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Lifetime Annuity: Avoid the Period Certain

A reader writes in, asking:

“Can you please write an article about SPIAs with guarantees of a minimum payout period?”

For those who are unfamiliar, a single premium immediate lifetime annuity (sometimes referred to as a SPIA) is an insurance product where you give the insurance company a lump sum of money (which you cannot get back) and in exchange the insurance company promises to pay you a certain amount of money every month for the rest of your life. In short, it’s a pension that you purchase from an insurance company.

Such annuities are useful because they protect against longevity risk (i.e., the financial risk that comes from living very long and therefore having to pay for a very long retirement).

One thing that stops many people from buying such annuities, however, is the fear that they’ll die soon after purchasing the annuity. For example, if you spend $100,000 on a SPIA that pays you $6,000 per year for the rest of your life, but the rest of your life only turns out to be a couple of years, you will have had a net loss of $88,000.

And that’s why insurance companies offer the option to purchase a “period certain,” whereby the insurance company promises to pay out for at least a given period of time. For example, for a lifetime annuity with a 10-year period certain, the insurance company promises to pay out for the rest of your life but no less than 10 years. (So if you died after two years, the insurance company would continue to make payments for another 8 years to your named beneficiary.)

Of course, because of this guarantee, a lifetime annuity with a period certain will cost more (i.e., will require a higher premium) for a given level of income than you would have to pay for a lifetime annuity without a period certain.

Why a Period Certain Is a Bad Deal

The whole point of insurance is risk pooling. For example, consider 1,000 people who purchase homeowners insurance from a given insurance company. Most of those people will not have their homes destroyed by a fire or a tornado. And that fact — the fact that the insurance company is going to collect money from all of those people without ultimately having to make a huge payout to them — is how the insurance company can afford to make a huge payout to the person whose home is destroyed by a fire.

A key point, however, is that for every dollar that an insurance company receives in premiums, they keep some part of it to cover their administrative costs and to provide profit to shareholders. So only some of the money spent on premiums ultimately goes to pay for claims to people purchasing the insurance product in question. So in general it is unwise to purchase an insurance product unless:

  1. There is risk pooling going on (i.e., many people are going to ultimately get a bad deal so that some people can get a very good deal), and
  2. You need such risk pooling (i.e., you cannot reasonably afford to cover this risk out of pocket on your own).

With a lifetime annuity, risk pooling occurs because some annuitants will die prior to reaching their life expectancy (i.e., the insurance company will pay less than the “expected” amount to those people — which is how it can afford to pay more than the “expected” amount to the people who live beyond their life expectancy).

But if the insurance company is providing a period certain, it knows it must pay out for that entire period. In other words, the annuity then offers no risk pooling for that period. Instead, what’s occurring for that period is just the insurance company gradually paying your money back to you — after taking a piece off the top for profit and expenses — without any actual net insurance effect.

In most cases you would be better off investing the money yourself for the period certain, then buying the annuity at the end of that period. (Of note: if you would be considering a 10-year period certain, don’t buy 10-year bonds. Instead buy longer-term bonds to offset the interest rate risk that you face with the annuity purchase. See this prior article and this Bogleheads discussion for a more thorough explanation.)

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