Some clients have an overly negative view of life annuities, and refusing to consider this product could damage the viability of their long-term retirement plans.
A good advisor can help clients change this perception.
We’ve found that explaining the fundamentals of risk pooling can help the client see an annuity as a way to mitigate the risk of outliving their savings.
For example, it would be unthinkable not to insure your home. Let’s say that for a $500,000 residence, the insurance premium is 0.5% per year. The accumulation of $2,500 per year over 30 years could be a dead loss if no claims are made, representing nearly 20% of the home’s future value. That’s hardly a small sum, but the outlay is better than the alternative of your home being damaged. The same principle applies to car insurance, although the frequency of accidents is much higher.
For life insurance, a 30-year-old father who wants to protect his children through a $500,000 policy could have spent $26,000 in premiums by age 60.
The “winners” of risk pooling are those who have made an insurance claim (due to a flood, a fire, a serious car accident or an early death), though these events are hardly anything to be happy about. Risk pooling works because there are many happy losers and few unhappy winners.
The inherent uncertainty of survival lends itself well to sharing mortality risk. Here are two scenarios, where the first scenario contains a form of risk pooling that is rarely brought into question.
- Many people envy employees who belong to a defined-benefit pension. To participate in such a plan, a person simply needs to be selected for a job. Their health is rarely part of the equation. Their salaries are adjusted to reflect the cost to the employer, and employees themselves must contribute a substantial amount. Upon retirement, these become lifetime benefits, and few retirees opt to decline these payments in favour of a lump sum they can invest in the markets. The benefits paid by the plan following an early death represent only a small portion of the savings in the fund but are necessary for ensuring the fund for pensioners living beyond age 90.
- Anwar, a 65-year-old retiree, uses $100,000 of his RRSP in October 2021 to purchase a life annuity that will give him a monthly benefit of $490 with a guarantee of 120 payments (see “The case for life annuities”). This guarantee ensures he’ll receive at least 59% of his premium if he dies before age 75, without interest. If he dies at age 95, he’ll receive 176% of his premium.
Situations 1 and 2 are similar, yet few people in Anwar’s position are willing to purchase an annuity. This is known as the “annuity puzzle.” People believe that buying an annuity means giving up accumulated funds. They focus more on the potential for losses rather than considering longevity risk coverage. As a result, life annuities are underused.
Furthermore, adding more guarantees to an annuity in case of an early death actually reduces monthly payments for the annuitant, and the annuity’s internal rate of return becomes smaller.
It’s your job to demonstrate to clients that they cannot obsess about leaving money on the table. Life annuities are simply a potentially lucrative way of insuring against longevity risk.
Mélanie Beauvais is a principal advisor and Daniel Laverdière is senior manager, both with the Expertise Centre, National Bank Private Banking 1859, in Montreal.