Using Annuities To Create Your Own Personal Pension In Retirement

By Robb Engen | May 10, 2022 | Comments Off on Using Annuities To Create Your Own Personal Pension In Retirement
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Using Annuities To Create Your Own Personal Pension In Retirement

*Sponsored by RBC Insurance*

The reason why retirement planning can be so difficult is because the one variable we need to know – how long we have to live – is impossible to predict. Sure, we have mortality tables and family history to help guide us, but statistically speaking, half the population will outlive their median life expectancy.

That makes longevity risk – the risk of running out of money before you die – a very real threat to your retirement. And yet many Canadians ignore this threat by not saving enough during their working years, retiring before they’re financially ready, taking Canada Pension Plan benefits too early, withdrawing too much from their RRSPs, and so on.

On top of that, a global pandemic and recent economic uncertainty has had a significant impact on seniors and their retirement plans. RBC Insurance conducted a survey of Canadians aged 55-75 in March 2022. The survey data showed that:

  • One third (33%) of Canadians say they retired sooner than planned, or intend to change the date of their retirement because of the pandemic
  • Among already retired Canadians, more than one quarter (28%) are spending more than they anticipated, while four in ten (41%) have experienced unexpected expenses
  • As Canadians live longer the impact of inflation on their savings, expenses and purchasing power is the most pressing concern for the majority (78%), as well as a lack of guaranteed income (47%), outliving their savings (48%) or their spouse (38%), feelings of loneliness (36%) and not having a legacy to leave behind (25%)

Having enough money to support their desired lifestyle is a real concern, highlighted by the fact that nearly half (48%) of those surveyed are worried about outliving their retirement savings.

How Annuities Can Help In Retirement

One way to protect against longevity risk is to purchase an annuity. Annuities fell out of favour (if they ever were in favour) when interest rates plummeted over the past 10-15 years. But with interest rates on the rise, annuities are certainly worth another look.

An annuity provides a predictable income stream for life – much like how a defined benefit pension, CPP, and OAS pays benefits for as long as you live. Nothing protects you from longevity risk quite like having a guaranteed income that’s paid for life.

It’s puzzling why more Canadians don’t choose to turn even a portion of their savings into an annuity – to pensionize their nest egg, to borrow a phrase coined by financial authors Moshe Milevsky and Alexandra Macqueen.

Lack of knowledge around annuities may also be why only 7% of those surveyed are taking advantage of them.

Let’s break down some of the advantages:

  • You have the option to continue your payments to your spouse or beneficiary if you pass away during a certain time period.
  • Your payments are locked in the moment you purchase a Payout Annuity. You don’t have to worry about what the market does or where interest rates go. Your income is guaranteed.
  • It’s possible to invest in an annuity using your RRSP and/or RRIF savings, or non-registered savings.
  • When purchased with non-registered funds, the interest portion of your monthly payment is spread out evenly over the Payout Annuity’s life. This levels out your tax payments and minimizes the taxes you pay.
  • You can stagger your annuity purchases to help increase payouts.

Annuity Payout Rates (How Much Will You Receive?)

Speaking of payouts, I thought it would be helpful to see some examples of just how much income to expect from an annuity based on several different scenarios:

AgeGenderInitial AmountAnnual Payment
65Male$100,000$6,508
70Male$100,000$7,310
65Male$250,000$14,894
70Male$250,000$16,856
65Female$100,000$5,411
70Female$100,000$6,125
65Female$250,000$13,921
70Female$250,000$15,713

*Calculations made at https://www.rbcinsurance.com/annuities/index.html

I’ll be honest, I perked up when I saw the payout rates were between 5 and 7 percent of the initial deposit. Now, keep in mind, those rates won’t increase with inflation each year, but it’s still a healthy (and guaranteed) amount to receive for life.

I mean, why wouldn’t a relatively healthy 70-year-old male not want to turn $250,000 into annual income of $16,856?

The break-even age on that $250,000 investment would be 85 years old (84.83 to be precise). But a 70-year-old male has a 50% chance of living until age 89. By that time, he will have collected $320,264 in annuity payments. That’s impressive, considering he is receiving 6.74% of the initial balance each year.

Remember, we’re talking about protection against longevity risk. As tragic as it would be to get hit by a bus in the year you purchased an annuity, you won’t be around to curse the decision and, if you get a 10-year guarantee period, you’ve built in some protection for your beneficiaries.

RBC Annuity Payout

Quick Facts About Annuities

Your annuity income is determined at the time you buy the annuity and is based on several factors such as interest rates, age, and your life expectancy.

Your payments will be higher if current interest rates are high (and vice-versa).

The older you are when you buy the annuity, the higher your payments will be because you’re not expected to live as long.

Men will receive more money than women because they have a lower life expectancy.

There are many types of annuities, including:

  • Single life annuity – guaranteed income for the life of one person
  • Joint life annuity – guaranteed income for the lives of two people
  • Term certain annuity – guaranteed income for a set period of time

You can also customize your annuity to include:

  • A minimum payment guarantee if you (or you and your spouse) pass away before the end of the guarantee period (ranging from 1 to 25 years), remaining payments will be paid to your beneficiary
  • A return of premium guarantee where your entire premium deposit is refunded to your beneficiary if you (or you and your spouse) pass away before you receive your first annuity payment.

Under-spending In Retirement

One last thing on the annuity puzzle. Some proponents argue that annuities not only protect against longevity risk, but also the risk of under-spending in retirement.

A U.S. study found that roughly two-thirds of retirees who have $150,000 in savings at age 65 tend to spend no more than they receive from guaranteed income sources, such as Social Security and pensions. They’re afraid to spend the lump sum because they value liquidity.

An annuity, being a guaranteed income source, would make it possible to spend a bit more freely in the early years of retirement.

Final Thoughts

Annuities can play a vital role in your retirement planning by helping to mitigate the threat of outliving your money while providing a predictable income stream for life.

I’m not suggesting you turn every penny of a million-dollar portfolio into an annuity but carving out a portion to create your own personal pension will add another valuable and guaranteed income stream that you never have to worry about managing in retirement.

RBC Payout Annuities are provided by RBC Life Insurance Company.

 

Weekend Reading: Update From Italy Edition

By Robb Engen | April 23, 2022 |
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Florence

Buongiorno! We’ve spent two glorious weeks in Italy, arriving first in Rome before moving on to Florence and Venice. Three very different, yet equally amazing cities!

I loved the history of Rome. We toured the Colosseum, the Roman Forum, and the Vatican, ran through Circus Maximus and along the Tiber, tossed a coin into Trevi Fountain, and climbed the Spanish Steps.

Florence stole our hearts with the spectacular views from Piazzale Michelangelo and inside Boboli Gardens. Pictures cannot properly capture the experience of standing in front of the Duomo, or at the statue of David. A truly remarkable city.

We stayed in Florence over Easter, and it was insanely busy. We attempted to view the exploding Easter cart (Google it) but ended up on the wrong side of the square in a crowd. It sounded amazing, though!

Then we spent three magical days in Venice – which was a dream come true for me. We took the kids on a gondola ride across the Grande Canal (under the Rialto Bridge) and through the many small canals that flow through the city. We got lost in the many side streets (alleys). We toured Doge’s Palace, walked through the Bridge of Sighs, and climbed St. Mark’s Basilica for a breathtaking view of Piazza San Marco.

Piazza San Marco

Yesterday we took a train from Venice to Arezzo and then rented a car to drive to our final destination – Cortona – to spend a week in Tuscany.

Even though we’ve been on a 32-day trip before, three weeks is still a long time to travel and we were feeling burnt out yesterday. It will be nice to relax in our quiet hilltop house for the rest of our trip.

Cortona

A magical view, even in the rain last night

It has been so nice to be able to travel again and see such amazing places in Italy. We’re looking forward to a relaxing stay in Tuscany before heading back home next weekend. In the meantime, feel free to follow along on Twitter where I’ll semi-regularly update this thread:

What I’ve Been Reading:

I shared my thoughts about how young investors should handle their first taste of market volatility for this Toronto Star article:

“The challenge, he said, is that investors want all of the upside in a good market and none of the downside in a bad market, which can cause investors to overestimate their risk tolerance in bull markets then panic when their investments fall in value.”

A terrific video from Dimensional to give some perspective on short-term investment performance. Investors can focus on the daily rain clouds and sunshine the markets bring. Or they can think about the long term.

“You go to a sunny climate because, on the whole, you expect nice weather. But, even in a tropical paradise, it will rain from time to time. Global markets have been bumpy so far in 2022. Investing for the long term means breaking out the umbrella from time to time. It doesn’t mean that the rain will last forever.”

Andrew Hallam on why your investment results sometimes have little correlation with the intelligence of your plan.

Here’s PWL Capital’s Justin Bender explaining the math behind why passive investors MUST beat active investors:

A great article by Nick Maggiulli at Of Dollars and Data on why you’ve been thinking about inflation all wrong.

Here’s Nick Maggiulli again with an op-ed at CNBC arguing that high inflation won’t hurt stock returns in the long run.

Why a mere 2% allocation to cryptocurrencies in an otherwise diversified portfolio will account for 25% of your overall portfolio volatility.

Rob Carrick says it’s time for banks to reverse a rate grab from 2015 that punishes borrowers to this day (looking at you, TD).

A really good piece by mortgage broker David Larock on the Bank of Canada’s 0.50% rate hike:

“Variable rates are still available at discounts of more than 1% over their fixed-rate equivalents, and I continue to believe that they have the potential to save borrowers money over the next five years.”

I’ve been getting a lot of questions from readers asking if they should change their investment strategy, or lock-in their variable rate mortgage because of everything going on in the world.

For the record, I’m still invested in 100% VEQT across all accounts. I’m still in a variable rate mortgage. What was sensible three months ago or three years ago is still perfectly sensible today.

I love how Andrew Hallam connects financial freedom and happiness, and in this piece he explains why some FIRE devotees really miss the mark when it comes to their goals.

Why you might need to update the executor in your will as you get older. Makes good sense.

Finally, these cautionary tales about investing in private mortgages seem to come up all too often. Here’s one that collapsed, affecting 500 homes and $10 million in investor money.

Ciao – enjoy your weekend!

How To Invest During High Inflation

By Robb Engen | April 2, 2022 |
Posted in

How To Invest During High Inflation

It’s common for investors to be concerned about inflation because it brings to mind the high inflationary period of the 1970s that completely wrecked stock and bond returns. It’s also easy for investors to draw spurious conclusions about government debt and linking that to the hyperinflation that occurred in Zimbabwe or Venezuela. This article aims to set the record straight about inflation and let investors know how to invest during periods of high inflation.

Are We Experiencing High Inflation?

Inflation is one of the biggest concerns as we near the end of the global pandemic and economies begin to re-open. Governments around the world spent record amounts to keep their citizens, small businesses, and corporations afloat over the past two years, while a majority of those still employed were able to save money thanks to an economy devoid of travel and entertainment.

The result was a significant uptick in savings rates, with Canada’s household savings rate reaching a high of 28.2% in July 2020.

Canada household savings rate

All this money sloshing around on the sidelines has been and will continue to be deployed into goods and services, creating additional demand for a still strained global supply chain. Consumers are ready to dine out in restaurants, attend concerts, and engage in “revenge travel” to make up for lost time.

When that happens, prices tend to rise. Canada’s consumer price index (CPI) has been rising steadily since March 2021. The 12-month change in the CPI for February 2022 was 5.7% (Stats Can). That’s well above the Bank of Canada’s 2% inflation target, and even above their acceptable range of 1-3%.

Meanwhile, the U.S. inflation rate soared to 7.9% in February 2022. (Trading Economics).

Both the Federal Reserve and the Bank of Canada previously signalled they were willing to let the economy run a little hotter than usual to make sure we achieve so-called full employment. But both central banks are now in tightening mode, raising interest rates by 0.25% in March 2022 to kick-off a series of expected rate hikes for the rest of 2022.

It’s clear that high inflation has arrived and persisted for longer than expected. The question is what should investors do about it (if anything)?

How Investors Should Position Their Portfolio to Deal with High Inflation

What exactly is an inflation hedge? In an episode of the Rational Reminder podcast, Benjamin Felix said an inflation hedge needs the following three characteristics:

  1. It will correlate positively with inflation, including responding to unexpected inflation.
  2. It won’t be too volatile
  3. It will have a positive real expected return

The problem, Felix said, is that asset doesn’t exist.

Indeed, most investors should just stick to their original (sensible) investment strategy and not try to change it up based on market conditions. But there may be good reasons to re-position your portfolio to try to combat high inflation. Here are some ideas to consider:

Stay Invested in Global Stocks

We don’t know for sure which sectors and individual stocks will outperform in the future, especially over the long term. That’s why it’s always wise to invest in all of them through a low-cost and globally diversified ETF portfolio.

Even if Canada or the US experiences inflation, that doesn’t necessarily mean that Europe or Asia will also be hit with higher inflation, or that global markets will react in the same way. So, we diversify that risk away by owning a global portfolio of stocks.

For example, Canada’s resource-driven stock market seems to have held up better than the US stock market over the past year, and in particular since the beginning of 2022. That’s not to say investors should pile into Canadian stocks – it just illustrates why diversification is so important.

Canadian vs US stocks

Investors may look for profitable businesses that generate positive cash flow and that can raise prices. Since inflation increases the input costs for businesses (think lumber and gasoline), the ones that can respond quickly and increase their prices can keep their profit margins intact. Energy and industrial sectors have performed well during periods of high inflation. As demand for commodities rise, so do their prices and in turn their profits. Oil and gas stocks were particularly hit hard during the pandemic and are now surging higher as the global economy recovers.

It’s important to note, however, that individual stocks or sectors are too volatile to be considered an inflation hedge. The same is true for commodities.

Hold Some Cash in High-Interest Savings

It may sound counterintuitive to hold cash during periods of high inflation since the increased cost of goods is literally eating away at your purchasing power.

But consider that central banks will likely continue to raise rates to combat any sustained high inflation. This should drive up the interest rates earned on your savings deposits. This favours the idea of putting your cash in a high-interest savings account over a GIC, since you can’t take advantage of the upswing in rates when your money is tied up in guaranteed vehicles.

EQ Bank offers one of the leading high-interest savings account rates at 1.25%. Keep in mind, EQ Bank’s interest rate was as high as 2.45% in March 2020 before the Bank of Canada’s emergency rate cuts took hold, so there may be upside as the year goes on.

EQ Bank rate history

Inflation-protected Bonds

Rising interest rates and inflation are terrible for long-term bond prices. If rates increase by 1%, a bond with an average duration of 10 years would fall in price by 10%. That’s not ideal when central banks increase rates to cool things off in a high inflationary environment.

But investors who are concerned about inflation can hold US Treasury Inflation Protected Securities (TIPS), or real return bonds in Canada, for inflation-protected income. These bonds offer inflation-protected income from federal government bonds that pay semi-annual interest.

According to Benjamin Felix, inflation-protected bonds are an obvious inflation hedge if the bond duration perfectly matches your investment time horizon. However, short-term inflation-protected bonds have negative real return yields, and long-dated inflation protected bonds are too volatile to be a hedge in the short term.

Holding Fixed Interest Rate Debt

Rising inflation can actually be a good thing for fixed interest rate borrowers (such as mortgage holders) because they’re repaying their loans with money that is worth less than what it was worth when it was originally borrowed.

Think about it: Let’s say you still have a $250,000 balance outstanding on your mortgage and make payments of $1,600 per month. In a high inflation environment, your money isn’t worth as much as it used to be. So that $1,600 mortgage payment becomes less and less of a burden as wages (hopefully) rise and interest rates move up.

The bottom line – don’t be in a hurry to pay off your low-interest fixed rate mortgage during periods of higher inflation. But, don’t go actively seeking fixed rate debt as an inflation hedge. You still need to borrow sensibly, and you may be forced to renew a mortgage term at much higher rates in the future.

What About Gold?

Investing in gold has long been touted as an inflation hedge, but in reality, gold is an unreliable hedge at best over an investor’s lifetime. Researchers analyzed gold returns dating back to 1975 and found that, due to its price volatility, gold had not been a good inflation hedge over the short or the long term.

The researchers even looked at gold during Brazil’s hyper-inflationary period between 1980 and 2000 (where annual inflation averaged 250%) and found that the real price of gold in Brazilian terms fell by 70%.

One of the main findings was that the real price of gold – its purchasing power – remains the same around the world at any given time. That means if your home country happens to be experiencing periods of high inflation there is no reason to expect that gold will be a reliable inflation hedge for you.

Going back to our three characteristics of an inflation hedge, gold is not positively correlated with inflation, including with unexpected inflation, it is a volatile asset, and it does not have a positive real expected return.

Final Thoughts

Inflation has increased in Canada and the United States over the past year and that has many investors panicking to re-position their portfolios. While it’s doubtful that inflation will run out of control in our advanced and developed economies, central banks have retired the ‘transitory’ language and will be working quickly to cool inflation and return it to the target range of between 1% to 3%.

Most investors with a long time horizon should not concern themselves with temporarily high inflation numbers. With no perfect inflation hedge, investors would be smart to stick to a sensible, low cost, globally diversified investment portfolio.

Related: An evidence based guide to investing

Investors who are concerned about the impact that rising inflation may have on their investments – particularly their fixed income holdings – may consider shifting away from long-term bonds and move into short-duration bonds or treasuries as an inflation hedge.

Be mindful that the type of stocks and commodities often touted as inflation hedges are likely too volatile to offer true inflation protection. 

Think of your fixed rate mortgage debt as a small hedge against inflation, since your payment stays fixed while the purchasing power of your dollars erode.

Finally, holding some cash in a high-interest savings account may offer more upside than locking it into a GIC (and certainly more upside than keeping it under your mattress or in a chequing account).

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