There are various investment strategies out there; each strategy suitable for a candidate with their specific risk tolerance. For instance, a twenty-year-old looking to take on more downside risk for a higher upside may invest in risky stocks or even cryptocurrency. However, older individuals looking to minimize risk to guarantee a safe and comfortable retirement may purchase GICs or even bonds.
In this article, I want to inform you of an alternative investment strategy that guarantees higher returns than bonds and GICs with similar or even fewer risks. This type of investment return is made possible with back-to-back annuities.
Origin of Back-to-Back Annuities
After the 2008 housing crisis, there was a massive crisis for a specific demographic - individuals over 60 approaching retirement. Many of these individuals had lost significant retirement savings due to the recent stock market crash. Additionally, federal expansionary monetary policy had introduced a new era of low-interest rates.
With the fear of another stock market crash and low-interest rates, there werenโt many investment strategies for these soon-to-be retirees, which led to the popularity of back-to-back annuities and have been quite popular in the past decade.
In 2011, an article featuring Beverley J. Moir, Investment Advisor and Financial Planner with The MoirTEAM, ScotiaMcleod, stated back-backs were extremely popular with her clients. โ80% of our business last year (2010) was insured annuities. Theyโre a hot item right now.โ - Beverely Moir.
What are Back-to-Back Annuities?
A back-to-back annuity is essentially two financial products - a Single Life (Prescribed) Annuity and a Permanent Life Insurance Policy.
There are various types of annuities, which include:
- Fixed annuities.
- Fixed indexed annuities.
- Variable annuities.
I wonโt get into too much detail about the different annuities, but a key feature of annuities is the fixed guaranteed payments until death. So, you donโt have to worry about a loss of investment income twenty years later in your retirement. Itโs incredibly similar to having a defined benefit pension.
An additional detail to note about the annuity is if itโs prescribed or non-prescribed. Prescribed annuities are non-registered life annuities. Its difference from non-prescribed annuities lies in the tax treatment, as its post-retirement payments tend to be
Similarly, there are many types of insurance policies which include, but are not limited to:
- Term life insurance.
- Permanent (Whole) life insurance.
- Universal life insurance.
For a back-to-back annuity, you will be targeting a permanent life insurance policy as you want a natural hedge to your single life annuity. Essentially, the two financial products will start simultaneously and have the same number of payments. For instance, if you purchase a term life insurance policy for ten years and live longer than that, your annuity payments will continue to be paid out.
Why should you have a Back-to-Back Annuity in your Portfolio?
Most people looking for some diversification in their profile will be a great product as it is exceptionally tax-efficient since insurance income gets taxed differently than investment income. In most portfolios, market risk is a crucial risk, as most assets are correlated to the stock market. Due to this, there has been a considerable push in the investments industry to reduce market risk by seeking low correlation assets to the stock market.
On the other hand, a back-to-back annuity is an asset with no market risk. So, this is a great asset to have in your portfolio. However, keep in mind there is interest rate risk and counterparty default risk, so ensure you trust a reputable insurer and perhaps gold to hedge for interest rate risk.
Who is the Perfect Candidate to Purchase a Back-to-Back Annuity?
This product is quite niche-like and requires a specific demographic to make the most out of this product. This product isnโt for everyone as it has its advantages and disadvantages, but the perfect candidate would be most likely:
- Retired or approaching retirement.
- Risk-averse with their investing style.
- Looking to preserve wealth for their children or beneficiary.
- Looking for a guaranteed investment or retirement income.
- Concerned about lower interest rates in the foreseeable future.
How to Set Up a Back-to-Back Annuity?
For the most part, this set-up will focus on the insurance environment in Toronto, Canada. Note, this illustration does not include the inherent tax advantages of the product. See below for an example of a back-to-back annuity for a male non-smoker aged 60.
Single Life Annuity: Using a demographic of an individual aged 60 and male using Sunlifeโs Annuity Calculator, the estimated annual annuity income will be $5,084 annually pre-tax.
Whole Life (To 100 Guaranteed Life Pay): Similarly, for a male non-smoker aged 60 with a coverage of $100,000, an approximate whole life insurance policy quote using LifeInsuranceCanadaโs tool gave me various quotes.
Weโll be going with the cheapest quote from Foresters. Foresters, an extremely reputable insurer in Canada, is giving me a non-par whole life policy for $2,717.
Creating a simple illustration in Excel, I determined the cash inflow and outflow for a single-life annuity quoted by Sunlife and a whole life insurance policy quoted by Foresters. Ultimately, the demographic for a non-smoker male aged 60 expected to live for 27 years would earn up to $2,367 annually with a final payout of $100,000 from the death.
Comparison to Alternative Investment Strategies
In the previous case study, we determined for an individual aged 60 expected to live for 27 years; the individual will earn up to $2,367 with a final payout of $100,00 from death.
If we compare this to a GIC, the profitability of this strategy is extremely convincing.
For the quote provided by Ratehub, the highest rate they can provide for a $100,000 upfront payment is 2%. However, there are a few advantages that the GIC does not include, such as GIC income is taxed as investment income, whereas only a portion of the annuity payment is taxed.
The other issue is as interest rates remain low, GIC returns will remain low as well. For a developed country where interest rates seem to follow a trend of becoming lower and lower with no sign of being increased, GICs will become a weaker financial product in the foreseeable future.
Bonds are another investment vehicle similar to GICs that offer a slightly higher interest rate with robust coupon payments, but this has been a topic of discussion within the past few years if bonds can beat GIC returns. I would view bonds and GICs as fixed income when comparing against back-to-back annuities.
Lastly, stock investing through ETFs, real estate, or other small businesses are other great investments that promote significant upside but are extremely privy to market fluctuations and volatility.
Conclusion
Ultimately, for an individual seeking retirement soon, back-to-back annuities may be an appropriate investment strategy, as it provides consistent guaranteed investment income. Meanwhile, the retiree can focus on making the most out of their retirement.
Itโs essential to note one of this strategyโs critical features is tax-efficiency and wealth preservation, which is why this strategy makes the most sense for older individuals. Considering each individual has their own financial and tax situation, it is vital to reach out to an accounting professional to see if this strategy makes sense for you.
