline in confidence in financial decision-making abilities.
Annuities do have some shortcomings.
A basic annuity provides no inflation protection. For a substantial reduction in the annuity payment, some insurance companies offer an indexing feature which increases payments annually by a chosen percentage of up to 4% for registered annuities.
Another disadvantage is that a basic annuity ends at the annuitant's death, leaving no money for heirs. This can be partially countered by purchasing a joint-and-last-survivor annuity that provides payments for as long as either spouse is alive. Another alternative is to buy an annuity that guarantees payments for a specified period. If the annuitant dies within the guarantee period, her estate receives the remaining payments.
Perhaps the best way to deploy RRSP funds is a combination of one or more annuities and a RRIF.
The annuities would cover fixed living expenses such as food, shelter and clothing. Annuity purchases could be staggered over a number of years, much like building a bond ladder, to manage interest-rate risk. The remaining funds would be transferred to a RRIF and invested in a portfolio that includes equities. The RRIF should deliver a positive return after inflation, and probably leave some money for heirs.
Financial advisor Warren MacKenzie, author of Zen and the Art of Wealth, suggests a variation on the above approach for a retiree without a pension: Buy an annuity with the fixed-income allocation of the portfolio and invest the rest inside a RRIF. He says that an annuity can also be used to provide additional diversification in some portfolios.
An annuity offers retirees a guaranteed income for life, simplified finances, peace of mind and protection against bad financial decisions and the vagaries of equity investments. It should be on your radar screen when deciding what to do with your RRSP money.
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