FACED WITH A SEVERE FUNDING CRISIS, THE FUTURE OF defined benefit plans looks bleak. While defined contribution(DC)plans are gaining popularity, there are critics who maintain that one of the problems with DC plans is that they don’t provide a guaranteed lifetime income at retirement.
DC plan sponsors can overcome this obstacle by educating plan members about annuities. A life annuity is a contract that obligates a life insurance company to make regular payments to the annuitant for the duration of their lifetime. When most DC plan sponsors enter into a group annuity policy with their provider, the policy includes a provision that all plan members have the right to purchase an annuity when they leave the plan.
In today’s low interest rate market, annuities are generally ignored by plan sponsors and members. However, the following example illustrates why annuities still make sense as a key piece to the retirement puzzle.
Bob Jones, a 65-year-old plan member with ABC Company, is retiring and will be withdrawing his accumulated savings of $100,000 from the group RRSP. His life expectancy is just over 20 years.
Using today’s annuity rates, if Jones purchases a lifeonly annuity, his monthly income will be $668.66. If, however, Jones transfers his savings to a registered retirement income fund (RRIF), he will need to earn a net investment return of 5.32% over 20 years to match the monthly income of the life-only annuity, assuming that the balance of the RRIF is zero at the end of the 20 years. If he lives to be 88, just three years beyond his life expectancy, his RRIF will have to earn a net investment return of 6.21% over those 23 years. If Jones prefers a 10-year guarantee with his annuity, his RRIF will need to earn a net investment return of 4.73% over 20 years and 5.65% over 23 years.
In other words, the longer Jones lives past age 85, the higher the investment return he will need to achieve in his RRIF to match the annuity purchase.Retirees generally invest their RRIFs fairly conservatively, so achieving the modest rates of return in the above example might be difficult for some investors. Moreover, because Jones cannot predict how long he’ll live, he has very little idea of what investment returns he will need to achieve. Purchasing a life annuity addresses these issues.
In the context of a DC plan, then, having a guaranteed income for the duration of a plan member’s life is prudent because it eliminates the financial risk incurred should one outlive their retirement nest egg.
Moreover, annuities offer a safe alternative to the volatility of capital markets. If a retiring plan member shifts their DC plan balance to a RRIF, the plan member bears all the investment risk. Purchasing an annuity shifts the investment risk back to the annuity provider.
If annuities are an important piece of the retirement income puzzle, then plan sponsors should incorporate them into their plan design and compare the types of annuities offered, associated rates and member education around annuities when conducting a search for a new recordkeeper.
Plan members who are looking for the security of a guaranteed lifetime income should strongly consider a life annuity possibly coupled with a RRIF or locked-in retirement income fund. Of course, plan members considering the purchase of an annuity should also consider seeking the advice of a financial planner or advisor.
Rick Headrick is assistant vice-president, investment services, group retirement services with Sun Life Financial in Toronto. firstname.lastname@example.org