I wrote recently about the sales traction that insurance companies are getting with deferred income annuities, or DIAs. In this post, I’ll consider the pros and cons of using a DIA as part of a retirement portfolio plan, and expand the conversation to include the DIA’s first cousin: single premium income annuities, or SPIAs. We’ll also consider questions of timing an annuity purchase and how to get unbiased guidance.
Income annuities–whether deferred or immediate–have two key value propositions. One is certainty about income and a hedge against longevity risk–running out of money at a very advanced age. The second is the potential of higher returns via a mortality credit or yield: The premiums paid by buyers with less-than-average longevity provide higher yield to those who live longer.
But potential annuity buyers should ask themselves these seven questions before deciding this solution is a good fit.
1. First Things First: Annuity or Social Security?
Before buying a commercial annuity, consider meeting your income goals through a delayed claim of Social Security benefits. This is a way of “buying” an annuity from Social Security, if you consider the cost to be spending portfolio assets and/or income from work in the early years of retirement to fill any gap in living expenses, before claiming Social Security at a later age.
The cost of a Social Security annuity will beat anything available in the commercial market, and it comes with free inflation adjustments–the annual cost-of-living adjustment, or COLA, awarded to beneficiaries. COLAs also are factored into your benefit while you delay filing. This strategy can also stretch your portfolio’s life by as much as 10 years.
A study by the Center for Retirement Research at Boston College found that a Social Security annuity beats a commercial annuity handily. The price of the Social Security annuity benefits from its unisex mortality ratings, whereas in the commercial annuity market, women pay more because of their longer life expectancy. Insurance companies also must charge more for inflation protection and spousal and survivor features, all of which are provided at no charge by Social Security.
“I would always start by optimizing Social Security,” says Joe Tomlinson, principal of Tomlinson Financial Planning, who has done extensive research and writing about annuities. Tomlinson also has analyzed the rate of return from a delayed Social Security filing.
2. How Much Annuity Should I Buy?
If you’ve already optimized Social Security, an income annuity can be used to plug any projected gap in nondiscretionary expenses. Start with your projected total expenses for housing, food, utilities, transportation, and health care, and subtract guaranteed income you already can count on from Social Security and a defined-benefit pension (if you’re lucky enough to have one). The gap between those two figures is what you might consider filling with an income annuity.
“If you start with your basic living needs and get those covered by Social Security and an annuity, your other investments can be used for discretionary spending, like vacations or gifts for your grandchildren,” says Steve Vernon, a research scholar at the Stanford Center on Longevity and an actuary. “That’s a general strategy that would work very well for many people.”
3. When Should I Buy?
DIAs are being marketed to pre-retirees in their 50s or early 60s, with income starting at age 65 or 70. How does that approach compare with waiting to buy a SPIA at the point of retirement or later?
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