SPIA: The Good Annuity

Today’s Saturday Selection from the White Coat Investor comes from way back in 2012. I don’t spend a lot of time discussing annuities here, because in general, I’m not a big fan.

There is one type of annuity I would potentially consider someday, however, and that is the Single Premium Immediate Annuity. If you take good care of yourself, have a family history of longevity, and are willing to bet on yourself, you might just come out ahead buying a SPIA at the right time.

I’ll let the good Dr. Dahle explain in more detail, but by purchasing a SPIA, you are essentially shifting your longevity risk to an insurance company. It can also be an avenue to loosening the purse strings for those afraid to start spending from principle at an advanced age.

As always, this classic article first appeared on The White Coat Investor.


 

Life insurance agents don’t like selling term life insurance for the same reasons that it is the main, and probably only, type of life insurance you should buy.  It is a simple, low-cost, low-commission financial product.  Who wants to sell the most boring, lowest-commission product out there?  That’s like seeing nothing but URIs all day.  If there were a product among annuities similar to term life insurance, it would be a single premium immediate annuity (SPIA).

 

What is a SPIA?

 

A SPIA is a contract with an insurance company where you give them a lump sum of money, and the insurance company pays you a set amount every month for the rest of your life.  This ensures you’ll never run out of money, and so can be a useful part of retirement planning for just about anyone.

Portfolio withdrawal experts such as Wade Pfau have been recommending them for a long time.  Now that most investors don’t have a pension from their company, an annuity can take its place in the “three-legged retirement stool” (Pension, social security, savings / investment portfolio).  You’re essentially buying yourself a pension with a portion of your portfolio.

 

What’s so great about a SPIA compared to the fancy annuity my agent is trying to sell me?

 


A SPIA is a simple commodity.  The terms are simple, standardized, and pure.  Because of this, there are lots of insurance companies out there competing for your business.  This competition keeps prices (and agent commissions) lower and provides you a better deal.

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 a little more.  Not only because the insurance company has to pass the cost of it on to you, but also because as the product becomes less standardized, there is less competition for it. 

How much can you expect from a SPIA, and what kind of a return will that probably be?

 

This chart demonstrates payout rates and rates of return for a $100K SPIA purchased today [PoF: in 2012].  The last three columns indicate the return on the SPIA as an investment.  The return column is your return if you live to your expected life expectancy.  The +5 column indicates the return if you live 5 years longer.  The -5 column indicates the return if you die 5 years before your expected age.

 

Age Payment Life Expectancy Total of Payments Return LE + 5 Years Return LE – 5 Years Return
50 5.23% 82 167360 4% 4% 3%
55 5.68% 82 153360 4% 4% 2%
60 6.21% 83 142830 4% 5% 1%
65 6.95% 84 132050 3% 5% 0%
70 7.96% 85 119400 3% 6% -5%
75 9.43% 86 103730 1% 6% -18%
80 11.66% 88 93280 -2% 8% -56%
85 14.87% 91 89220 -4% 12% N/A
90 19.70% 94 78800 -14% 18% N/A

 

As you can see, the returns aren’t necessarily high, although they can be quite good if you’re 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.  In fact, I wouldn’t be surprised to see data that indicated that those who purchase SPIAs actually live longer.

 

Are there some other benefits of a SPIA I should know about?

 

Part 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 may save your estate some taxes.

 

Savannah Headstones

 

What if the 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 decades from now.  Similar to FDIC coverage for bank accounts, most states will cover annuities up to $100K-300K per person.

You can minimize the risk by buying from highly-rated companies, and perhaps by buying several different annuities from several different companies.  For example, if you wanted $400K in annuities, but your state guarantee was only $100K, you could buy two policies, one on each spouse, from each of two different companies.

 

At what age should I buy an annuity?

 

Some experts, such as Larry Swedroe, recommend you buy them around age 70.  My personal opinion is that you should buy them when you need them.  If you’re retired at 50, there’s nothing wrong with putting some of your money into SPIAs to ensure a “floor” for your retirement income.


I wouldn’t put it all in SPIAs at that young age, and you can always buy more 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 a fixed income.  Some people like to buy an inflation-indexed annuity, which like Social Security adjusts each year for inflation. But there are fewer companies selling them (making them more expensive), so some experts, like Steve Weisman, recommend against them.

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 the portfolio.  Hopefully having some of the portfolio still invested in assets expected to beat inflation, such as stocks or TIPS, will mean that you still have something left to buy that 2nd (or 3rd) annuity with.

 

Where can I get one?

 

The easiest place to get an estimate of what you’d get paid is to look at the free calculator at immediateannuities.com.  Since it’s an insurance product, you have to buy it from an agent.  But just like walking into an agent’s office to buy life insurance, know what you want before you walk in lest you be talked into something that is a better deal (for him or her.)

 


You’re still not using Personal Capital? Track all your accounts in one place like I do.


 

Have you considered annuitizing a portion of your portfolio? Are any other annuity products on your shopping list? Sound off below and let us know!

16 comments

  • Millennial Doc

    Interesting. I’m sure these could serve some people well. However, let’s consider some drawbacks of the annuity

    -if you die early (i.e. Accident) you just made a large donation to the insurance company instead of your family or favorite charity
    -if you are diagnosed with terminal illness, you no longer have control over that money and can’t make a large lump sum withdrawal even if you wanted to.

    There is certainly a cost to losing control of that money. Annuitizing a small percentage of your portfolio is probably no big deal, but remember insurance companies (like casinos) are always set up to win, so avoid annuitizing the majority. For the more conservative person, why not just go heavier in bonds?

    • I think annuitizing enough to supplement your Social Security to have your core / basic expenses met would bring some peace of mind, and if you live long enough, might be a smart financial move.

      It is a somewhat conservative move, though, I agree.

      Best,
      -PoF

  • Thanks for that through review on SPIA’s. The three legged stool approach sounds like a great way to diversify your retirement income. We have a pension and are still considering adding a SPIA at some point. I also read mixed messages as when you should buy one. I like your suggestion of buying one when you need it.

  • I helped my Mom get a SPIA. It has worked well for her.
    She is extremely risk-averse and she needed more monthly income. I don’t need any inheritance when she passes away since I’m already FI. She has always been healthy and likely will live a long time. She has some assurance that she won’t live longer than her cash flow thanks to the SPIA.

  • Would be good to redo the calculations with more up to date annuity quotes. I calculated the IRR of the annuity at age 50, conditional on living to 95 (!). It’s 4.82% nominal. So, probably 2.82% real. I might just self-insure with a SWR=2.8% and preserve the capital. And better tax treatment for dividends and capital gains. It seems like even SPIA is not that attractive.

  • It’s interesting to consider the potential benefits of an SPIA. I like having full control over my money, so I plan to have a 60:40 allocation of stocks to bonds in retirement, 3 years living expenses in cash, and a 3% withdrawal rate to insure against market fluctuations and longevity.

  • Still on the fence about an SPIA. I guess I’ll decide in a decade or two when I’m older nnd depending on whether I’ve managed to get some passive streams going in the mean time. Chances are its not for me, but always good to have a refresher. Thanks!

    • For sure. No need to decide in advance. I mean, the ideal is to have so much money that the last thing you need is guaranteed income. But for someone who could really use a 5-6% withdrawal rate to get their ideal standard of living in retirement, a SPIA is a fantastic option. I just had an email today from a high income couple still working in their late 70s/early 80s due to poor financial choices. They could buy a SPIA paying 12%! They don’t need 25-30X to retire, they only need 8X!

  • I admit to real estate colored glasses. But if I want to annuitize some equity, I would rather make a 30 year loan at 6% secured by a low loan to value (<70%) quality property. I get to steadily eat my equity + interest over time. And if I die my heirs get to continue receiving the income. Plus, this is a smart exit strategy to defer some capital gains tax for landlords who are done managing property and have a big gain built in.

    With all that said, for non real estate people who want some certainty, I can see the appeal of an SPIA.

    • Yea, real estate is great, but it’s not in the same risk universe as a SPIA, and it requires significantly more work and expertise.

      • I’ll agree that executing a real estate deal takes more work and expertise. But universes are big things:) Another risk country or even another risk state – maybe. And certainly for many investors, understanding the risk of a single family house in a solid neighborhood is MUCH easier than
        understanding the financial strength of an insurance company and their complicated annuity contract drafted by high-paid attorneys. My point was the premium return, the simplicity of collateral, and other benefits are worth the added risk/hassle (for me & perhaps others). Plus, it’s a fun discussion.

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