The insured annuity, also called back-to-back annuity, is a combination of two products: a life insurance and a fixed annuity. This product has been created for investors who seek both revenues and a guarantee of capital to be left to their heirs.
Back to Back Annuities Structure
As previously mentioned, the back-to-back annuity is a simple combination of a life insurance covering the amount used to buy a fixed annuity.
The idea behind this structure is to provide income to the investor while he lives and still protect his assets to be given to his heirs upon his death. The fixed annuity provides a steady stream of income to the investor. This distribution is used as a pension and also pays for the life insurance premium. Therefore, the net amount received by the beneficiary is smaller than a simple fixed annuity payment, but the capital used to purchase the contract remains intact upon his death. This strategy is used when the investor wants to make sure to leave something behind to his spouse or his children.
As any other fixed annuity distribution, the insured annuity provides tax efficient revenue to the investor. Part of the annuity payment is considered a return of capital and therefore is not taxed. If an investor purchase an annuity at the price of $100,000 in exchange of payment worth of $7,000 per year, only a portion of this amount will be shown on his tax report as taxable revenue.
Income + Capital are Guaranteed
The main advantage of this strategy is definitely to assure both a stream of income and the capital used at death. This product is 100% guaranteed from one way to another as both payments and amount at the end of the contract (death) are known in advanced and secured by the Life Insurance Company.
Better Return than CD’s
In order to appreciate the back-to-back annuity to its full value, an investor must compare it to a certificate of deposits where he would receive the interest but not the capital until maturity. In this case, the maturity is the death of the investor. The combination of the annuity return minus the insurance premium cost is considered to be the net annuity payment. Usually, the net distribution is higher than a certificate of deposit yield if both contracts are taken at the right age. There is a sweat spot between the actuarial calculation to price both annuities and life insurance premiums between the age of 65 and 75. This is always a case by case analysis you must do prior to enter into such contract.
The Money is Locked-in
Once the annuity is purchased and the life insurance premium paid, it is not possible to withdraw more than the annuity payment (unless it is specified in the contract which would incur additional costs). You can always stop paying the life insurance premium and keep the fixed annuity, but you will lose the capital guarantee at the same time. While it is a good product to secure a part of your income at retirement, it is also wise to not invest all your money in a locked-in product.
If you purchase a sample fixed annuity, the payment will remain the same throughout the contract. If you happen to live a longer life than expected, inflation will gradually erode the value of your distributions. Since the money is not invested in the stock market, there are no ways for you to increase this payment.
Don’t Buy it Too Young or Too old
As previously mentioned, there is a sweat spot where the calculation for the back-to-back annuity is advantageous for the investor. If you buy it too young, the annuity payment will not be high enough to net a payment better than a certificate of deposit’s yield. If you buy it too old, the insurance premium will become too important to be paid by the annuity payment. Then again, your net investment return will fail to compete against a CD yield.
Final Thoughts on Back to Back Annuities
Since you have the option of securing both your pension payment and your capital you want to give to your heirs, the back-to-back annuity could be a great solution for a part of your nest egg. Its lack of flexibility makes the product inadequate to become the one and only source of income at retirement. Having said that, it is definitely worth it to have a talk with your adviser to see which scenario is best for your situation.