The following is an excerpt from my book Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less.
Many annuities (maybe even most) are a raw deal for investors. They carry needlessly high expenses and surrender charges, and their contracts are so complex that very few investors can properly assess whether the annuity is a good investment.
That said, one specific type of annuity can be an extremely useful tool for retirement planning: the single premium immediate annuity (SPIA).
What’s a SPIA?
A single premium immediate lifetime annuity is a contract with an insurance company whereby:
- You pay them a sum of money up front (known as a premium), and
- They promise to pay you a certain amount of money periodically (monthly, for instance) for the rest of your life.
For some annuities, the payout is a fixed amount each period — making for a single premium immediate fixed annuity.
For other annuities, the payout is linked to the performance of a mutual fund — making for a single premium immediate variable annuity. For the most part, I’d suggest steering clear of variable annuities. They tend to be complex and expensive. And because they each offer different bells and whistles, it’s difficult to make comparisons between annuity providers to see which one offers the best deal.
In contrast, fixed SPIAs are helpful tools for two reasons:
- They make retirement planning easier, and
- They allow for a higher withdrawal rate than you can safely take from a portfolio of stocks, bonds, and mutual funds over the course of a potentially-lengthy retirement.
Note: It’s possible to buy a fixed SPIA with a payout that adjusts upward each year in keeping with inflation. Naturally, inflation-adjusted fixed annuities require higher initial premiums than fixed annuities without an inflation adjustment.
Retirement Planning with SPIAs
Fixed SPIAs make retirement planning easier in exactly the same way that traditional pensions do: They’re predictable. If you know that you need $X of income each year in retirement, you can go to an online annuity quote provider, put in $X as the payout, check “yes” for inflation adjustments, and you’ll get an answer: “For $Y, you can purchase an annuity that will pay you $X per year, adjusted for inflation, for the rest of your life — no matter how long you might live.”
Pretty easy, right? You now have a specific figure for the minimum amount of savings necessary to retire safely. With a traditional stock and bond portfolio, retirement planning is more of a guessing game.
SPIAs and Withdrawal Rates
Fixed SPIAs are also helpful because they allow you to retire on less money than you would need with a typical stock/bond portfolio. For example, as of this writing (with interest rates near historical lows), according to Vanguard’s online SPIA quote provider , a 65-year-old male could purchase an inflation-indexed annuity paying 5.35% annually.
If that investor were to take a withdrawal rate of 5.35% from a typical stock/bond portfolio, then adjust the withdrawal upward each year for inflation, there’s a meaningful chance that he’d run out of money during his lifetime. That risk disappears with an annuity.
How is that possible? In short, it’s possible because the annuitant gives up the right to keep the money once he dies. 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 SPIAs 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 an annuity will not go to their heirs is a deal breaker. It’s perfectly natural to want to leave something to your kids or other loved ones.
The important takeaway here is that, depending on how your desired level of spending compares to the size of your portfolio, choosing not to devote any portion of your portfolio to an annuity could backfire. That is, there’s a possibility that, rather than resulting in a larger inheritance for your kids, the decision results in you running out of money while you’re still alive, thereby causing you to become a financial burden on your kids.
Annuity Income: Is It Safe?
Because the income from an annuity is backed by an insurance company, financial advisors and financial literature usually refer to it as “guaranteed.” But that doesn’t mean it’s a 100% sure-thing. Just like any company, insurance companies can go belly-up. 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). So presumably, we’re talking about a fairly long period of time.
However, if you’re careful, the possibility of your annuity provider going out of business doesn’t have to keep you up at night.
Check Your Insurance Company’s Financial Strength
Before placing a meaningful portion of your retirement savings in the hands of an insurance company, it’s important to check that company’s financial strength. I’d suggest checking with multiple ratings agencies, such as Standard and Poor’s, Moody’s, or A.M. Best. (Note that each of these companies uses a different ratings scale, so it’s important to look at what each of the ratings actually means.)
State Guarantee Associations
Even if the issuer of your annuity 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 goes 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. Equally important: The rules regarding the coverage vary from state to state.
For example, Arkansas provides coverage of up to $300,000 per annuitant, per insurance company insolvency. But they only provide coverage to investors who are residents of Arkansas at the time the insurance company becomes insolvent. So if you have an annuity currently worth $300,000, and you move to Missouri (where the coverage is capped at $100,000), you’re putting your money at risk.
In contrast, New York offers $500,000 of coverage, and they cover you if you are a NY state resident either when the insurance company goes insolvent or when the annuity was issued. So moving to another state with a lower coverage limit isn’t a problem if you bought your annuity in New York.
Minimizing Your Risk
In short, annuities 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 an annuity.
- Know the limit for guarantee association coverage in your state as well as the rules accompanying such coverage.
- Consider diversifying between insurance companies. For instance, if your state’s guarantee association only provides coverage up to $100,000 and you want to annuitize $300,000 of your portfolio, consider buying a $100,00 annuity from each of three different 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.
One last point about annuitizing: Even if your only goal is to maximize your spending power, you may not want to annuitize everything. The reason is that annuities cannot easily be sold. And, since it’s always possible that you’ll be faced with a sudden, large expense, it’s usually best to keep a portion of your portfolio in liquid assets: stocks, bonds, cash, and so on.
- Single premium immediate fixed annuities can be helpful because they allow for a higher level of spending than would be safely sustainable from a typical portfolio of other investments.
- In exchange for this increased safety, you give up control of the money as well as the possibility of leaving the money to your heirs.
- Before buying an annuity, check the financial strength of the insurance company and make sure you’re familiar with the rules and coverage limits for your state’s guarantee association.