Canadian annuities offer a predictable source of income—but we advise against buying them

An annuity may be worth considering for part of your assets, depending on your age, investment experience, the time you want to devote to your investments, your desire to leave an estate to your heirs and other aspects of your retirement investing.

But a key drawback to annuities is that annuity rates are closely linked to interest rates, which are at historic lows. In addition, annuities have no liquidity. If interest rates and inflation move up, your annuity payments would remain fixed and you would lose purchasing power. Plus, you would have no way to rearrange your portfolio. This is why we generally advise against investing in Canadian annuities.

There are basically three types of Canadian annuities:

1. Term-certain annuities are payable to you, or your estate, for a fixed number of years. Your estate will receive the payments even if you die. You could outlive this type of annuity.
2. Single-life annuities are payable to you for as long as you are alive. These annuities may come with a minimum number of years of payments. If you die while the minimum payment period is still underway, future payments would go to your estate.
3. Joint and last survivor life annuities are payable as long as you, or your spouse, are alive.

3 ways Canadian annuities can hurt your retirement investing

Stable, predictable income is a plus for any retirement plan. However, annuities do have disadvantages that can lower your overall retirement investing income.

Here are 3 key drawbacks you should keep in mind when deciding whether annuities are right for you:

1. Link to interest rates makes today a poor time to buy annuities: The rate of return you receive on an annuity is linked to interest rates at the time you buy it. That makes periods of low interest rates, like today, an especially poor time for buying annuities. However, if you want to buy annuities, you could buy one annuity a year for the next five years. That way, your returns will increase if interest rates rise, as we expect.
2. It may be hard to get out if you change your mind: Unlike stocks, it can be difficult or impossible to sell an annuity if you decide it no longer meets your needs. Moreover, you will likely get a low price for your annuity because the date of your death is uncertain.
3. Tax treatment: When you own an annuity, the income payments you receive are made up of interest and a return of your principal. The return of your principal is tax free, but the interest portion of the payment is taxed as ordinary income.

Ordinary income is taxed at a higher rate than returns on a stock portfolio. If you build your retirement investing portfolio as we recommend, part of your return would come in the form of dividends from Canadian stocks, which qualify for the dividend tax credit. The remainder would come in the form of capital gains, which are taxed at half the rate of ordinary income, and are only taxed in the year you sell.

A safety-conscious investment portfolio is often a better option than Canadian annuities. 

No matter what kind of stocks you invest in, you should take care to spread your money out across the five main economic sectors: Finance, Utilities, Consumer, Resources & Commodities, and Manufacturing & Industry.

By diversifying across most if not all of the five sectors, you avoid overloading yourself with stocks that are about to slump simply because of industry conditions or investor fashion.

You also increase your chances of stumbling upon a market superstar—a stock that does two to three or more times better than the market average.

Our three-part Successful Investor strategy:

• Invest mainly in well-established companies;
• Spread your money out across most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; Consumer; Finance; and Utilities);
• Downplay or avoid stocks in the broker/media limelight.

Have you included Canadian annuities in your overall investment portfolio? Share your thinking and strategy with us in the comments.

Note: This article was originally published in 2010 and has been updated.