Annuities in Canada: How They Turn Your Savings Into a Pension

What an annuity is and how it pays you

An annuity is a contract, usually with a life insurance company, that converts a lump sum (or a series of payments) into a guaranteed stream of income. You can receive payments monthly, quarterly, semi-annually or annually, starting right away with an immediate annuity or at a later date with a deferred one.

The Financial Consumer Agency of Canada (FCAC) explains that each payment is made up of three parts: interest, a return of your own capital, and, for life annuities, a transfer from annuity holders who die earlier than expected to those who live longer. That last element, often called mortality pooling, is what makes a life annuity different from simply drawing down your savings. It lets the insurer pay you more each year than you could safely withdraw on your own while still guaranteeing payments for life.

The trade-off is that the money is no longer yours to access. Once you buy a typical annuity, you can't usually change the terms, take the lump sum back or leave it to your heirs unless you buy options that provide for that.

Life annuities vs term-certain annuities

A life annuity pays you for as long as you live. In most cases, payments stop when you die, which is why the payment is higher than other options for the same purchase price. If you live a long time, you'll receive far more than you paid; if you die early, you may receive less, unless you add a guarantee.

A term-certain annuity pays for a fixed period, such as 10 or 20 years, regardless of whether you're alive. If you die before the term ends, your beneficiary or estate continues to receive the payments. A longer term means a lower payment for the same investment. The main risk is outliving the term, since the income then stops.

There are also variable annuities, where part of your money is invested in market-linked products. They pay a guaranteed portion plus a variable portion that can rise or fall, and the guaranteed income is lower than with a standard annuity. They suit people who want some upside and can accept less certainty.

Options that change the payment

Life annuities can be customized, and each option reduces your regular payment in exchange for protection you value:

• Joint and survivor: payments continue as long as either you or your spouse is alive, sometimes at a reduced level after the first death. This is often the key option for couples where one partner relies on the other's income.
• Guarantee period: if you die within a set period, payments continue to your beneficiary or estate until the period ends.
• Cashback or refund: a lump sum is paid to your beneficiary or estate on death, typically related to the purchase price less payments already received.
• Indexing: payments increase over time to help offset inflation, starting from a lower initial amount.

Choose options based on the problem you're solving. If your concern is outliving your money, a plain life annuity delivers the most income per dollar. If your concern is a spouse being left short, joint and survivor coverage matters more than a cashback feature.

What determines how much you'll get

FCAC lists the main factors insurers use to set your payment:

• Your age when you buy: the older you are, the fewer years the insurer expects to pay, so the higher each payment.
• Your sex and, in some cases, your health, which affect life expectancy. Some insurers offer higher payments to people with health conditions that shorten life expectancy.
• Interest rates at the time of purchase: when rates are higher, insurers can generally offer larger payments for the same premium, and the rate is locked in for the life of the contract.
• The amount invested, the type of annuity, its length and any options you add.
• The provider: pricing varies between insurers, sometimes meaningfully.

Because the payment is locked in at purchase, timing matters. Some retirees buy in stages over several years, a technique sometimes called laddering, so they aren't locking all their savings in at a single interest rate. Always compare quotes from several insurers, ideally through an independent advisor or broker who can access multiple companies.

Using registered savings: RRSPs, RRIFs and pensions

You can buy an annuity with registered or non-registered money, and the rules differ. The CRA says that by the end of the year you turn 71, you must choose what to do with your RRSPs: withdraw them, transfer them to a RRIF, or use them to buy an annuity. Your RRSP issuer doesn't withhold tax on amounts used to buy an annuity; instead, the annuity payments are taxed as income when you receive them.

Many retirees don't choose just one. A common approach is to convert part of their RRSP to a RRIF for flexibility and use another part to buy an annuity that, together with CPP and OAS, covers essential expenses. Money in a locked-in account from a former employer's pension can also often be used to buy a life annuity, subject to pension rules.

There's also the advanced life deferred annuity (ALDA), which can be bought with registered funds and lets you defer payments until later in life. CRA rules require ALDA payments to start by the end of the year you turn 85. It's a way to insure against very long life while keeping more of your money accessible in your 70s.

If you have a defined benefit pension, you may already have what is effectively an annuity. If you're offered a lump sum instead, compare it with the guaranteed pension carefully; our guide to the commuted value explains the trade-offs.

How annuity income is taxed

Annuities bought with registered money (from an RRSP or RRIF) produce fully taxable payments, reported as income each year, just like RRIF withdrawals.

Annuities bought with non-registered savings are taxed differently. Each payment is a blend of capital and interest. The capital portion is a return of your own after-tax money and isn't taxed again; only the interest portion is reported, on a T5 slip. This can make a non-registered annuity relatively tax-efficient. Ask the insurer how the taxable portion of each payment will be calculated, as the method affects how much tax you pay in each year.

Annuity income can qualify for the pension income amount, a federal non-refundable tax credit on up to $2,000 of eligible pension income. Annuity payments from an RRSP, RRIF or a regular non-registered annuity generally qualify if you're 65 or older at the end of the year, or at any age if you receive them because of your spouse's or common-law partner's death. Eligible pension income may also be split with a spouse in some cases; see pension income splitting.

How your annuity is protected

An annuity is only as good as the insurer behind it. If a member life insurance company fails, Assuris, the industry's policyholder protection organization, protects annuity income. According to Assuris, you retain up to $5,000 a month or 90% of your promised monthly income, whichever is higher. For example, a $6,500 monthly benefit would be protected at $5,850.

If you plan to buy a large annuity, you can stay fully within that protection by splitting the purchase among more than one insurer. Confirm the insurer is an Assuris member before you sign.

Also ask about any cooling-off period. Once that window closes, you typically can't cancel or change the contract, so read it carefully, along with all fees and commissions.

When an annuity makes sense, and when it doesn't

An annuity tends to fit when you have more savings than your guaranteed income covers, you want your essential expenses covered no matter how long you live, and you're in good health with a family history of longevity. It can also suit people who find managing investments stressful or who worry about sequence of returns risk, the danger of a market drop early in retirement.

It's less suitable if you already have a generous defined benefit pension, you're in poor health, you need flexibility for large or uncertain expenses, or you want to leave a significant estate. Annuities also usually make less sense early in retirement for people who are still deciding when to retire fully or when to start CPP and OAS.

A practical way to think about it: add up your guaranteed income from CPP, OAS and any pension, compare it with your essential spending, and consider an annuity to close part of the gap. Keep the rest in flexible savings for emergencies, travel and the unexpected. A fee-only advisor can model the options with real quotes.

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