Today’s guest blog is from Lea Koiv, BComm, CPA, CMA, CA, CFP, TEP at Lea Koiv and Associates and Alexandra Macqueen, CFP at Pension Acuity. Lea and Alexandra are strategic partners providing advice in areas including longevity planning and the use of annuities in client estate plans, and pension decisions including commutations, transfers, and wind-downs.
Many wills provide for a spousal trust with the spouse as the income beneficiary. This is common, for example, in second marriages, when the deceased’s primary concern when drafting is that a surviving spouse have an income stream for their remaining life.
In this situation, the residue of the estate will be not be distributed to the remaining heirs—typically any children from the first marriage—until after the surviving spouse has died. In today’s era of rising life expectancy, however, the heirs awaiting any residue may need to be exceptionally patient. Although individual life expectancy is uncertain, if the second spouse lives many years past the first death, the period between the first death and the distribution of assets upon the second death can be much, much longer than either the residual beneficiaries or the drafter of the original will might anticipate.
In this article, we explore two questions: first, what is the likelihood of living to an advanced age in Canada? Secondly, given the uncertainty around life expectancy, is there an approach that can help “close the gap” between the first death and the distribution of residual assets at the second death?
Outlier, or the new normal?
Over the past decades, life expectancy among Canadian adults has been rising—and the issue of advancing longevity has recently been receiving a considerable amount of attention. For example, in September, 106-year-old Roberta McCain attended the funeral of her 81-year old son, Senator John McCain. Is she an outlier when we look at life expectancy, or will this be the new normal?
In thinking about life expectancy, it’s important to keep in mind two basic facts: population life expectancy is an average measure, setting out the point at which half of a population cohort is expected to have died, while half remains alive; and individual life expectancy does not remain constant, but changes over your lifetime—your life expectancy at birth is not the same as your remaining life expectancy at age 50, 70, or 90.
The C.D. Howe Institute recently released a study on the policy implications of increasing longevity in Canada. Drawing on data from the Canada Pension Plan, the study concluded that “increases in longevity have been brisk for Canadians, with both men and women experiencing longer lifespans past age 50 than the generations before them.”
Specifically, the study found that since 1965, average male life expectancy increased by 7.7 years after the age of 50, while women gained 6.4 years. These findings are echoed in data about the growing number of centenarians in Canada. Over the past 40 years, those of us older than 100 have often been the fastest-growing age group in Canada. Between 2006 and 2011, this group grew by 26.7%.
Perhaps not unexpectedly, the C.D. Howe study also concluded that income had a bearing on life expectancy (producing what the authors term an “earnings-longevity gradient”), with higher income-earners outliving lower income-earners. Data examined in the study found that males in the highest income quintile outlived those in the lowest quintile by eight years, while for females the gap was three years. This finding shows how individual characteristics (such as higher education, good health, or higher income) can suggest a longer-than-average lifespan.
Today, actuarial life tables for Canadian pensioners (used by Canadian pension plans to estimate mortality, and by Certified Financial Planners in developing financial plans for clients) tell us that a male age 65 has a 25 percent chance of living to age 94 and a ten percent chance of living to age 97, while a female age 65 has a 25 percent chance of living to age 96 and a ten percent chance of living to age 99. These figures, of course, are significantly different from Canadian life expectancy at birth, which hovers around 82 years for both sexes.
How long might residual beneficiaries wait?
This brings us to the issue at hand: understanding and estimating just how long a surviving spouse might live, when heirs are waiting for the distribution from an estate—and how a life annuity might help resolve that waiting time, to the benefit of all parties.
Let’s return to our original scenario, that is, a spousal trust with a surviving, second spouse as income beneficiary and remaining heirs as residual beneficiaries of the estate (once the income beneficiary has died). In this situation, the residual beneficiaries are faced with uncertainty about how long it might be before the residue can be distributed, including the possibility that it might be a significant number of years if the surviving spouse lives to an advanced age. In this scenario, the surviving spouse is both the owner of the annuity, and the annuitant (the person on whose life the annuity is based).
Annuities as a solution to “close the gap”
Where a spousal testamentary trust is in place, one potential solution is to arrange for the purchase of a life annuity that is to be owned by the surviving spouse, presuming the children and the spouse are able to come to an agreement on this option. The life annuity will pay an amount to the surviving spouse for as long as they are alive, in exchange for a payment to the insurance company providing the annuity.
Once the annuity is in place, lifetime income for the surviving spouse has been secured, the uncertainty surrounding the remaining lifetime of the surviving spouse from the estate’s point of view has been eliminated, and the remaining assets in the estate can be distributed to the children. The ongoing costs of administering the trust have also been removed, as has any requirement to maintain a relationship between the surviving spouse and the residual beneficiaries.
The use of an annuity in these circumstances will necessarily raise many questions and technical issues which must be addressed. Primary among them will be the question of whether the children would have been better off “waiting out” the remaining lifetime of the surviving spouse, rather than funding a life annuity.
Preserving capital through the use of guarantees
Since these are life annuities, the payments will continue so long as the measuring life survives. The payments can, however, continue past the lifetime of the annuitant if guarantees are used. A common option is a guarantee for a fixed period, say 10 or 15 years, in which payments continue to the annuity beneficiary or beneficiaries if the annuitant dies within the initial 10-year (or 15-year) period. Should the annuitant die within the guarantee period, the payments for what remains of the guarantee period will be commuted (or might continue to the beneficiaries).
For tax purposes, a life annuity could receive beneficial tax treatment. If it qualifies as a “prescribed annuity”, it will be taxed on a level basis. (By this we mean that the same portion of each payment is subject to tax). A number of conditions must be met for the annuity to qualify as a prescribed annuity, including ensuring that the guarantees do not extend beyond when the survivor attains age 91.
A life annuity that does not meet all of the conditions for level taxation will be taxed on an accrual basis. With this being the case, the income will be highest in the early years, and will decline over the life of the annuity. (We do remind the reader that how the annuity is characterized for tax purposes does not impact the total payment. What varies is the amount that must be reported for tax purposes).
Should the survivor be age 65 or older, and should he/she remarry (or enter into a common-law relationship), the taxable portion of the annuity does qualify for income splitting under the Pension Splitting rules.
Importantly, annuity guarantees are not limited to just a specified number of years, as some issuers offer special features. For example, the annuity contract may provide that upon the death of the measuring life the beneficiaries (or the estate, if no beneficiaries are named) will receive a lump-sum payment equal to the purchase price of the annuity, less the sum of the payments made to date. Thus, if the annuity cost $1 million, and the owner received only two payments of $20,000, the beneficiaries would receive $960,000. With this option there is no loss of capital if the annuitant dies while the payments total less than the sum used to purchase the annuity.
When we are looking at who might be the beneficiaries under the annuity contract, we often recommend that these be the children. Thus, upon the death of their step-mother (or step-father) they receive the capital that they would have otherwise received as residual beneficiaries of the estate.
Annuities are of considerable value as they have many applications, beyond just those related to estates. In the scenario that we have described above, the surviving spouse is ensured of life-long income. Longevity risk has been taken off the table. (Inflation risk might also be eliminated, were an indexed annuity to be acquired.) Moreover, the costs of administering the estate have been eliminated. Finally, the very long wait that the heirs might otherwise have has been eliminated.