Did Andrew make a mistake in preventing his mom from buying annuities?

Q. My mom is 64 years old and attended a seminar about annuities for her retirement. She was about to transfer her $300,000 in retirement savings to the sales people but I stopped her from doing that after getting a better understanding of the financial product. The bottom line is that the actions of these sales people appear predatory, and buying annuities can impair growth and limit flexibility with my mother’s account. My mom’s entire retirement savings is this $300,000 but her condo is almost paid off and she will have a company pension that pays about $14,000 annually starting next year. I have two questions. Did I do the right thing by dissuading my mom from buying an annuity? Also, if she chooses to keep the $300,000 invested in a balanced portfolio of low-cost exchange-traded funds (ETFs) as I have set up for her, is this type of investment good for the long-term for her? —Many thanks, Andrew

FP Answers: I feel your concern Andrew, but what if I told you that purchasing an annuity would automatically double your mother’s money from $300,000 to $600,000, not mathematically but psychologically? In Retirees Spend Lifetime Income, Not Savings , by David Blanchett and Michael Finke, the two research fellows suggest that every $1 transferred from an investment portfolio to a guaranteed income resulted in $2 worth of spending.

They found that the person who buys an annuity paying $10,000 a year, with $140,000 will spend more on non-essential things than the person who doesn’t buy an annuity and spends from $140,000 kept in savings. Why? Because for one thing, the spending is on nonessentials, such as vacations, dining out more, and so on. And second, with an unknown future regarding inflation, interest rates and longevity, there is a reluctance to draw from investments.

I see this in my own practice: even many retired clients with lots of money live a lifestyle well below their means. They say they are content, which may be, or they may feel more content about their prudence in dealing with the risk of future unknowns. It is as if they need two amounts of money saved for retirement: the mathematical amount that says they can retire, and an additional psychological amount providing them comfort to spend what the mathematical amount says they can spend. Having a larger guaranteed income may allow them to live a little larger.

Andrew, think about your career progression. I am guessing you started out with a smaller income, which gradually grew along with your spending on nonessential things and you enhanced your lifestyle along the way. You do that because you have an income. At some point your paycheque may transition to a pension, which is another form of guaranteed income. It is not uncommon for pensioners to spend up to the maximum of their pension income because they know the income will keep coming for the rest of their lives. The fact is, people spend income, not investment portfolios.

Does this resonate with you Andrew? If it does, then you will see that buying an annuity is not limiting, but freeing. It may ease limits around what you do with your remaining money, and give you freedom to spend more with less worry.

If you disagree with the research findings and discount the psychological benefits of an annuity, then you will end up evaluating annuities only on their mathematical basis. Viewed mathematically, they will, as you say, come across as limiting and impair financial growth.

Once the $300,000 goes to an annuity your mom no longer has access to the capital. A basic annuity, with no safeguards built in, has no inflation protection. Income stops when your mom dies, and there is no inheritance for you. It is a long-term commitment based on today’s economic climate and there is no changing your mind.

Equity investors will look at the income from an annuity and feel they can do better by investing. They may or may not do better, but if they do better, the research suggests they may not use all that growth for themselves. Plus, they have the worry and work of investing as they age.

Still, you may be looking at your mom’s situation and thinking she will have a pension of $14,000 a year, plus Canada Pension Plan (CPP) and Old Age Security (OAS), bringing her guaranteed income to about $40,000 a year. Then your thought is to invest the $300,000 into a balanced portfolio to use for lump sum spending and help protect against inflation and other future unknowns. And this approach may make perfect sense for your mom.

I have one final thought. Think about drawing down some of the $300,000 to allow your mom to defer her CPP and OAS to age 70. This is an annuity purchase providing a much higher benefit than any annuity you can purchase. And it is not just an increase of 42 per cent or more for CPP and 36 per cent for OAS. It is the big psychological lift allowing her to spend more, live larger and have fun.

• What should Victor do if his uncle says there is a will but refuses to produce it?
• How much money should Gerry have in equities, bonds and cash?

Purchasing an annuity is a big decision and if you want to explore it more, I highly recommend you work it through with a financial planner.

Allan Norman, M.Sc., CFP, CIM, provides fee-only certified financial planning services and insurance products through Atlantis Financial Inc. and provides investment advisory services through Aligned Capital Partners Inc., which is regulated by the Canadian Investment Regulatory Organization. He can be reached at [email protected].