Accepting Annuities

It’s sometimes difficult to think about relatively mundane financial planning topics with all that’s going on right now. But these things are still important. They’re what we can control. That said, let me indulge in a little “inside baseball” this week.

I’ve written previously about how much I loathe annuities. They’re expensive, complicated, and are said to be sold and not bought. (In other words, a reasonable person wouldn’t buy one, someone must sell it to them.) That latter point is probably my biggest problem with annuities; armies of highly trained and highly paid salespeople masquerading as financial planners and peddling their wares to unsuspecting grandmas.

But that’s just a stereotype. As with all stereotypes that emanate from grains of truth, we should look deeper to see what, if any, value there is to be had. This is what I’ve tried to do over time with annuities. I’ve attended copious continuing education sessions and have delt with many companies and brokers, while always trying to peel back the layers to find the good stuff. This has led to an evolution in how I think about annuities and which types I think might be most appropriate for retirees. Simply put, not the variable or equity-indexed kind, but a simpler variety known as a SPIA (Spee-Ah), short for Single Premium Immediate Annuity.

SPIAs aren’t appropriate, or even necessary, for every retiree. But for those folks needing to stretch their savings into extra income, or for others who like the peace of mind that comes with having a specific expense, such as a monthly mortgage payment, covered by a specific income source, a good quality SPIA can work.

It’s interesting that other fiduciary financial planners have been on a similar path in recent years. I’ve talked with these folks and other experts at conferences (when we used to have conferences in person) and read analysis from the more analytically minded.

The following article is a good example of this thought evolution. Like me, the author is a practicing planner who has pinched their nose long enough to develop a better understanding, even an appreciation of, the utilitarian nature of a SPIA. What follows are excerpts from the article. It was written for an industry audience so there’s some jargon to contend with. I’m also including a link to the whole thing if you’d like to read additional detail and see some charts.

Continue reading…

I’m on record as being a skeptic when it comes to single premium immediate annuities.

Just two years ago, I wrote that although an “SPIA is the least ugly of annuities, guaranteed returns from variable annuities are far worse since the return comes in the form of an annuitization later on, at below-market rates rather than cash.” Indeed, buying a SPIA today is essentially buying a long-term bond with a duration of the rest of one’s life at a time when long-term interest rates are at an all-time nominal low.

But looking for the answer to the financial advisor’s eternal question — How can we generate income for our clients? — and noting that nominal rates on bonds are at an all-time low with the iShares Core U.S. Aggregate Bond ETF (AGG) yielding 1.20% as of Sept. 3, I took another look at SPIAs and was somewhat surprised at their relative attractiveness and their implications for clients.

… I went to and got quotes based on a $100,000 purchase, then decided to use New York Life SPIA to conduct my experiment.

… I decided that, for me, a $5 monthly reduction from the highest rate of $456 a month was worth the peace of mind to have a higher credit rating. I discussed this with two experts — David Blanchett, head of retirement research at Morningstar, and Wade Pfau, founder of Retirement Researcher. Both thought I had made a reasonable tradeoff.

One big concern about buying a SPIA is that if a client dies shortly after purchasing, it may leave nothing for heirs. But this risk can be mitigated — somewhat — by buying a SPIA where an early death results in a payment.

For example, a minimum 10 years of payments from New York Life only slightly reduces the payment to $449 a month, which guarantees $53,880 during those 10 years — or a cash-back guaranteeing the full $100,000 back, though that reduced my monthly payment to $405. I decided to forgo these guarantees because the purpose of the SPIA is longevity insurance and paying to insure against both a short and long life seemed to defeat the purpose.

Simplicity a plus
While Blanchett and Pfau agree that delaying Social Security to get a much higher inflation-protected annuity is the single best option, both also said SPIAs were also good ways to supplement additional cash flows later in life.

“I like the simplicity of SPIAs with no bells and whistles,” said Blanchett, while Pfau said SPIAs were “a better alternative to bonds with steady payments calibrated to pending needs.” Both noted having additional guaranteed income allows one to spend a bit more safely from the rest of their portfolio.

My quote from New York Life stated that I would receive this 5.41% “income” for my lifetime, which is a heck of a lot more than any high-quality bonds or CDs. And only $65 of my $451 income would be taxable.

Of course, that’s because the IRS considers the $386 return of principal and doesn’t tax the whole payment until all $100,000 of principal is paid back. You cannot compare this 5.41% to the bond funds or CDs yielding 1.20% since those are pure income, rather than mostly return of principal.

Expected returns
To determine the return I would get on this SPIA, I turned to estimated life expectancies. For a 63-year old male in excellent health, I have a median lifespan of 25 years though a life expectancy of just under 24 years, as calculated by David Blanchett on the Society of Actuaries longevity calculator and the chart beneath it. I used the highest health status because it would make little sense for your client to buy a SPIA if they are in poor health.

My expected return came out to be a 2.30% IRR, which compares favorably to a 20-year AAA corporate bond rate of 2.12%. While New York life is only AA+ plus, I take some comfort in the state guarantee should NY Life default.

The great unknown
Unlike Social Security, there are no longer inflation-adjusted annuities on the market. I suspect that’s because insurance company actuaries don’t want to take on the inflation risk, which is difficult and expensive to hedge against.

By my calculations, buying a fixed-rate annual COLA now actually increases the inflation risk and lowers the expected return. Pfau points out that it does, however, increase the longevity insurance. I compared the fixed annuity to one with a 2% annual COLA and the break-even was age 92, or five years past the life expectancy. Finally, a deferred income annuity (DIA) dramatically increases inflation risk.

Revised verdict
Revisiting SPIAs revealed some strong arguments for using them as part of a financial plan. On the other hand, one is trading longevity risk for inflation risk, taking on undiversified counterparty risk, since one cannot buy hundreds of SPIAs, and buying a bond-like portfolio when nominal yields are at an all-time low.

How good a bet are SPIAs?



Longevity Insurance

Inflation risk

Peace of mind

Counterparty risk

Competitive expected return

Lack of diversification vs. bonds

Increases safe spend rate for remainder of portfolio

Long-term bond-like investment with historically low nominal yields.

Here’s a link to the full article if you’d like additional detail.

Have questions? Ask me. I can help.

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