Humble annuity back in vogue

The oft-touted market mantra — buy and hold — has proven dangerous, says Bruce Cumming, founder of Cumming & Cumming Wealth Management Inc., as it can’t really time the market. “I don’t think we can glibly hang on to that axiom as we’ve done in the past. Going forward, we’re going to need to be different. We need to have a dynamic asset allocation.”

To hedge against risk, Cumming strongly suggests life-only annuities for clients looking retiring. “People absolutely and unequivocally must begin to embrace annuities. Our parents had annuities, and they took the commuted value. It provided them guaranteed income.”

Clients looking for certainty and guarantee — and who can live without flexibility — are best suited for life-only annuities.

And when non-registered dollars are used to purchase annuities, there’s also a tremendous tax benefit, he adds, especially for clients who come upon sudden income. Cumming recommends a 20-year term certain annuity is a powerful instrument for sudden wealth (lottery or inheritance, selling a business).

Let’s say the client just inherited $3 million. If $1.6 million were to be used to buy a term 20 annuity, starting next month it would give them $10,000 of income for the next 20 years. And because it is non-registered income, the tax treatment would be that of prescribed taxation, and they would get a T4A slip for just $40,000 dollars — even though the total annual income is $120,000, only the investment growth part of this blended, capital and investment income is taxable.

If the income were to be split with a spouse, the taxable portion would be down to $20,000. Further deduct from that $10,000 in basic personal exemption, and investment counseling fees on the other $1 million or $2 million being invested.

“You could very likely have no tax on the $120,000 annual income, and that’s my claim to fame, that’s how I try and set it up,” Cumming says.

However, if it is RRIF money flowing into annuities, all of the income is taxable. Contrast RRIF from an annuity, Cumming says the strength of an annuity is its guaranteed; its weakness is its inflexibility. A RRIF, on the other hand, is highly flexible but provides not an iota of guarantee.

Cumming says he has two sorts of clients — “smart and nice” — white collared and blue collared, and that the non-risk aspect of fixed annuities is an especially sound investment decision for most of his blue-collared clients.

“We have a lot of people who don’t get pensions when they retire. They get a commuted value of $300,000 or $400,000. Prior to debacle they were very happy having this lump sum because they’d never seen such a large chunk of money. It was reasonably easy to invest the money, I could buy 5% or 6% term deposits, and give them an income they could enjoy while keeping their capital protected. But when challenges came, if they were equity invested, they were savaged. I think for the less financially sophisticated person, an annuity is really simple,” he explains.

“But obviously there’s no perfect solution. Perfection comes with a little bit of everything, but most people have zero in annuities. That’s a mistake. They should have some in annuities, some in equities, some perhaps in bonds,” he adds.

But one of the biggest challenges financial advisors have, Cumming says, is dealing with “this wretched” concept called asset allocation. “Wretched not because it’s the wrong concept, but by definition it means a certain percentage of the money should be in fixed income. And with one-year term deposits paying 1.4% interest, the problem with asset allocation is a significant amount of money is earning peanuts. And if we’ve projected average return in retirement as being 5% or 6% and our fixed income is making 1% or 2%, our equities need to make 9% or 10%. That’s not the right scenario.”

Cumming suggests when clients are getting ready to retire and live off their assets advisors should take 60% of those assets and buy life-only annuities. The other 40% he says could be allocated to blue chip stock. “So the investment portfolio is going to look all equity but that’s ok because we’ve bought our income with the annuity. Equities will help provide the inflation protection and income protection.”

Clients do stand to lose capital in annuities. Cumming agrees accumulating capital is important to clients who wish to bequeath a healthy estate, but he says there’s a “real simple” solution for that as well — life insurance.

“The best, most optimal way to leave anything behind is with permanent insurance. There’s no other way you leave your capital behind. It’s hugely inefficient. When I’m selling term insurance policies to young clients in their 40s, I try and explain the cost of buying T100 instead of T10 or T20.

The logic, Cumming says, is obvious: “GICs at 8%, maybe 9% if you’re in your 70s.”

“If you had the foresight to buy life insurance in your 40s, and made the stretch and bought the T100, you’d then be positioned to buy annuities that would give you high guarantee of income in retirement,” he says.

Underwriting A T100 in your 40s would be markedly cheaper, thus pushing the premiums down, and making the cost of funding an inheritance cheaper than saving the actual assets and passing them through to the estate.

Cumming has concerns about Income Plus products, which address the shortfall risk — the risk an individual will run out of money before dying — and says retail clients only know the front half the story. The back half of the story he says is that inflation alone could ravage the portfolio’s value if it earns nothing for such a long period of time. “The prospect of outperforming your 5% income and making more than what the market will give you is well nigh impossible.”

By suggesting simple vanilla annuities to clients, advisors Cummings says, earn peanuts. “But they’re doing the right thing for their client and they have no worries.”

The one thing, Cumming says, the industry needs to start doing is to underwrite annuities. “You could be a smoker, have breast cancer, your dad could have died of prostate cancer, they’re all the same person. The only thing they distinguish is male and female.”

(08/14/09)