Retirement is near or perhaps you are already retired. It’s time for choices. How do you want to receive your income? Is an annuity a good choice?
Annuities can be considered as backwards, long-term mortgages with a couple of twists. Rather than a financial institution giving you a lump sum and you repay them monthly, the annuity does the opposite. The payment to you is normally a level fixed amount that is payable for as long as you live with a minimum payout guarantee. You also have the choice of having payments continue for as long as at least one person is alive in the case of joint annuities.
Annuities can be purchased with both registered and non-registered money. If purchased with registered funds, the payments are fully taxable to you. If you purchase the annuity with non-registered money, then only a small portion will be taxed – most of it will be tax-free.
So what is the attraction of an annuity?
Guaranteed income for your lifetime (or the lifetime of 2 people for joint annuities)
You cannot outlive your money
You want to minimise your income tax payable (from non-registered funds called “Prescribed Annuities”) compared to other investments such as mutual funds or GICs
You do not have to worry about the ups and downs of investment markets – no management needed
You want to minimise the impact of lifestyle income reducing your OAS payments under the clawback rules in the Income Tax Act
The principal of the annuity is protected from claims by your creditors
You can name a beneficiary (or beneficiaries) for the remaining payments if you pass away before the end of the guaranteed period
Nothing is perfect, so what are other considerations?
Once purchased, it cannot be cashed
You cannot change the level of income or other terms after it is purchased
You no longer have control of the money or how it is to be invested or managed
Some of the choices you will need to make include:
o Single life or joint life?
o Do you want a guaranteed payment period and if so, for how long?
o If you chose a guaranteed payment period, who should be the beneficiary if you pass away before the end of that period?
o Do you want level or increasing payments?
o Should you replace the capital used to purchase the annuity with life insurance so your heirs can still get the full value of your estate?
I saw a question posted on a popular social network. The question was: ‘What is the difference between gambling and investing?” I’m inspired to reproduce (edited with permission) the following excerpt from A Maverick Investor’s Guidebook (Insomniac Press, 2011) which I believe provides as good an answer as one might find.
How to Tell the Difference Between Investing and Gambling!
“How do you develop ‘smart thinking’ and when do you know you’ve got ‘avarice’?”
My instinctive response would be: “You always know when you’re being greedy. You just want someone else to say that your greed is okay.” Well, I’ll say it then: greed is okay. The proviso is that you fully understand when greed is motivating your decision and live with the consequences. Avarice is driven by desire, which is not a trait of an investor.
Remember, it’s best if investment decisions are rational and stripped of emotion. Greed is associated with elation on the one hand, and anger (usually directed at oneself) on the other hand.
When decisions are motivated by greed, I call it gambling. In my mind, there are different sorts of gamblers. Some gamblers place modest bets, and if they win, they move along to another game. For me this might be roulette. There are those who enjoy playing one game they’re good at, such as blackjack or craps, hoping for a big score. Finally, there are those who are addicts. I can’t help those folks, so let’s assume we’re just discussing the first two types.
It’s okay to do a bit of gambling with a modest part of your disposable income. In fact, investors can apply some of what they know and have fun too. Unlike the casinos, financial markets have no limits or games stacked in favour of the house. It’s the Wild West, and if an investor understands herd behaviour and the merits of contrarian thinking, and does some research, the results can be quite lucrative. Whether using stocks, bonds, options, hedge funds, domestic mutual funds, foreign equity or debt funds, or commodity exchange-traded funds (if you don’t know what these things are and want to know, buy a book that introduces investment theory and the various types of securities), applying investment principles will help you be more successful.
To put it plainly: counting cards may not be allowed in a casino, but anything goes when it comes to markets. Just don’t forget that most of the financial industry is trying to make your money their money. There’s a reason why a cowboy sleeps with his boots on and his gun within reach.
The fine line between gambling and investing is hard even for old cowhands to pinpoint. Investing also involves bets, but the bets are calculated. Every decision an investor makes involves a calculated bet—whether it’s to be in the market or not at all, biasing a portfolio in favour of stocks versus bonds, skewing stock selection in favour of one or several industry groups, or picking individual stocks or other types of securities.
I met a lady once in line at a convenience store. She bought a handful of lottery tickets, and I asked her, “Aren’t the odds of winning pretty remote for those lotteries?” Her reply was, “The odds are good. There’s a fifty/fifty chance of me winning.” Confused, I asked, “How do you figure?” I laughed aloud when she said, “Either I win or I lose; that’s fifty/fifty, isn’t it?”
A maverick investor knows there’s always a probability that any decision to buy or sell or hold can prove to be incorrect. The objective is to minimize that probability as much as is feasible. It’s impossible to make it zero. This is why financial firms have sold so many “guaranteed” funds lately. People love the idea, however impossible, of being allowed to gamble with no chance of losing. Whenever there’s a promise that you won’t lose or some other similar guarantee, my senses fire up a warning flare.
There’s usually a promise of significant upside potential and a guarantee that at worst you’ll get all (or a portion) of your original investment back. Many investors a few years ago bought so-called guaranteed funds only to find that the best they ever did receive was the guaranteed amount (extremely disappointing) or much less after the fees were paid to the company offering the product. If you think this stuff is new, trust me, it’s not.
A fancy formula-based strategy back in the ‘80s called “portfolio insurance” was popular for a brief period. An estimated $60 billion of institutional money was invested in this form of “dynamic hedging.” It isn’t important to know in detail how the math works. Basically, if a particular asset class (stocks, bonds, or short-term securities) goes up, then you could “afford” to take more risk because you are richer on paper anyway, so the program would then buy more of a good thing. If this better-performing asset class suddenly stopped performing, you simply sold it quickly to lock in your profits. The problem was that all these programs wanted to sell stocks on the same day, and when everyone decides they want to sell and there are no buyers, you get a stalemate.
The “insurance” might have worked if you actually could sell the securities just because you wanted to, but if you can’t sell, you suffer along with everyone else—the notional guarantee isn’t worth the paper it’s printed on. Remember these are markets, and even though you see a price in the newspaper or your computer screen for a stock, there’s no trade unless someone will step up to buy stock from you. The market crash that began on Black Monday— October 19, 1987—was, in my opinion, fuelled by portfolio insurance programs. The market was going down, so the programs began selling stocks all at once. There weren’t nearly enough buyers to trade with. By the end of October ’87, stock markets in Hong Kong had fallen 45.5%, and others had fallen as follows: Australia 41.8%, Spain 31%, the U.K. 26.4%, the U.S. 22.7%, and Canada 22.5%.
Minimizing the Probability of Stupidity
If you’re gambling, follow the same steps you would as ifyou were investing. If it’s a particular stock you are anxious to own, do some homework, or at least look at someone else’s research available through your broker or on the Internet. When I was a younger portfolio manager, there were limited means to learn about a company. I would have to call the company and ask for a hardcopy annual report to be sent to me. When it arrived after several days, I’d study it a bit so I didn’t sound too ignorant, then I’d call and try to get an executive (controller, VP finance, or investor relations manager) to talk to me. If asking questions didn’t satisfy my need to know, then I’d ask to come and meet with them in the flesh. Nowadays, you have all the information you need at your fingertips.
Money.ca is a PRIME example of just one such source of valuable information available to investors today!
Back in February of 2012, I recall a prominent CFO departing a global insurance company. This particular individual was labelled “the highly regarded architect of a hedging strategy that proved key in rebuilding investor confidence in the wake of the financial crisis.” The company had suffered financially during the prior market meltdown because of a huge exposure to equity-linked products; pre-crisis the company had introduced investment products that guaranteed to return a substantial (if not all) amount of the investor’s initial investment. The money was invested in the company’s funds which in turn invested in stock markets. During the financial crisis, the value of these assets (stocks) held in the funds declined below the amount that was guaranteed spelling serious trouble for the company. In response a stricter approach to risk management was adopted after-the-fact.
Sounds sensible doesn’t it? But it just isn’t! I’ve watched this pattern time and again over decades. The fundamental flaw is a complete misunderstanding of what constitutes risk.
Risk is almost always equated to volatility. For example, stocks move up and down rapidly with much magnitude so they are deemed more risky than bonds. But are we really as averse to upside risk as downside risk? Strangely people become more averse to volatility when they’ve suffered downside risk (and come to adore volatility when upside risk has rewarded them). Because our internal model of risk is so much more complex than mathematics can reckon with, our efforts to ‘manage’ volatility can actually subject us to less volatility but more risk. When we reduce risk (hedging strategies usually reduce volatility – both up and down) at the wrong times, we miss the chance to be rewarded by the kind of volatility we adore. We are our own worst enemies.
The President and CEO of a completely different insurance company was quoted as saying this, also in February of 2012:
“We are maintaining our equity hedges as we remain very concerned about the economic outlook over the next few years. We continue to be soundly financed with year-end cash and marketable securities at the holding company of about $1 billion.”
This statement followed the company’s earnings release, having reported substantially increased losses from its investments – management had hedged the company’s equity position in 2010 (again, after-the-fact) and suffered investment losses in that year’s fourth-quarter because stock markets rose (instead of declining). The actions designed to protect the company against volatility lost money. Risk aversion after-the-fact caused the company to lose money and avoid potential returns from upside volatility.
Because the pain caused by the downside volatility suffered previously was still fairly recent, aversion remained at a high level causing the company to stick to its hedging strategy (in denial?) despite these huge losses, and it continued to lose money as the market continued to go higher and higher still.
The financial crisis is behind us and now that markets are hitting all-time highs, record amounts of dollars are scrambling to get some upside volatility action. Too late? It’s hard to put a pin in it, but intuitively might one conclude that if managing risk (or ‘risk off’ as they say on business television) was a bad idea during and immediately after the financial crisis, then perhaps chasing volatility (‘risk on’) might not be such a good idea at present?
It might seem as if I was picking on insurance companies earlier, but many pension funds, other financial services companies, portfolio managers and everyday investors follow the same destructive pattern. Adoring upside risk but loathing downside risk – always at the wrong times – has ruined careers and put a serious dent in the life-savings of families. More experienced money managers (there are fewer of us nowadays) increase risk when others are most averse to the idea, and begin to manage risk (hedging, raising cash balances) during periods of ‘irrational exuberance.’ They’ve learned the hard way that it’s easier to keep all the hair on your head if you avoid circumstances that make you want to pull it all out.
I saw this headline on a half-page ad in the Vancouver Sun this past week – 4 colours – no-one could possibly miss it. The headline in very large print read INVEST RISK FREE with a very, very small asterisk directing readers to the bottom of the ad for the usual disclaimers.
I must say that it continues to amaze me that companies (in this case a very large bank) would continue to advertise such absolute rubbish. In this instance, the institution publishing the ad was promoting their version of an equity-linked GIC. The theme being, buy this product, hold it until maturity and regardless of what happens to the stock market index chosen as the benchmark, you will be guaranteed to get your money back. With this fact, the ad promotes this as a “risk free” investment – oh, by the way, this was for a non-registered product. If the benchmark market went up, then within certain limits, the holder would get back some interest return on the positive side – no losses.
Let’s examine this a bit more closely – has everyone forgotten about this thing called INFLATION? Or how about TAXES?? I am not going to do a lot of fancy calculations here – you can all do that on your own time.
Product pays ZERO interest at the end of the 5-year holding period – you get back 100% of your initial investment – so according to the bank in question – no loss – therefore risk free. Absolute nonsense! If no interest – no taxes so they drop out of this equation. But inflation is still here! If we assume that inflation stays at the current low level of 1.9% and it stays there for the next 5 years, then (ignoring compounding), your money has lost at least 10% in purchasing power – that is a LOSS to the investor and worse, it is a loss which is NON-DEDUCTBLE!!
Same as number 1, but let’s throw in an average gain of 3% for each of the next 5 years. Lowest marginal tax bracket currently in BC is about 25%. So 3% gross equals about 2.25% net, after tax. If we again subtract inflation of 1.9%, then the client is left with a real, net, after-tax, after inflation rate of return of .35% – yes .35% – but at least in this possibility, the client hasn’t lost any $$ nor have they lost any purchasing power. If the investor is in a 35% marginal tax backet or higher, then we are back to Scenario ONE but with a smaller net loss of purchasing power.
But – that is a lot of buts! Please, don’t be fooled – there is NO SUCH THING as NO RISK INVESTING!