Q and A: What is an annuity and how does it work?

Question:

One of my friends recently purchased an annuity, saying it would provide a guaranteed income for life. What is an annuity and how does it work?

Answer:

A life annuity is a financial vehicle that allows you to exchange a lump sum of capital for a guaranteed income for as long as you live (or you and your spouse or partner lives).

Life annuity income payments are essentially a blend of principal and interest paid over your life expectancy. You make a lump sum deposit and a life insurance company in turn pays you a guaranteed income for life. If you live beyond your life expectancy, the insurance company still continues the income payments.

While life annuity payments generally cease at death, you can elect to have a guaranteed minimum amount for a life annuity. For example, you can opt for a guaranteed payment period such as 15 years. This means that even if you pass away before 15 years of payments have been made, payments will continue for the remainder of the 15-year guarantee period.

It is also possible to arrange an insured annuity, which provides a 100% return of the annuity deposit at death combined with a tax effective lifetime income.

Life annuities can be purchased using “registered” funds (a transfer from an RRSP or RRIF), in which case, the annuity income is fully taxable. Life annuities can also be purchased using “non-registered” funds, in which case, significant tax advantages can result.