What is a Retirement Annuity? - James K. Ault

Even if you aren’t sure what a retirement annuity is, this financial vehicle could make the difference between living a stress-free retirement or worrying day in and day out about whether you’ll run out of income when you still need it in the future.

Retirement annuities have become quite popular over the past decade or so. One reason for this is because most employers have done away with the traditional defined benefit pension plan. So, while there are still defined contribution options available – such as the 401(k) – not all employers offer these savings vehicles. In addition, these “traditional” retirement savings plans won’t ensure that you’ll have a sure and steady income stream for life.

But a retirement annuity can!

In fact, many financial advisors now refer to retirement annuities as “personal pension plans,” because they operate in a similar manner. Retirement annuities (or RA’s) are a type of fund in terms of the Pension Funds Act in that they are tax-advantaged investment vehicles designed for individual investors (versus employees who are participants in a workplace retirement fund).

With a retirement annuity, you can grow your savings on a tax-deferred basis. This means that there are no taxes due on the gain until the time of withdrawal. And, if you don’t access your money for many years, your account value can grow exponentially, because your money is earning a return on the principal, a return on the interest, AND a return on the funds that would have otherwise been paid out in taxes. It’s a triple-win! Keep reading if you’re still curious about what a retirement annuity is and how they work.

How Do Annuities Work?

Traditional annuities are a type of insurance product. So, they come with some nice guarantees – one of which is the lifetime stream of income it can generate for you, regardless of what happens in the market.

How exactly does an annuity work?

These financial vehicles are actually a contract between you and an insurance company where, in return for one or more contributions from you, the insurance carrier will pay out a regular stream of income to you for a set time frame, or even for the remainder of your life. This income can start right away (with an immediate annuity), or alternatively, it can start at a time in the future (with a deferred annuity).

Deferred annuities can also provide some added benefits before they start paying out income. For instance, during the “accumulation” period, the funds that are inside of a retirement annuity are allowed to grow tax-deferred. So, because there are no taxes to be paid until withdrawal, funds can accumulate exponentially.

These annuities may also have a death benefit feature. In this case, if the annuitant (i.e. the person who is the income recipient) dies before all of his or her premiums have been returned, the insurance company will pay out the remainder to a named beneficiary. Typically, the beneficiary will have the option of receiving one lump sum, or alternatively, a stream of payments over time.

Over the past several years, many financial professionals and annuity researchers agree that annuities are the most effective safeguard against longevity risk (i.e. the possibility of outliving your savings in retirement).

In addition to that, research has also shown that people who can count on a guaranteed, lifetime income stream from an annuity are not only happier and worry-free (at least from a financial standpoint), but they are also healthier.

What other type of investment or financial vehicle can claim that?

Retirement Annuity Benefits

There are a number of benefits that can be received through a retirement annuity. The biggest of these is the ongoing stream of income the annuity can provide – along with a death benefit if the RA plan participant passes away during retirement.

Other benefits include the opportunity to deduct contributions – up to a certain maximum annual limit. If the participant’s employer makes contributions on behalf of an individual, these contributions can be deducted by the employer (however, they are considered taxable to the RA participant).

Should You Use an Annuity for Retirement?

Given the disappearance of traditional pension plans over time, more people must look for alternatives for generating a reliable stream of income in retirement. One such option is the annuity.

According to Moshe Milevsky, Associate Professor of Finance at the Schulich School of Business at York University, as well as the Executive Director of the IFIS Centre in Toronto, “Of all the hurdles that individual investors face in saving for retirement, perhaps the most challenging is the need to avoid running out of money before they die.”

Milevsky goes on to say that, “The technology that solves this problem – the life annuity – has existed for centuries and, amazingly, predates ordinary stocks and bonds.”

One of the best examples of an annuity is Social Security retirement income because for those who qualify, this program will continue to pay out a regular income stream for the remainder of the recipient’s lifetime – no matter how long that may be.

Retirement Annuity vs Pension Fund

Although retirement annuities and pension funds have a several commonalities, there are also some key differences. For example, both of these vehicles have the ability to pay an ongoing stream of income that the recipient cannot outlive – regardless of how long he or she collects on it.

In addition, as of just a few years ago (in 2016), the retirement annuity can now qualify for the same tax-related incentives as pension funds. In this case, the participant may deduct their contributions into a retirement annuity – up to 27.5% of taxable income or gross remuneration – whichever is the highest.

It is important to note here that, similar to with Individual Retirement Accounts (IRAs), an individual is allowed to join more than one RA plan. However, the tax benefits are determined in aggregate. In other words, the deduction limits do not pertain to EACH retirement annuity, but rather to the total amount that one contributes to all of their RAs across the board.

Other similarities between retirement annuities and pension funds include the ability of the RA participant’s employer to make contributions into the RA on the individual’s behalf. The employer may also deduct an unlimited amount of contributions – however, those contributions will then be taxed as a fringe benefit to the individual.

When it comes to accessing funds from a retirement annuity, there are some key differences between an RA and a pension fund. First, an RA participant can only retire from their retirement annuity once they have reached the age of 55 (although there is one exception here in that he or she may retire earlier if they are in poor health).

Another key difference between retirement annuities and pension funds is that the annuity is a personal retirement savings vehicle, whereby a pension fund is handled through one’s employer.

With that in mind, individuals may have a bit of added flexibility when participating in a retirement annuity. For example, an RA can be “paid up,” meaning that the participant no longer needs to make monthly contributions. (The participant will, however, have to remain invested until they are ready to retire at age 55 or over).

Also, once an RA participant retires, they can take up to one-third of the cash in the retirement annuity as a lump sum. The other two-thirds of the RA funds, however, must go into a compulsory annuity.

Similar to the tax deduction on RA contributions, if you are invested in more than one retirement annuity, the one-third/two-thirds withdrawal limitation will apply to all of the account balances in total. However, if you have multiple RAs in different RA funds, then the annuitization requirement will be applied to each of the retirement annuities individually.

While traditional pension funds may continue paying out benefits to a spouse upon the plan participant’s passing, in the case of retirement annuities, the RA benefit will be allocated by the fund trustees in accordance with the rules set out in the Pension Funds Act.

In this case, the trustees are required to consider all of the deceased participant’s dependents. In order to ensure that all such participants are included in this consideration, it is beneficial for the plan participant to list all of his or her dependents on a beneficiary form.

If this is not done – or if the RA participant has no financial dependents – then the funds from the retirement annuity will instead fall into the estate and will be distributed according to the participant’s will.

With regard to the taxation of these benefits, any lump sum payment that is received upon the participant’s passing will be taxed as a retirement benefit, as though it had been received by the investor before his or her passing.

Understanding Your Retirement Annuity Contract

Participating in a retirement annuity can allow you the income security of a defined benefit pension plan, even if your employer does not offer one. But because not all retirement annuities are the same, it is essential that you have a good understanding of how the plans operate, and how they may be beneficial for you.

For instance, there are two primary types of retirement annuities. These include the more “traditional” plan that is offered by the large insurance companies, and alternatively, the “new generation” unit trust based RA that is offered via asset management companies.

With the former, it is required that participants enter into a long-term contract that specifies how much they must save, as well as for how long. If needs happen to change, though, breaking the terms of this type of RA contract will accelerate up-front expenses – such as commissions – and/or early withdrawal, or surrender, charges.

Depending on when the retirement annuity was initially entered into, these fees could be as much as 30% of the account value. Plus, surrender fees may also be incurred if the participant simply transfers his or her RA to another carrier.

The second type or RA – the “new generation” plans that are more unit trust based – are typically much more flexible than the former. For instance, with these retirement annuity plans, the participant is allowed to decrease – or even cancel – his or her contributions at any time. Likewise, they may even opt to take a “break” from contributing and pick back up at a later time.

Because the newer generation retirement annuities do not have to be purchased through a broker, the costs can be quite a bit lower, as participants may simply purchase the annuity directly through the money manager.

If you’re researching annuities or need help understanding an annuity contract, feel free to reach out to us and we’ll do our best to point you in the right direction.

Who Should Consider a Retirement Annuity?

While retirement annuities can certainly offer some nice benefits, these financial vehicles are not right for everyone. So, should you consider one?

The answer is, it depends.

But a retirement annuity could be a good option for you if you are:

Self-employed
Not a participant in an employer-sponsored pension plan
Want to supplement your pension or other retirement income stream(s)
Currently earning a large amount of “non-pensionable” income (such as rental income and/or interest)

How to Ensure Income with a Retirement Annuity Plan

Over time, as the responsibility of ensuring retirement income has shifted from employers and governments to individuals, investors will need to be mindful of their options – particularly in light of longevity and keeping income flowing for an indefinite amount of time.

Knowing what a retirement annuity is can help individuals to ensure that income will continue to flow in – even if they are not a participant in an employer-sponsored plan. But retirement annuities come with a fair amount of fine print. So, it is essential to understand the do’s and don’ts before you lock into a long-term financial commitment.

At Sooner Retirement, our focus is on making sure that consumers are educated about annuities and retirement income strategies. Our team of annuity specialists can help to walk you through the options that are right for you, depending on your specific short and long-term financial objectives.

If you’d like more information regarding which way to turn when setting up your retirement income strategy, we’d be happy to help. You can reach out to us directly via phone at (888) 440-2468, or you can send us an email through our secure online contact form and set up a convenient time to chat with an annuity expert.

Knowing how annuities work, and what you can expect when you purchase one, can eliminate a whole host of worries and surprises in retirement. So, contact Sooner Retirement today. We look forward to talking with you.