Recently, a life insurance agent wrote me about my railings against the SECURE Act now allowing annuities in 401(k) plans. He politely—and accurately—noted my “unfavorable opinion towards annuities (and by extension insurance sales reps).”
He suggested, however that my attacks on annuities may be too broad. After reading his email, I agreed.
What I advise against are variable, indexed, and other similar annuities that pay high commissions, have high surrender charges, and have high annual fees. These fees make it hard to impossible for consumers to come out ahead.
A lesser-known product, paying significantly lower commissions, is a Single Premium Immediate Annuity (SPIA). These provide a guaranteed income for life in return for a one-time cash investment. For a one-time premium of $120,000, one company will provide a 65-year-old woman with an annual lifetime income of $8,040.
An SPIA locks in an income for life that isn’t subject to market fluctuation. They can be wonderful vehicles to protect unknowledgeable investors from themselves. If, for example, someone in their sixties with a limited income, few assets, and little financial knowledge inherits $150,000, purchasing an SPIA could be an excellent choice.
Yet in almost 40 years, I have only had one client come to me with a previously purchased SPIA and had no client purchase one when I’ve offered them as an option. Why? There are three reasons.
1. With the basic SPIA policy, the income stops the day you die. Like Social Security, if you die a day before or after your benefits start, your heirs receive no return of your contributions. Unfair? No. This is how true insurance works. Premiums from those who die prematurely fund those who live longer, just as property insurance premiums from those with few claims fund payments to those whose homes burn down.
Yet while most homeowners have no problem “losing” their premium payments because their houses don’t burn down, people typically recoil at the idea of paying a large annuity premium and having their heirs get little or nothing if they die prematurely.
2. The wiring in our brains urges us to “have our cake and eat it too.” For a 65-year-old woman who pays a single premium of $120,000 and receives $8,040 a year, the payout rate (not equal to an investment return) is 6.7%. If she dies in 15 years, the return on the investment is 0.06% annually. If she lives 30 years, it is 5.26%. According to the mortality tables she will live 20 years, giving her a probable annual return of 2.97%.
If she invested $120,000 in a diversified portfolio like the Vanguard Managed Payout Fund, it’s historically probable to project that over 15 to 30 years she would earn a return of 5% after all costs. If she withdrew $8,040 per year, she would have over $83,000 left for her heirs after 15 years, over $52,000 after 20 years, and nothing after 28 years.
Yet while a 5% return is historically reasonable, it is not guaranteed. The longer someone’s lifespan, the more attractive the SPIA becomes. The shorter the lifespan, the more attractive the diversified portfolio becomes. Our brains will accentuate the probability of dying sooner, opting for the portfolio and the chance of leaving an inheritance.
3. Buying an SPIA trades a large cash amount for an annual but fixed income. Someone may feel more comfortable with investment options that leave them ownership of and access to their principal.
Even though self-funded guaranteed income streams like SPIAs rarely get a second look from clients, I agree with this agent that planners like me need to consider them as part of our overall retirement planning advice.