“Think of income annuities as the term insurance of the annuity world.” – Professor of Retirement Income Wade Pfau of The American College in an article for Forbes – August 27, 2015.
As I outlined in Part I, fixed-rate and fixed indexed annuities can be utilized as a sleeve in an asset allocation program to minimize overall portfolio volatility. Fixed annuities are not subject to downside risk, and in the case of FIAs, allow partial participation in the upside of major stock indexes like the S&P 500.
Income riders or addendums may be added to FIAs to convert them to income annuities deferred to some period in the future, usually ten years or longer.
As referenced in Part I, riders add ongoing annual costs to annuities; formal financial planning should be completed before guaranteed income riders are considered to determine whether there’s a household retirement funding shortfall. In other words, if your investment portfolio has a greater than 30% probability of depletion in retirement before you and your spouse run out of time on the planet, annuitizing a portion of retirement assets should be considered along with a plan to maximize Social Security benefits.
A method to accomplish this is to add a rider to convert the fixed annuity into a future stream of income. Another idea is to purchase an income annuity indexed to inflation early in retirement.
Income annuities are solely designed to provide a stream of income now or later that recipients cannot outlive. These annuities are simple to understand and are generally lower cost when compared to their variable and indexed brethren.
Deferred income products where owners and/or annuitants can wait at least 5 years before withdrawals, may participate in market index gains (subject to caps) and have an opportunity to receive higher non-guaranteed annual income withdrawals depending on market performance. Withdrawals can never be less than the guaranteed withdrawal benefit established by the insurance company but may be higher depending on annual market returns. As with all annuities, there is never market downside risk. Details about deferred income annuities will be outlined in Part III. Here, I focus on the purest form of annuity: The SPIA. It’s the “Ivory Soap” of insurance products.
Single Premium Immediate Annuities – “The Pension Replacement.”
SPIAs are splendidly simple – Provide a life insurance company a lump sum and they pay you or you and a spouse for life. That’s it. I consider SPIAs the best replacement for the pension your company no longer provides. You as an employee, must create a pension on your own.
There are several valid reasons to allocate a portion of an investment portfolio to an income annuity. I’ll list them in the order of importance:
- Above average life expectancies. On average, American males live to 76.1 years, females add 5 years to 81.1. If you or you and a spouse have a family history of longevity and enjoy excellent health along with life-prolonging habits like exercise and healthy diet, a SPIA may be a viable addition to a traditional stock and bond portfolio.
- Retirement plan survival deficiency. Life has a way of altering good financial intentions. If lucky, you have a solid 20 years to save uninterrupted. Along that path may come unexpected life changes like divorce, major illness, job loss, and let’s not forget the portfolio-busting bear markets or worse. If working longer, saving more, part-time employment in retirement and smart Social Security decisions don’t dramatically improve the probability of financial plan success, then a SPIA can be purchased to make sure along with Social Security, your household never runs out of money.
- A legacy intent. Studies indicate that purchasing an inflation-indexed SPIA at retirement reduces portfolio depletion and allows for a larger inheritance for those who believe leaving a legacy to children and grandchildren is an important goal.
Although SPIAs are simple in theory, consumers have a difficult time grasping how they provide return or yield. Prospective SPIA owners should swap the word “return” for the concept of payout. Let’s take an example: An investor purchases a high-quality $100,000 bond for five years that pays 2.25% on an annual basis. Easy, right? The bond purchaser earns $2,250 every year for five years, then at the end of the period or upon maturity, $100,000 is returned. Obviously, the return is the interest earned.
Consider now $100,000 in a SPIA. Not so easy. A couple provides $100,000 to an insurance company and expects payments to begin the following month. Here, there’s no return per se, there’s a payout rate which distributes principal and interest. From there, the internal rate of return can be calculated. Not to be morbid, however the best that can happen for the insurance company is income recipients pass early or within age ranges the life insurance actuaries expect. The worst that can occur for the organization is that income recipients live long lives. Way beyond years the mathematics dictate. SPIAs are primarily designed to manage or hedge longevity risk.
Back to my example: A 65-year-old male and his 62-year-old spouse invest $100,000 in a non-qualified (after-tax,) SPIA with an increasing payout option (indexed for inflation at 3% per annum) and will receive every month beginning next month, $291.01. The taxable portion of each payment (interest) will be $80.61, the remainder – return of principal. Thus, the tax exclusion ratio is 72.3%.
The 12-month income figure is $3,492.12 which makes the annuity payout rate 3.49%. The internal rate of return or IRR after 21 years is .012%, after 25 years – 1.722%, 30 years – 3.101%. You get the picture. The longer you live, the greater the “return” on a SPIA. The IRR here is negative for 20 year and shorter timeframes.
The SPIA along with Social Security generates a combined lifetime income stream which should permit a lower withdrawal rate from a stock and bond portfolio especially through sequences of low or poor market returns, thus reducing risk of portfolio depletion. The use of a SPIA affords retirees an opportunity to increase stock allocations, especially if capital isn’t required to be distributed during corrections and bear markets due to the guaranteed income the SPIA provides.
Gary Mettler author of the book “Always Keep Your Hands Up!” exclusively about SPIAs, shared his 35-years “in the SPIA business,” perspective:
“SPIAs exist to keep you from going broke. While going broke may happen towards the end of life at age 85+, it can happen very early on too. Adverse changes in mental health, business collapse, marriage failure, unreimbursed casualty losses, medical/care costs, litigation expense, etc. you want to make sure you continue to receive an uninterrupted flow of retirement income. After all, at age 60+, you no longer have time to make up for portfolio losses.”
RIA and Clarity’s Rules or Financial Guardrails for the Purchase of SPIAs:
- Nothing happens without comprehensive planning as a first step. A financial plan will expose portfolio longevity concerns that may require the use of income annuities. Working longer, part-time employment through retirement, downsizing, boosting savings and maximizing Social Security may be sufficient to improve portfolio survivability. If not, annuitizing a portion of a portfolio will at least ensure lifetime income. If there’s a 30% or greater probability of outliving retirement assets, purchasing a SPIA at retirement should be explored.
- Think of SPIAs primarily as “longevity insurance.” Per the example above, it can take many years, possibly decades, to jump the hurdle to positive numbers or those which exceed your original investment in a SPIA. Living a very long life, 35 years or longer through retirement, makes SPIAs a smart choice. Put your life expectancy to the test at livingto100.com. The Living to 100 Life Expectancy Calculator uses the most current medical and scientific data to estimate how old you’ll live to be. There are 40 questions that span health and family history. Thomas Perls, MD, M.P.H. created the calculator. He’s the founder and director of the New England Centenarian Study, the largest study of centenarians and their families in the world.
- Inflation-adjusted SPIAs vs. fixed SPIAs – When to choose. Fixed SPIAs are not adjusted for inflation. Income remains the same throughout the payout period. So, why would I choose a fixed SPIA over one that accounts for inflation? At a 3% inflation rate, the fixed SPIA provides a 45% larger initial retirement date payout than the inflation-adjusted selection for my retiring couple. In other words, with the fixed SPIA, there’s a greater chance of recovering and exceeding their $100,000 investment in a shorter timeframe when compared to the 21 years required for the inflation-adjusted alternative. Your choice would depend on your: 1). Personal expectations of inflation throughout retirement, 2). Life expectancy assessment. The longer your life expectancy, the greater the benefits of an inflation-adjusted option. Professor Wade Pfau provides back-up to this analysis in his blog post “Efficient Frontiers: Inflation Assumptions, Fixed SPIAs, & Inflation-Adjusted SPIAs.”
Are SPIAs the right choice for you?
We hope the guidelines provided will help you understand when and how single-premium immediate annuities may be incorporated into a holistic retirement income strategy.
Richard Rosso, MS, CFP, CIMA is the Head of Financial Planning for RIA Advisors. He is also a contributing editor to the “Real Investment Advice” website and published author of “Random Thoughts Of A Money Muse.” Follow Richard on Twitter.