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?
Market-timing is one argument in favor of using a SPIA instead of a DIA. The current low-interest-rate environment makes income annuities more expensive to purchase, and you’re locking in a low rate. If you think interest rates will jump, it might be tempting to wait out the market.
The key question here, Vernon argues, is how you’ll invest your money in the intervening years–and how long you’re prepared to wait.
“If I’m very sure interest rates will go up, then you would probably just be in cash, earn nothing, and hope interest rates rise and your money would buy a better SPIA [later],” he says. “That would work if rates go up, but we might be waiting a long time for interest rates to rise significantly. It’s a tricky challenge to know whether you’ll do better by investing now and buying a SPIA five years down the road. On the other hand, if I’m in my 50s or early 60s, another argument to buy a DIA is that I can let the insurance company manage the interest rate and mortality risk.
“It’s a series of trade-offs,” he adds. “Buying a DIA at age 55 is like locking in a very long-term interest rate that protects you for the rest of your life. It’s like buying a long-term bond with mortality pooling.”
4. Where Should I Get Advice?
It’s critical to get objective advice for any aspect of retirement planning, and annuities are no exception
I’m a big believer in working with registered investment advisors, or RIAs, who are required to meet the so-called “fiduciary standard,” which is a legal responsibility requiring an advisor to put the best interest of a client ahead of all else. Many stockbrokers, broker/dealer representatives, and people who sell financial products for banks or insurance companies are not fiduciaries, and they are subject to a weaker “suitability” standard (though this is subject to ongoing debate and possible new rule-making as a result of the Dodd-Frank financial-services reform law).
It’s certainly possible to get balanced advice from a nonfiduciary adviser, broker, or agent, but the difference between “best interest” and “suitability” can be huge. A product might be “suitable” for you without necessarily being the best solution available in the marketplace. Compensation also is an issue; it’s important to understand if the person advising you is compensated primarily on commission, and to weigh that in your decision-making and be on the lookout for conflicts of interest.
The stakes here are big; insurance companies are jostling alongside other financial-services providers for a share of the wave of rollover dollars moving out of workplace retirement plans and into IRA accounts. (A large share of DIA sales occur inside IRAs because outright withdrawals from workplace plans generate penalties for buyers younger than age 59 1/2).
5. How Does My Portfolio Plan Change?
Boosting guaranteed income through an annuity can create more running room to invest a greater share of remaining assets more aggressively. “If you have significant income from Social Security and an annuity, you could go 100% in equities with the rest of your assets in retirement,” says Vernon. “A lot of people will have trouble with that from a behavioral standpoint, but it’s a nuance I accept.”
This argument isn’t unique to annuities, of course. Morningstar director of personal finance Christine Benz points out that there are plenty of other ways to balance income-generating investments for living expenses with equities using a bucket strategy. And research by financial-planning experts Michael Kitces and Wade Pfau also demonstrates that a rising equity glide path doesn’t have to be tied specifically to an annuity.
The choice really boils down to a debate over the flexibility of straightforward fixed-income investments versus the higher potential return of an annuity generated by mortality credits. (Premiums paid by those who die earlier than expected boost the growth of the insurance company’s overall risk pool, providing higher yield to those who live longer; the credits increase significantly with age.)
Kitces and Pfau found that the mortality credits really only materially help those who outlive their own life expectancy. SPIAs underperformed fixed-income and equity portfolios during very short time frames, and over the intermediate term, the annuity also underperformed a portfolio with an equivalent rising equity glide path but that used fixed-income investments rather than an annuity. (Several interesting papers have been published recently challenging the traditional wisdom that exposure to equities should fall with age. Kitces and Pfau have done some of this work; another analysis comes from Rob Arnott, CEO of Research Affiliates.)
6. What About Inflation?
What about inflation’s corrosive effects on the value of annuity payouts over time. Some income annuities can be purchased with inflation protection that boosts payments either by a set percentage annually or at a rate tied to the consumer price index. (With DIAs, the inflation protection begins at the time payments begin.) But the protection is costly, Tomlinson says. “You could buy an annuity with inflation protection, or just invest other assets in stocks or a commodity-based asset that provides that protection.”
Specifically, Tomlinson suggests measuring the market’s expectation for inflation against the cost of inflation protection in the annuity. (You can get the market expectation for inflation by comparing yields on a Treasury Inflation Protection Security with a conventional Treasury bond with the same maturity date.)
“If the market expects 2% inflation, I can get a quote for a SPIA with a 2% annual step-up and compare the price for that with what I would have to pay to receive the same initial income from an inflation-adjusted annuity,” he says. “That will tell me how much of a markup there is for the protection from the risk of higher-than-expected inflation.”
Vernon acknowledges the risk that inflation can erode the value of an annuity with a fixed payment. But he thinks annuities also offer an inherent protection against rising prices because they offer higher levels of income at the start of retirement than a traditional drawdown plan. “I’d argue more money is better if inflation is high,” he says.
7. How Does My Spouse Factor In?
Married couples should approach annuity purchases as they would Social Security-claiming decisions–that is, buy protection with a surviving spouse in mind. Joint-and-survivor coverage can be purchased with varying percentages payable to the survivor–50%, two thirds, and 100% are popular choices. Initial payments while both spouses are alive will be lower than for single-life annuities, but it does provide valuable additional protection.
“I always lean toward protecting the spouse,” Tomlinson says. “Don’t assume you will die and your wife will marry some rich guy immediately. I run into many situations where people have come up short in providing for their spouse.”
Spousal protection also underscores one of the virtues of an income annuity, says Vernon. “They’re very user-friendly as you get older; the check comes in the mail or via electronic funds transfer,” he says. “As people get older and less able to manage finances, that’s a real plus–especially if you have a surviving spouse who typically hasn’t been in charge of handling the family finances.
“I don’t mean to sound sexist, but that usually is the wife, so having a monthly check come in without having to lift a finger is a very good thing. As a man, having a joint-and-survivor policy gives me the comfort of knowing my wife will be taken care of after I’m gone.”