I’ve been writing a lot recently about single premium immediate annuities. It wasn’t until after receiving several questions from readers that I realized I’ve never covered the basics of how they work and why they’re useful.
A single premium immediate annuity (SPIA) is a contract with an insurance company whereby:
- You pay them a sum of money (known as a premium) and
- They promise to pay you a certain amount of money periodically (usually monthly) for the rest of your life.
The payout may be fixed (making for a single premium immediate fixed annuity), or it may be linked to the performance of a mutual fund (making for a single premium immediate variable annuity).
Often, the payout on a fixed SPIA will be set to adjust upward each year in keeping with inflation. Naturally though, an inflation-adjusted fixed annuity requires a higher initial premium than a fixed annuity without an inflation adjustment.
Why are single premium immediate annuities helpful?
SPIAs (fixed ones, in particular) are helpful tools for two reasons:
- They make retirement planning easy, and
- They allow for a higher withdrawal rate than you can safely take from a portfolio of stocks/bonds.
Retirement Planning with SPIAs
Fixed SPIAs make retirement planning easy 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 annuity quote provider, put in $X as the payout, and you’ll get an answer: “For $Y, you can purchase an annuity that will pay you $X per year for the rest of your life.”
Easy.
With a traditional stock and bond portfolio, retirement planning is more of a guessing game. There are whole books written on the subject of how to determine how large your stock/bond portfolio must be in order to retire safely.
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, a 65-year old male could purchase an inflation-indexed annuity paying 5.56% annually.
If that investor were to take a withdrawal rate of 5.56% 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. With an annuity, that risk disappears.
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.
Annuities and Safety
While it’s uncommon for insurance companies to go out of business, it’s not impossible. So if you think that a single premium immediate annuity may be helpful for your own retirement planning, I’d suggest that you try to stay under the state-backed limit (by spreading your annuity purchases across multiple companies, if necessary).
The limit per contract varies by state, so you’ll want to check with your state’s guarantee association to be sure.
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{ 16 comments }
The ‘only’ trade off that SPA seems to have is that your hard earned money is gone after you, nothing left to your kids or whatsoever.
Even though it may provide me some comfortable life in retirement, insurance company keeping the money sounds like a deal breaker to me, unless I have lots of money I can spare that I am willing to forego.
Are there any other investments that provide this type of arrangement and still be able to keep the money after one dies!? (not including mutual funds/stocks/CDs/money market/ etc) or is it a ridiculous question to ask?
Why cant they come up with some thiing better than these kind of corny investment vehicles?
That tradeoff is what makes the whole thing work. The only reason SPIAs allow for a higher safe withdrawal rate is that you forgo the ability to leave the money to your heirs.
In my opinion, SPIAs are actually at their most helpful when you don’t have lots of money to spare–precisely because they allow for a higher withdrawal rate.
I would be concerned with the fees you’re paying. Maybe you’re getting 5.5% annually, but if the fee for the annuity is 2.5%, then what’s the difference between that and taking 3% from your own accounts? (I know – one answer: you’re getting that amount indefinitely without any fear of running out of money.) I’d like to know the break-even point between these annuities and funding your own retirement.
And if the payout is pegged to the performance of a mutual fund, how does that benefit the annuitant when the value of the fund fluctuates negatively? I really dislike the very idea of a variable annuity.
Yes, annuities have fees. And yes, they’re important. The major difference between fixed SPIAs and a mutual fund though is that the quote you get for a fixed SPIA is a promised payout, already net of fees.
“I’d like to know the break-even point between these annuities and funding your own retirement.”
Break even point expressed how?
“If the payout is pegged to the performance of a mutual fund, how does that benefit the annuitant when the value of the fund fluctuates negatively?”
The annuitant does not benefit from negative fluctuations.
A variable annuity, stripped of all the bells and whistles, is essentially the same gig as a fixed annuity, but with a mutual fund as the basis rather than fixed income investments. In other words, several people pool their investments, and the money of those who die sooner goes toward funding the payout of those who live longer.
Frankly, I’m not much of a fan of variable annuities in most cases. They each come with different gimmicks that a) make comparison shopping difficult and b) are often not worth the additional cost. It’s fixed SPIAs that I find to be significantly underutilized.
Mike,
One thing you didn’t cover- tax treatment of a SPIA. I suspect it is taxed as ordinary income. That could be an important factor especially if you had other taxable income. After all it wouldn’t be a higher payout if the government takes a larger share.
SJ,
You don’t have to put your entire nest egg in SPAs- you could hold back a portion that goes to the kids if you die young. You could also use the monthly payments to save up an inheritance for your kids.
I suspect my kids would prefer the peace of mind that they would never need to support their parents then the possibility of a large inheritance at our death. That’s conversation I plan to have in about twenty years.
-Rick Francis
“I suspect it is taxed as ordinary income.”
The following statement regarding annuities in a taxable account is from IRS Publication 939: “In general, you can recover your net cost of the pension or annuity tax free over the period you are to receive the payments. The amount of each payment that is more than the part that represents your net cost is taxable” [as ordinary income].
“Break even point expressed how?”
I mean is (all other things being equal), how do you determine whether the fees you are paying for the annuity are more cost-effective than going it all on your own? I see what you mean by the payout being net of fees. But what are the usual fees?
Sorry, I should have clarified in last comment, are we talking about fixed or variable SPIAs here?
For a fixed SPIA, I’d ignore the fees actually. Just look at the annuity’s payout, compare that to whatever withdrawal rate you deem to be safe from a typical index fund portfolio, and calculate how long you’d have to live before a (fixed) SPIA is a better option.
For a variable SPIA, I definitely would pay attention to fees. (Though I’d be hard pressed to come up with an easy step-by-step method to do a comparison, because, as I mentioned, the particulars of variable annuities tend to vary significantly.)
A few comments about SPIAs:
1) They operate on the concept of “mortality pooling,” ie, those who die early subsidize those who die late. For that reason, they tend to be the most beneficial for those who are close to or beyond their life expectancy.
2) It doesn’t have to be an “all or nothing” proposition. A combination SPIA/traditional investment portfolio can extend the life of the portfolio and/or increase the withdrawal rate while still leaving some to survivors.
3) SPIAs are very sensitive to the interest rate environment in which they are purchased. SPIAs purchased now are paying substantially less than the same amount spent on a SPIA five years ago (for example). Buying multiple SPIAs over time can help (potentially) reduce this risk.
4) SPIAs are only as good as the future strength of the insurance company that issues them. Choose carefully, and buying multiple SPIAs from different top-rated carriers can help reduce this risk.
There are issuers that sell SIPAs direct to the consumer, and these should be looked at as part of the shopping around process. When an agent isn’t getting a commission, the same premium amount results in a higher benefit. I’ve seen the exact same annuity (same company, same premium) quoted differently, one as low-load and one as no-load, to the same consumer.
Wow. That’s good to know! Thanks for mentioning.
Mike makes several very good points about the value of a SPIA within a retirement plan. Just want to clarify a few issues in the article and comments. The first is that Fixed SPIAs have no expense ratio or stated expenses. Insurance companies make money issuing SPIA’s the same way bank’s make money issuing CD’s. They make more on the money than they pay, but as an investor your only concern on a SPIA is the amount you are paid.
Second, tax treatment of SPIA payouts is based on two issues. If a contract is purchased using qualified money, ex. IRA, then the payout if fully taxable. If it is non-qualified, a portion of every payment is considered a return of principal and that portion is not taxed. This is referred to as the “exclusion ratio” and it varies with each insurance company. The older you are when you buy the SPIA the higher the exclusion ratio and the lower the income taxes. Generally, for purchasers above 65, I’ve seen exclusion ratios from 65% up. At 75%, a $1,000 monthly payment would have $350 as taxable income and $650 as a return of principal. The ratio is for the life of the contract.
Speaking of the life of the contract, SPIAs can be “life only”, 5 years plus life, 10 years plus life, 20 years plus life, installment refund, or for a period certain (ex. payments for five years only). The highest payout, and exclusion ratio, is for life only since it terminates at death. SPIA’s can also be purchased jointly with the same options.
Dylan, sorry to disagree but the commission does not always affect the payout. I regularly quote both load and no-load SPIA’s and in any given month the load might be higher. Quality of the insurance company is the primary factor in payout amounts with lower quality companies paying out more. Any specific product from the same company will have the exact same payout and load, or no-load. These products are highly regulated and the companies cannot show two different payouts for the same product assuming both are identical in their terms. Different products by the same company will have different payouts.
As an example, USAA offers clients insurance products from load carriers. Their quote is the exact number as the loaded insurance quote for the same product. USAA keeps the commission, which is fine, just using as an example.
SPIA’s can be useful for a portion of a retirement plan for the reasons Mike listed in his post. I would add that the quality of the company is critical because once you purchase a SPIA you are depending on the company to make the payments.
You are free to disagree, but the fact remains that annuities can be purchased direct at a saving, which equates to a higher benefit. This is easily verifiable by getting a quote directly from a carrier that also sells direct to consumers. Your USAA example is not the same as a consumer going direct to the carrier.
Here is a relevant example. NAPFA planners have access to institutional pricing through Income Solutions; however, there are companies on that platform that also sell direct. Without the payout to Income Solutions, the benefits on a direct purchase are higher.
Thanks Dylan,
I was not aware that any of the companies available in the Income Solutions program sold immediate fixed annuities to individual clients. All are load companies, which ones offer direct sales?
For a better example of what I was attempting to describe, get a quote on Vanguard’s site (offered by AIG) and then go to http://www.immediateannuities.com and get a quote there. At the moment, a 65 year old is cheaper on the load quote. It is a different company however, but in this case allowing someone to get paid results in a higher guaranteed payment to the purchaser. Now that I think about it, AIG is a load company. I assume the product offered by Vanguard is no load? Anybody know?
Western and Southern can be accessed direct. The point I am advocating is for consumers to shop around and investigate direct purchase opportunities. I’m not advocating avoiding commissioned agents, just not using them if you can get a better deal by not using them. If you can’t, then use them. Simple enough.
You are free to disagree with me, but the simple math is that the less and insurance company pays in commissions, the more that’s available for benefits. That simple economic principle shouldn’t be ignored.
Dylan,
Now I get what you are saying, my apologies. We agree on shopping and comparing and consumers buying the best insurance product even if it involves a commission. The simple economic principle is where we are not in total agreement. I agree that it makes sense, but with insurance companies involved, common sense and simple economics often do not apply.
Without my naming insurance companies, have you compared some of the no-load company offerings to load companies and found examples of insurance, term for instance, cheaper in a load form? I was stunned. Explanation given to me by several in the insurance industry was that commission is only one insurance company expense. If a no-load company has higher expenses in other areas, they may charge more, or pay less, than their loaded counterpart. That was the explanation anyway…
This was fun, I intended no offense, best regards,
Paul
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