SPIA – The Good Annuity versus accumulation based Annuity Products
By Donald J. Lester
What happened to the Retirement Pensions my Grandfather had?
Most
of us probably know someone that collected a monthly pension from their
company after 30+ years of loyal service on the job. My grandfather
was one of the few I knew that did. He worked for 30 years as a welder
for a large corporation and touted to me that his pension income would
be greater than what he made each year when he was working. In
financial jargon, a pension is also referred to as a defined benefit
plan. The reason we don’t know many people collecting pensions today is
because they have purposely been phased out over the past 40 years due
to the high costs associated with providing a lifetime of pension income
and health benefits to workers that are no longer productive to the
company. American corporations have largely replaced the pension plan
with some form of 401k plan (known as a defined contribution plan).
Defined contribution plans have the effect of shifting the
responsibility of providing for retirement from the company to the
worker.
SPIA – The Good Annuity versus accumulation based Annuity Products
I
feel many annuity products (maybe even most) are a raw deal for
investors. They generally come with high investment related expenses,
mortality and insurance costs, and lengthy surrender charges. When you
combine the high internal costs associated with accumulating assets
inside an annuity, it can dramatically reduce your long term investment
performance and increase your risk. Ultimately, your contributions plus
your net investment performance will determine the size of your
retirement nest egg as you enter retirement. Additionally, annuity
contracts tend to be very complex instruments and few investors can
properly assess whether using an annuity for accumulation is actually a
good idea for them or not. That said, one specific type of annuity can
be a useful and powerful tool for generating guaranteed amounts of
retirement income: a Single Premium Immediate Annuity (SPIA).
What’s a SPIA?
A SPIA is a contract with an insurance company whereby:
- You pay them a lump-sum of money up front; and
- They
promise to pay you a certain amount of money each month for the rest of
your life, the joint life of a husband and wife, or a certain period of
time as defined in the contract at the time of purchase.
SPIA’s can be helpful tools for retirees for two reasons:
- They help make retirement income planning predictable and easier; and
- They typically provide a higher withdrawal rate than you can otherwise safely take from a market based investment portfolio.
A
properly structured SPIA will ensure that you never run out of money in
retirement. This is a feature of retirement planning that fits just
about anyone’s situation. Now that most retiree’s don’t have a lifetime
pension from their company when they retire, a SPIA can take its place
by providing guaranteed income to supplement social security and other
non-guaranteed income sources such as regular withdrawals from your
investment portfolio. With a SPIA you’re essentially buying yourself a
form of “Private Pension” with a portion of your investment portfolio.
What’s so great about a SPIA compared to the other fancy annuity products that my agent or financial advisor is promoting?
A
SPIA is a commodity. The terms of the contract are simple,
standardized, and pure. Because of this, there are lots of insurance
companies out there competing for this business. Competition keeps
prices and costs lower, which should translate into a good deal for
you. There are plenty of bells and whistles that can be added on to a
SPIA. But keep in mind that every additional feature will cost you in
the form of a lower distribution rate which means less income to enjoy
retirement with.
What distribution rate (income stream) can you expect from a SPIA?
The
chart below demonstrates historical distribution rates based on the
Life Only option. The distribution rates quoted are averages based on
historical data covering the period of 1986 through 2011.
MALE
|
|
FEMALE
|
Age 60
|
Age 65
|
Age 70
|
Age 75
|
|
Age 60
|
Age 65
|
Age 70
|
Age 75
|
8.27%
|
10.04%
|
11.23%
|
12.57%
|
|
7.73%
|
9.18%
|
10.00%
|
11.14%
|
Ultimately,
the rate of return you will earn on your principal will depend on how
long you live to collect the monthly payments. Rates of return will be
quite good for those blessed with longevity. But a high return isn’t
the point of these things. The point is that the return is guaranteed.
It’s an insurance product, and you should buy it for the insurance
benefit. You’re insuring against the possibility of a long life and
that you cannot “out live” the income stream. It is important to
understand that the income from a SPIA is not market driven, nor is it
negatively affected by poor investment performance or decision making.
In fact, I wouldn’t be surprised to see data in the future which
reflects that those who purchase SPIA’s actually live longer (less
stress watching the markets go up and down).
Fixed
SPIA’s are also helpful because they allow you to retire on less money
than you would need if you relied on a typical market based investment
portfolio for most of your retirement income. For example, most the
financial professionals would advise you to assume 3.5% to 4% as safe
annual withdrawal rate from your investments during retirement. Any
higher withdrawal rate and there’s a meaningful chance that you would
run out of money during your lifetime. The risk of outliving your
assets disappears with a SPIA.
How is that
possible? In short, it’s possible because the annuitant gives up the
right to keep the money when they die. If you buy a SPIA and die the
next day, the money is gone. Your heirs don’t get to keep it — the
insurance company does. And the insurance company uses (most of) that
money to fund the payouts on SPIA’s purchased by people who are still
living. In essence, SPIA purchasers who die before their life
expectancy end up funding the retirement of SPIA purchasers who live
past their life expectancy.
But I Want to Leave Something to My Heirs!
For
many people, knowing that the money used to purchase a SPIA will not go
to their heirs is a deal breaker. And that’s OK. It’s perfectly natural
to want to leave something to your kids or other loved ones.
The
important takeaway here is that if your retirement may last thirty years
or more, and if your savings are of a size such that you’d need to use a
withdrawal rate much higher than 3.5% to 4%, you may not have much of a
choice. If you choose not to annuitize — in the hope of leaving more
to your kids — the decision could backfire on you. If you run out of
money while you’re still alive, instead of leaving an inheritance to
your kids, your final gift will be to become a financial burden on
them. This is not a pleasant thought for any parent.
Are there some other benefits of a SPIA I should know about?
Assuming
you are not using IRA/401k or Roth IRA money to purchase a SPIA, a
portion of the SPIA payments are considered by the IRS as a return of
your principal, and thus are tax-free. An annuity is also generally
protected from creditors and sometimes isn’t counted toward your
Medicaid assets when qualifying for Medicaid coverage of nursing home
care. It also is not part of your estate (since it is gone at your
death) so this could help in the area of estate planning depending on
the size of your estate.
What if the insurance company goes under?
One
problem with a long-term contract with an insurance company is that
you’re relying on the insurance company’s ability to actually pay in the
future (perhaps decades from now). Similar to FDIC coverage for bank
accounts, most states will cover annuities up to a certain limit per
person. You can minimize the risk by buying from highly-rated
companies, and perhaps by buying several different SPIA’s from several
different insurance companies. For example, if you wanted $400,000 of
SPIA’s, but your state guarantee was only $100,000 per company per
person, you could buy two policies, one on each spouse, from each of two
different highly rated insurance companies.
SPIA Income: Is It Safe?
Because
the income from an annuity is backed by an insurance company, financial
literature usually refers to it as “guaranteed.” But that doesn’t mean
it’s a 100% sure-thing like long term treasury bonds issued and backed
by the full faith and credit of the United States Government! Ha
Ha…laughing very hard. Just like any company, insurance companies can
go out of business. It’s not common, but it’s certainly not impossible,
especially given that:
- The longer the period in question, the greater the likelihood of any given company going out of business; and
- The
entire point of an annuity is to protect you against longevity risk
(that is, the risk that you last longer than your money). For the
typical 65 year old retiree, we could be talking about a fairly long
period of time (maybe 30 years). If you’re careful choosing your
annuity provider, the possibility of the insurance company going out of
business shouldn’t be something that keeps you up at night.
Check Your Insurance Company’s Financial Strength
Before
placing a portion of your retirement savings in the hands of an
insurance company, it’s important to check the company’s financial
strength. I’d suggest checking with multiple ratings agencies such as
Standard and Poor’s, Moody’s, and A.M. Best.
State Guarantee Associations
Even
if the issuer (insurance company) of your SPIA does go bankrupt, you
aren’t necessarily in trouble. Each State has a guarantee association
(funded by the insurance companies themselves) that will step in if your
insurance company becomes insolvent. It’s important to note, however,
that the state guarantee associations only provide coverage up to a
certain limit and that limit varies from state to state. Additionally
and equally important: the rules regarding the coverage vary from state
to state. For example, some States only provide coverage to investors
who are residents of their State at the time the insurance company
becomes insolvent. So if you move to a different State after purchasing
your SPIA, you could be putting your money at risk in the event your
insurance company gets in financial trouble.
Minimizing Your Risk
In
short, SPIA’s can be a very useful tool for minimizing the risk that
you’ll run out of money in retirement. But to maximize the likelihood
that you’ll receive the promised payout, it’s important to take the
following steps:
- Check the financial strength of the insurance company before purchasing a SPIA.
- Know the limit for guarantee association coverage in your state as well as the rules accompanying such coverage.
- Consider diversifying between insurance companies..
- Before
moving from one state to another, be sure to check the guarantee
association coverage in your new state to make sure you’re not putting
your standard of living at risk.
At what age should I buy an annuity?
My
personal opinion is that you should buy them when you need them and in
an amount that fits with the retirement lifestyle you want to ensure.
If you retire young, there’s nothing wrong with putting some of your
money into SPIA’s to ensure a “floor” for your retirement income. I
wouldn’t put it all in SPIA’s at that young age, and you can always
purchase additional SPIA’s later. Likewise, if you’re 90, and you’re
afraid of running out of money, a SPIA will keep you from doing that.
Plus, at that age you get huge payments every year (up to 20% of the
initial purchase price.) You only have to live 5 years to get your
money back. Keep in mind that the number of companies willing to sell
you an annuity goes down as you get older than 75.
What about inflation?
Most
SPIAs are fixed, meaning they pay out the same amount each year in
nominal dollars. Just like with bond coupon payments, inflation can
really eat up a lot of purchasing power on a fixed income as the years
add up. My recommended strategy is to avoid annuitizing your retirement
stash all at once. Then, if you find you need more income after
enduring 10 years of inflation, you can just annuitize another chunk of
your portfolio. Hopefully, your portfolio will beat inflation so you
would still have something left to buy another SPIA with.
The Role of Interest Rates
SPIA
distribution rates change as a function of market interest rates. When
market interest rates are higher, SPIA payouts are higher because the
insurance company can invest your money at a higher rate of return.
So
the decision regarding how much to allocate to the purchase of a SPIA
needs to also take into account the current interest rate environment at
the time of purchase. In today’s historically low interest rate
climate, I would be careful about allocating too much to the purchase of
a SPIA. Expecting that interest rates are heading up in the coming
years would likely to have a positive effect on the distribution rates
being offered by insurance companies when purchasing a SPIA. So, where
you think interest rates are headed next is something to be considered
and weighed carefully. If you expect interest rates to rise, delaying
your SPIA purchase is more attractive than if you expect interest rates
to decline. Delaying your purchase also means you will be a year older
which will increase the distribution rate.
How and where can I get a SPIA?
Since
it’s an insurance product, you would be well served to find an
experienced agent that can help you shop the SPIA marketplace at the
time you want to establish your own “Private Pension” plan for
guaranteed retirement income. When purchasing a SPIA, the agent should
help you take into account company ratings, available distribution
rates, State guarantee limits, and other income sources you have
available, available liquidity, net worth, longevity (family history),
permanent life insurance death benefits, and your estate planning goals.
©2012 Donald J Lester
