The pros and cons of variable annuities in Canada

Variable annuities make up a huge chunk of the American investment market, although it’s fashionable for commentators to criticize their high fees. You hear much less about them in Canada, where straight life annuities tend to get more attention.

At first acquaintance, variable annuities seem to have some appeal. These hybrid investments appear to offer the combination of a guaranteed minimum income for life, plus some market growth when stock and bond markets co-operate. If they don’t, however, you might receive higher returns from garden-variety fixed annuities (also known as life annuities).

Whatever type of annuity you choose, you will purchase them from a handful of Canadian life insurance companies. They will appeal more to investors who don’t already have a source of guaranteed lifetime income – typically an employer-sponsored Defined Benefit pension plan.

Of course once we hit the traditional age of retirement, most of us will have government-provided sources of lifetime income: Old Age Security and the Canada Pension Plan.

Whether such sources will provide enough guaranteed retirement income for life is a decision people need to make for themselves, being honest with themselves about their risk tolerance, desired lifestyle and current levels of savings in RRSPs, RRIFs, TFSAs and non-registered savings. This is one area where a good financial planner or investment advisor can help, particularly if you have found one who specializes not so much at the front end of asset accumulation, but on the later-life asset-reduction side, with a focus on tax-efficient gradual withdrawal of income.

Once you start evaluating individual products in this area, it soon gets complicated: you have to consider things like locking in capital gains, cash surrender values, annual bonuses in the early years when no withdrawals will be made, and guaranteed withdrawal balances once the payout phase begins at age 65. The problem is the advisors most on top of these features may also be excessively enthused about these products because they’re also benefiting from commissions on them.

So you’ll need to research thoroughly online and perhaps talk to a money coach or a fee-for-service financial planner who does not receive commissions on the sale of investment products.

The blog you are now reading is a good start, as is a recent article by David Aston on life annuities and variable annuities published in the September/October 2013 issue of MoneySense magazine. You might also want to consult books like Daryl Diamond’s Your Retirement Income Blueprint and Pensionize Your Nest Egg by Moshe Milevsky and Alexandra Macqueen.

Milevsky and Macqueen make the case for diversifying sources of retirement income by products, one of which may be traditional annuities or variable annuities. The terminology in Canada can be confusing: the insurance industry’s segregated funds are one type and have been around for decades. Newer options include the Guaranteed Minimum Withdrawal Benefit (GMWB) vehicles popularized by Manulife’s Income Plus, and similar products from Sun Life and Desjardins Financial. The first generation of these products arrived in Canada later than they did in the U.S. but the initial 5% payouts (the GMWB) appealed to many investors. Still, critics pointed to the fact the underlying Management Expense Ratios were on the high side – on the order of 3.5% per year, or more than the oft-criticized MERs of Canada’s mutual funds. True, such engineered products do take some risk off the table although ultimately there is still counterparty risk if the insurance company itself gets into financial trouble and is unable to meet its promises.

An alternative, at least for savvy investors willing to do some of the heavy lifting themselves, would be to “build it yourself” and cut costs by combining straight stocks or stock ETFs for the stock market upside, and substituting straight life annuities for their bonds or bond funds for the more conservative part of their portfolio.

Jonathan Chevreau is editor of MoneySense magazine and author of Findependence Day, available at www.findependenceday.com.