PanFinancial Group News
Wealth Care Strategies: Preserving capital, securing regular income for older clients
Investing in an insured or back-to-back annuity can be an effective financial planning strategy for clients seeking a guaranteed stream of income for life while keeping the value of their capital intact for their heirs.
This strategy entails investing in an annuity to provide regular income and buying an insurance policy to preserve the value of the investment for the next generation.
“Insured annuities make a great deal of sense for people who are over 60, in a high tax bracket and are looking for a guaranteed stream of fixed income without having to make ongoing investment decisions,” says Philip Kung, president of Markham, Ont.-based RGI Financial Services. “They offer safety and a relatively high yield compared to cash, guaranteed investment certificates, treasury bills and money market funds.”
Insured annuities are more appropriate for older clients because the investment is locked in for the life of the client. It would not be prudent, however, for a 40 year old, for example, with a life expectancy of 85 to tie up his or her funds for an extended period of time.
And because an insured annuity has the potential to reduce taxable income, it is more suitable for clients who have investable non-registered funds that generate income that would be taxed at a high marginal tax rate.
Typically, a client would use the proceeds of a non-registered fixed-income portfolio comprising interest-bearing guaranteed investments or cash to embark on the strategy, says Kevin Wark, senior vice president of business development in the Toronto office of PPI Financial Group. “The annuity offers potentially higher returns as well as preferential tax treatment on the income received.”
“The good thing,” says Kung, “is that the insurance component of the annuity ensures that the capital is preserved for the estate, regardless of how much is paid out as income over the life of the client.”
An insured annuity involves the purchase of two contracts — a life annuity and an insurance policy. The client buys the annuity, which provides a regular stream of income for as long as he or she is alive.
Although annuity payments will typically cease upon death, the terms and conditions of some annuity contracts may allow for them to continue to a named beneficiary for a defined guaranteed period if the client dies within a specified timeframe.
The annuity contract can be set up on the life of the individual or his or her spouse on a joint last-to-die basis. Usually, it is a permanent contract that cannot be cashed in or transferred to another party.
The second contract involves the purchase a life insurance policy with a death benefit equal to or lesser than the capital invested in the annuity, depending on the client’s specific needs. The life insurance contract is usually a Term 100 with constant annual premiums, no cash surrender value and a level death benefit. Premiums will cease at age 100 if the client is still alive but the insurance coverage will continue. The cost of the insurance is generally deducted from the cash flow of the annuity.
“With this arrangement, there is no need to prepay the premiums so that the policy will become self-funding at some point in time,” says Kung. “Therefore, the client does not have to make any further cash outlay.”
“It is generally recommended that the client obtains the insurance policy prior to the annuity contract. This is because acquiring insurance is subject to insurability, which is determined by health and other factors,” says Wark. “By acquiring the insurance first, the client will ensure that the capital invested in the annuity is secure at death.”
Wark adds that the common technique is to place the insurance with one carrier and the annuity with another. Although this is not always necessary, it is important to note that the issuance of the life insurance contract cannot be contingent upon the purchase of the annuity contract. Both contracts must be written as separate contracts or they would otherwise not benefit from preferential tax treatment by the Canada Revenue Agency.
Insured annuities benefit from favourable tax treatment because the client normally purchases a prescribed annuity,says Geoff Burman, president of Burlington, Ont.-based Broker Advantage Inc. With prescribed annuities, the tax is averaged over the lifetime of the annuity, providing an element of tax deferral. “They are not subject to accrual taxation rules [as applied to non-prescribed annuities], through which interest is taxed as earned — higher in earlier, lower in later years,” says Burman.
Rather, says Wark, “the total income expected to be earned over the entire life of the contract is spread over all payments.”
Mortality/annuity tables are used to determine the payout and return on capital/income split, heads. The even spread of interest income makes the payments received from a back-to-back annuity more favourable than that provided by a portfolio of other fixed-income investments, even after deducting the cost of insurance. The following example, from Toronto-based AIG Life Insurance Co. of Canada, illustrates this point using the example of a 60-year-old male, non-smoker, with an investment of $250,000.
If the client invests the $250,000 in guaranteed investments earning 4.4% annually, he will earn an annual income of $11,000. Assuming that the client’s marginal tax rate is 45%, he will pay $4,950 in taxes, leaving him with a net annual after tax payout of $6,050.
If the client purchases an insured annuity with the $250,000, he will receive an annual income for life of $18,073 (based on annuity/mortality calculations) of which $6,054 is subject to tax (based on average income on prescribed annuity payments);
the remainder is return on capital, which is not subject to taxes. The client would, therefore, pay $2,724 in taxes, assuming a 45% marginal tax rate.
The cost of insurance, using a Term 100 policy is $4,990, leaving the client with a net annual after-tax payout of $10,359 ($18,073 – $2,724 –$4,990). That’s $4,309 more than the $6,050 earned from investing in guaranteed securities.
Evidently, the insured annuity in this example, which provides a 71.2% higher annual after-tax payout, is a significantly better option for clients who have a lump sum to invest in an insured annuity.
“The only drawback is that the funds are locked in with an annuity, compared with a portfolio of guaranteed investments,” says Kung. “But the additional benefit is that with a back-to-back annuity, the client’s capital is protected through the insurance contract, and is passed on tax-free to his or her beneficiaries.”
“The younger you are, the lower the annuity payments,” says Burman. Conversely, adds Wark, “The older you are, the better it gets in terms of pricing the annuity which is based on mortality.”
Obviously, insurability will be the overriding factor.
Although insured annuities might be suitable for only some clients, the net result is a higher lifetime income stream relative to other fixed income investments, combined with the opportunity to leave an estate for heirs. IE