Single Premium Immediate Annuity SPIA
The need for consistent, reliable income during retirement is nothing new. In ancient Rome, retired legionaries received lifetime payments as a reward for their service to the state.
From the Latin term for the soldiers’ payments, annua, comes the modern word “annuity.” And, appropriately, annuities are designed to address the same dilemma that concerned the Romans – longevity risk.
Longevity risk is the danger of living long enough to exhaust your retirement savings. It’s a sort of financial planning paradox. You want your retirement to be as lengthy and comfortable as possible.
But if you last too long, you could deplete your assets and be left without a means of support at an age when going back to work is probably out of the question.
Annuities in general – and single premium immediate annuities (“SPIA”) in particular – are designed to guard against longevity risk.
When you purchase a Single Premium Immediate Annuity, you trade a large, lump-sum premium payment upfront for extended, periodic pay-outs from an insurance company or similar institution.
The payments start within one year after you sign the contract and continue for the rest of your life.
By contrast, a deferred annuity does not begin paying out until after a predetermined number of years, and a subscription annuity involves multiple premium payments to the insurance company over time (along similar lines as whole life insurance).
How Do Single Premium Immediate Annuities Work?
SPIAs are the simplest form of annuity, though riders are available at an additional cost which can make them much more complex.
After you sign the contract and pay the premium, the insurance company writes you a check each month, quarter, or year – whichever the contract specifies – for the rest of your life.
The payment can either be “fixed,” which means the amount is defined in the contract and never changes, or it can be “variable,” which means it can go up or down depending upon investment performance.
Fixed annuities grow at a predetermined rate, while variable annuities are based on prevailing interest rates, indexed to the stock market, or linked to investments you select from among a menu of subaccounts offered by the insurance company.
The tax treatment of annuity payments depends on the nature of the funds used for purchase.
If you buy the annuity with after-tax money, a payment from the insurance company is treated as return of premium and not subject to income tax except to the extent the payment is derived from the annuity’s earnings.
If you use pre-tax money, like for example rolling over funds from an IRA into an annuity, the entire payment is taxable income.
Types of Single Premium Income Annuities
The product names and precise contract terms vary from company to company, but there are essentially two types of SPIA.
“Immediate income annuities” (sometimes called “lifetime annuities”) are traditional, straight-forward annuities. You pay the lump-sum premium to the insurance company, and it pays you a fixed amount each month for life. You are basically purchasing your own pension plan.
“Variable annuities” come in several varieties, each of which links payout amounts to investment performance. This allows for greater upside in a good economy but also exposes you to risk in an economic downturn.
One form of variable annuity, “fixed indexed annuities,” ties returns to the Dow Jones or another stock market index but is guaranteed not to lose money in the event of a drop. In exchange, growth is capped at around 4.00% per year, with the insurance company retaining the excess.
“Structured annuities” are also indexed but allow you to receive much higher earnings (usually up to 12%) when markets are up. Instead of guarantying no losses, the insurance company sets a loss floor (around 5%) or agrees to absorb the first ten percent or so of losses.
Generally, the simpler the annuity, the lower the fees.
Because immediate income annuities are the simplest, they usually have the lowest broker commissions and management fees among annuity options. They also save you the trouble of having to research investments and worry about how the market is doing.
Variable annuities, on the other hand, tend to have higher fees and may require some research if the annuity is set up so that you pick where the money is invested. The upside, though, is that when markets are up, you receive bigger monthly payments.
Advantages of Single Premium Immediate Annuities
There are many pros and cons of annuities that you will need to consider. The major benefit of SPIAs is that they are very low-risk and provide consistent, predictable income.
With immediate income annuities especially, the insurance company is assuming all risk of poor investment performance and economic downturn.
And SPIAs also shift longevity risk to the insurance company. If you live well beyond your life expectancy, the insurance company keeps paying even if the total payments substantially exceed the annuity’s purchase price.
Predictable payments are especially useful in retirement planning and budgeting.
If you can buy an annuity with payouts that, when combined with Social Security, ensure sufficient recurring income to pay for necessities, you can afford to assume higher risk levels in investing other assets.
For example, if you know you need $3,000 each month to pay for all household expenses and regular bills, you can calculate an annuity purchase that, along with Social Security, translates into $3,000 per month in reliable income.
Then, you can save and invest the remainder of your retirement savings to cover irregular expenses, emergencies, and luxuries knowing that, if worst comes to worst, you’ll be able to eat and keep the lights on.
Conversely, a retirement plan that relies on earnings in an IRA is vulnerable to market fluctuations.
If a bad investment year necessitates drawing down principal, the reduction inhibits future earnings potential even after markets recover. More than one bad year, or an extended downturn, could deplete assets to the point where outliving retirement savings becomes a real threat.
Although annuities are not guaranteed by the FDIC like bank accounts or CD’s, they are insured by state guaranty associations, so, even if the insurance company goes belly-up, there’s no risk of losing the annuity’s value.
With that said, guaranty associations have coverage caps varying from $100,000 to $500,000, depending upon the state.
So, if you want an annuity in an amount greater than your state’s cap, you should consider buying more than one annuity from different companies so that no single annuity exceeds the cap.
It’s also a good idea to research the company and only purchase from a highly rated insurer. Insurance and Estates recommends limiting purchases of income annuities to companies with A.M. Best ratings of at least “A.”
Downsides of Single Premium Income Annuities
Purchasing a SPIA is a big commitment of resources up front to get the long term income stream.
After the “look-back period,” usually thirty days or less, you can’t get the large premium payment back other than through the periodic contractual pay-outs.
Because there’s no way to cash out other than selling the right to receive future payments (which is almost never a good financial decision), you need to make sure you have sufficient assets outside of the annuity to cover any emergencies or other large expenditures that pop up.
As with any other locked-in investment, annuities are also vulnerable to inflation. And, because the payments can extend for decades, the gradual decrease in adjusted value can add up substantially over time.
Most SPIA’s offer COLA or inflation riders that increase payment amounts in proportion to living costs, though those riders cost extra.
Depending on the inflation rate during the pay-out period and how long you live, it can end up being money well spent.
The pros of variable annuities are tied to interest rates and investment performance, so they are somewhat less susceptible to inflation.
However, a con of variable annuities is that they tend to have notably higher brokerage and management fees than do fixed annuities and don’t provide the same level of budgeting certainty.
Indexed and structured annuities mitigate some or all of the risk of loss while still allowing for growth. Structured annuities in particular have gained in popularity in recent years as a result.
And then there’s potentially the biggest drawback of all: after you die, the annuity does not become part of your estate.
Other than through a few available riders, an insurance company’s obligation to make annuity payments terminates upon an annuitant’s death.
If an income annuity is essentially insurance that, no matter how long you live, you will continue receiving regular income, dying before the annuity has paid out what you put into it is the equivalent of paying term life premiums and living through the term.
As with life insurance, insurance companies pool the risks of demographically similar annuity purchasers. With term life, premiums paid by insureds who live through the term pay for the death benefits of those who do not. Likewise, annuity premiums paid by annuitants who don’t reach their life expectancies subsidize payments to annuitants who live longer.
If leaving assets to your heirs is a priority, this aspect of SPIAs should not necessarily be a deal-breaker.
First, riders are available that provide for either payment of leftover principal to your estate or pay-outs guaranteed for the longer of your lifetime or a period of years.
So, for instance, if you added a “life or term” rider guarantying payment for at least 20 years and then died in year ten, the annuity would continue paying out – either to your estate or to a designated beneficiary – for ten additional years.
Overall Retirement Strategy
More importantly, income annuities are best employed as part of an overall retirement strategy rather than as an exclusive means of support.
When considered along these lines, an annuity can be viewed as a means of shielding other assets from depletion during economic downturns or if you live longer than you had planned. That is, an annuity helps ensure you have enough steady income to avoid burning through the rest of your potential estate.
For example, let’s say you retire at 70 with $1 million in combined assets and you live well into your 90’s. During your over twenty-year retirement, you will inevitably see more than one downturn.
If you’re relying exclusively on IRA distributions for support, you’ll have to continue making withdrawals during down markets, which limits growth potential when bull markets return. Repeat the pattern a few times, and you eventually eat away a sizeable chunk of your portfolio.
Alternatively, converting some of your retirement account balance into an annuity, though, allows you to weather the business cycle and avoid selling low.
Of course, whether an SPIA is a good option for you depends on your individual situation and goals.
An experienced financial advisor can help in developing a comprehensive retirement strategy and in deciding if an annuity should be part of it.
As with any financial product, it’s important to do some research before picking an annuity and to make sure you understand all the terms of the contract before signing.
This is why…
While we here at I&E like to present SPIA’s as a possible way for our clients to ensure that they’ll live a comfortable retirement, we also understand that this can be achieved through a variety of other financial instruments as well.
If your interested in discussing how a SPIA might be a good “fit” for you, or you’d just like to hear some “alternative” options to what you’re already considering, just give us a call and see what we might be able to offer. Who knows, you might be pleasantly surprised by what you learn!
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