Accrual Annuities

Generically, what is an annuity?

An annuity is a time-related blended interest and principal income stream from a pool of capital. The capital is placed with the annuity-issuing institution (usually a life insurance company) and the institution pays the income to the beneficiary at stated intervals such as monthly or quarterly. The amount of income is specified and the length of time for the payments to last is specified, such as for the beneficiary's lifetime, twenty years, whatever. In the early stages the income stream consists mainly of interest with a little principal; however the balance gradually shifts during the lifetime of the annuity so that, at the end, most of the payments are a return of capital.

In the case of life annuities, only life insurance companies issue them since there is an indefinite period during which the payments will continue, namely the lifetime of the beneficiary. Other financial institutions issue term certain-annuities, those that are for a specified number of years, regardless of whether the main income beneficiary is still alive or not.

Source of funds.

The source of the funds dictates the taxation of annuity payments. If the capital sum comes from a government-registered source, such as a registered retirement savings plan (RRSP) or a registered pension plan (RPP), the payments will be fully taxable when received. This is because there was tax relief granted on the funds that were placed in the registered plan in the first place and on the investment returns. However annuities that emanate from tax-paid funds are treated differently in that the tax-paid capital refunded is tax-exempt and only the earned interest portion is taxed. In most such cases the taxable portion can be "prescribed" as a constant for the duration of the annuity. Otherwise the payments would be heavily taxed in the early years due to the heavier interest component, and more lightly taxed in later years as more capital is actually being paid out later on.

Annuity options.

With a term certain annuity the options are basically the number of years for which payments are to be made and the frequency of the payments. Life annuities have more options. For example, payments could continue until the death of both partners in a marriage or other relationship. Or there could be a reduction of the payment amount on the first death or on the death of the primary annuitant (the one whose money was used to purchase the annuity). Alternatively, the annuity could have a minimum guaranteed period which might state that payments would continue for the lifetime of the annuitant but for at least fifteen years even if the annuitant(s) die(s) before that. This ensures that the heirs get at least some of the capital if the annuitants die earlier than expected, while not prejudicing the lifetime nature of the income that is to be paid.

What does "accrual" mean?

This is a provision that permits decreasing taxation of the income over the lifetime of the annuity. It only applies to annuities purchased with non-registered funds since those purchased with registered funds are fully taxable. For example, an annuity paying $500 per month might have as its "annual taxable portion" $3,000 if it is a prescribed annuity, levelled out over the term of the annuity. With an accrual annuity, probably, $5,800 would be taxable the first year, $5,600 the second year, and so forth. This has the net effect of providing the same income each year but exposing less of it to income tax each year. And this can be very useful as a hedge against inflation.

What is an accrual annuity for?

These instruments are ideal for a number of purposes. For example, a couple might need to increase the income they receive from accumulated capital and this might take precedence over leaving an estate to heirs. A lifetime accrual annuity would pay out a full interest return plus a portion of capital and this would be guaranteed not to run out before the death of the annuitant(s). For example, $60,000 of capital might purchase a monthly income of about $500 for a 75-year-old couple, no reduction on the first death, with a guaranteed minimum period of fifteen years. The taxable portion would be about $5,800 during the first year, $5,600 during the second year, and so gradually reducing during the lifetime of the annuitants. So the same after-tax income is gradually increasing even thought the actual income remains the same.

The same $60,000, if invested in term deposits would produce a fully taxable income. At a 50% income tax rate the annuity leaves less net after tax initially but the tax-free portion rises each year. The GIC's after-tax rate stays the same.

The difference, of course, is that you own the capital with the GIC but you no longer own it with the annuity since you spent the money to buy the lifetime annuity income stream.