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Single Premium Immediate Annuity: Why They’re Useful and When to Buy Them

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 annuity is a contract with an insurance company whereby:

  1. You pay them a sum of money up front (known as a premium), and
  2. They promise to pay you a certain amount of money periodically (monthly, for instance) for the rest of your life.

A single premium immediate annuity can be a fixed annuity or a variable annuity. With a single premium immediate fixed annuity, the payout is a fixed amount each period. With a single premium immediate variable annuity, the payout is linked to the performance of a mutual fund. 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:

  1. They make retirement planning easier, and
  2. 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.

It’s also 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.” (In order to get the most meaningful figure, be sure to get a quote for a SPIA with a payout linked to the consumer price index, rather than one that simply promises a fixed percentage increase from year to year.)

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, even with the low interest rates that prevail as of this writing, according to immediateannuities.com (a website that provides annuity quotes from various insurance companies), a 65-year-old male could purchase an inflation-indexed annuity paying 4.7% annually.

If that investor were to take a withdrawal rate of 4.7% 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—especially given the current environment of low interest rates and high stock valuations. 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 reaching 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, it’s a deal-breaker to learn that none of the money used to purchase an annuity will go to their heirs.

The relevant counterpoint 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:

  1. The longer the period in question, the greater the likelihood of any given company going out of business, and
  2. The entire point of a lifetime 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 Guaranty Associations

Even if the issuer of your annuity does go bankrupt, you aren’t necessarily in trouble. Each state has a guaranty 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 guaranty 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, the guaranty association in Connecticut provides coverage of up to $500,000 per contract owner, per insurance company insolvency. But they only provide coverage to investors who are residents of Connecticut at the time the insurance company becomes insolvent. So if you have an annuity currently worth $500,000, and you move to Arkansas (where the coverage is capped at $300,000), you’re putting your money at risk.

In contrast, the guaranty association in 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:

  1. Check the financial strength of the insurance company before purchasing an annuity.
  2. Know the limit for guaranty association coverage in your state as well as the rules accompanying such coverage.
  3. Consider diversifying between insurance companies. For instance, if your state’s guaranty association only provides coverage up to $250,000 and you want to annuitize $400,000 of your portfolio, consider buying a $200,000 annuity from each of two different insurance companies.
  4. Before moving from one state to another, be sure to check the guaranty association coverage in your new state to make sure you’re not putting your standard of living at risk.

*There are some exceptions. For example, you can buy a SPIA that promises to pay income for the longer of your lifetime or a given number of years. But purchasing such an add-on reduces the payout, thereby reducing the ability of the SPIA to do what it does so well—provide a relatively high payout with very little risk.

Simple Summary

  • 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 guaranty association.

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Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
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