With Interest Rates Near Historic Lows, Caveat Emptor Before Purchasing an Income Annuity
When most people think about buying an annuity to produce lifetime income to supplement their Social Security (and pensions if they are fortunate), they are probably envisioning income annuities, often called single premium immediate annuities, or SPIAs. The rub with SPIAs has always been the same. In exchange for that promise of unceasing, lifetime income, you relinquish control of the asset you used to buy the annuity. Further, you assume what has pejoratively been called “bus risk,” as in, payments end when you do, even if you were hit by a bus the day after you bought the “life only” annuity. Adding some degree of protection, such as in having payments continue for the longer of, say, 10 years or a lifetime, can mitigate that risk but will also reduce the payments.
You may recall the Monty Python “Dead Parrot” sketch from the 1970s. Like the dead parrot, the asset you used to buy that income annuity, “has ceased to be” and “is no more” for all intents and purposes regarding your ability to access it. It is now an asset of the insurer, backing the lifetime liability they’ve assumed to pay you a regular income for what may be perhaps several decades. That lack of access and “bus risk” is a major objection for many and likely always will be.
While SPIAs were never volume sellers in the overall world of annuity product sales because of those issues, they have retained a modest presence in the portfolios of those wanting a lifetime check after they stop earning paychecks. The reason for that is that the cash flow produced by a life-contingent income annuity is typically significantly higher than the cash flow produced by other methods. For instance, compared to the traditional “4% safe withdrawal rate,” the cash flow from an income annuity for a 65-year-old wanting income to start immediately is substantially higher.
For example, assume someone has a $2 million portfolio, and they want to use half that money to produce retirement cash flow. If they chose the 4% safe withdrawal, their $1 million would produce an initial annual cash flow of $40,000. If that $40,000 were increased by the rate of inflation each year, say 2%, the second-year cash flow would be $40,800, the third would be $41,616, and so on. That safe withdrawal rate assumes a portfolio consisting of roughly 50/50 stocks and bonds, and while not guaranteed, it does have a high probability of lasting 30 years based on back-tested returns.
Of course, the study that produced those results was conducted almost 30 years ago by a financial planner named Bill Bengen, using data based on the prior half century of returns in stocks and bonds, with bonds on average producing an average yield of about 5.5% in that prior time period. Now with bonds yielding far less than that, some, including most recently Morningstar, have revisited that 4% number and come up with a number closer to 3% as the “safe withdrawal rate,” given the presumed low returns forthcoming in bonds should rates rise from here. Regardless, we’ll stick with 4% for purposes of our current discussion.
Now let’s look at an income annuity for comparison. A plain vanilla “life-only” single premium immediate annuity purchased today, for a 65-year-old, will produce significantly more income and guarantee that income for life, according to Blueprint Income’s online immediate annuity quotes calculator. Penn Mutual’s SPIA product will pay a 65-year-old female $56,530 annually on a $1 million premium, and AIGs will pay $59,190 to a male and $57,980 for a joint life payout, with payments continuing until the second spouse “is no more,” according to Blueprint Income. (Caveat: the quotes were for $100,000 purchase payments, which were then multiplied by 10. It is possible that a $1 million purchase amount would yield a slightly different amount than quoted here.)
Those annuity cash flows are possible because of the benefits of what is called mortality pooling or what some refer to as mortality credits, a defining feature of income annuities.
A 4% safe withdrawal rate (or maybe it’s 3% in today’s low interest rate world?) needs to account for worst-case scenarios of living longer than average and having portfolio performance be below average. In contrast, an income annuity can be priced to assume that a 65-year-old female purchaser will live to the average life expectancy of all 65-year-old women, which is 20.6 years or about 85, while 65-year-old men on average are expected to live to age 83, according to the CDC. The law of large numbers helps support the concept of mortality pooling. Insurance companies like Penn Mutual can afford to pay a 65-year-old woman $56,530 for life even if that woman lives far beyond age 85, say to age 100. They can do this because there will be 65-year-old women who don’t live longer than average. The insurance company uses those funds from the folks who die early to make sure they have the funds to pay those who live much longer than average – that’s the beauty of mortality pooling. (Sidebar: If ever there was a socially conscious form of retirement income, mortality pooling seems to fit the bill, with everyone contributing to the cause for the greater good so that nobody runs out of income.)
For those who don’t want to collect income immediately, a second flavor of income annuity is available, called the deferred income annuity, or DIA. It sells in even smaller numbers than single premium immediate income annuities (SPIAs) such as those we’ve quoted here, for the same reasons. However, they can produce significant cash flows for those willing to wait to collect them. For example, a 60-year female who buys Guardian Life’s deferred income annuity (life only) with $1 million would enjoy a cash flow of $65,740 if that income began five years later, at age 65, according to Blueprint Income. For a man buying at 60 and beginning income at 65, $1 million produces an almost 7% cash flow: $69,070. Those are healthy increases over buying an immediate income annuity at 65, with both men and women seeing an almost 20% increase in cash flow by purchasing at 60 and waiting until 65, according to Blueprint Income.
So yes, income annuities – both immediate and deferred varieties – can produce handsome cash flows relative to the traditional methods of producing cash flow from a portfolio of assets, even in today’s low interest rate environment. But buying one before doing a bit more due diligence might be a mistake. Because while the mortality pooling certainly helps make income annuity cash flows attractive, a different type of annuity can, in limited circumstances, produce the same level of income, without any of the drawbacks.
For example, let’s look at a fixed indexed annuity. This product is classified as a fixed deferred annuity: the owner retains control of the asset they use to purchase the annuity, and it is not subject to market losses. However, and this is where the “indexed” comes into play… it does credit interest up to a defined limit based on the performance of an underlying index, like the S&P 500. For example, it might have an indexed interest cap of say 4% in a given interest rate term of one year, meaning the most it could credit after a year would be 4%, if the S&P 500 index performed at 4% or better. But if the S&P 500 lost 10% in a year, the fixed indexed annuity in our example would credit nothing but lose nothing. It is not a security like a variable annuity.
Many fixed indexed annuities today also offer an optional (or built-in) feature, for an additional charge, that allows the owner to withdraw a fixed percentage of the value of the annuity (or of a separate “benefit base”), and have that withdrawal amount be guaranteed to last for one or two lives, even if the value of the annuity is depleted to zero. And in this low interest rate environment, and if purchased in one’s 60s, these kinds of annuities can produce cash flows that compete with the purest of income annuities – meaning life-only payments from SPIAs and DIAs. But again, they can do so without requiring the purchaser to say goodbye to control of the asset they use to purchase the annuity, and whatever remains in the annuity at the death of the owner can be transferred to heirs, thereby avoiding the dreaded “bus risk” inherent in life-only income annuities.
To illustrate, let’s go back to our first example of a 65-year-old looking to purchase an income annuity with $1 million, and for income to begin immediately. The plain vanilla “life-only” single premium immediate annuity produced $56,530 annually for a female (issued by Penn Mutual), or $59,190 for a male and $57,980 for a joint life payout (issued by AIG). Yet if that income seeking 65-year-old man or woman instead looked at the fixed indexed annuity category and specifically variations that include guaranteed lifetime withdrawal benefits, they’d discover that they could get a unisex rate (which is great for women, given they take a haircut on mortality pooled products like income annuities given their longer life expectancies) that produced a cash flow in the same general vicinity as the pure life only income annuity.
Symetra Income Edge, a fixed indexed annuity with a built-in guaranteed lifetime withdrawal benefit (GLWB) and a 1.20% annual charge, is available for purchase from age 50-85, with lifetime withdrawals being available beginning at 60. It would provide a 65-year-old purchaser a cash flow of 5.75% of the amount of the purchase, immediately. Meaning our female in the income annuity example who can get $56,530 a year from Penn Mutual, can get $57,500 a year with the Symetra product. Here’s the key distinction: if our 65-year-old woman’s need change after buying the fixed indexed annuity with the GLWB feature, and she no longer needs the cash flow, she can cease taking withdrawals. She can also surrender the annuity and use the remaining proceeds for other purposes. Further, if she dies after buying the indexed annuity, her heirs will receive the remaining value. To summarize, she can enjoy all the robust cash flow of the life-only income annuity, without the tradeoffs of lack of liquidity/access or “bus risk.” Note that a joint payout for 65-year-olds wanting to exercise lifetime withdrawals from this annuity immediately would be lower, by 0.50% – to 5.25%.
Let’s now turn our attention to 60-year-olds who want to plant the seeds for income beginning in five years at age 65. We’ll compare deferred income annuity cashflows to indexed annuities with a GLWB. Both products produce higher cash flow the longer the period of deferral, with indexed annuities typically limited to a ten-year deferral regarding income ramping up, and deferred income annuities pay a higher cash flow for every year that income is deferred, with much higher deferral limits. For our purposes here, we’ll limit our comparison to those 60-year-old folks who are looking ahead to retirement at age 65.
Eagle Life Insurance Company offers a fixed indexed annuity product called Eagle Select Income Focus, which is available for purchase from ages 50 to 85 and permits lifetime withdrawals to begin at age 50. It will guarantee the purchaser at age 60, for a 1% annual charge, a lifetime withdrawal amount of 7.5% of the initial purchase payment if those withdrawals begin at age 65, whether male or female. That’s $75,000 of income for life beginning at 65 for a $1 million purchase at age 60. Compare this to our deferred income annuity example earlier, where a female who purchased Guardian Life’s DIA (deferred income annuity) at age 60 would be entitled to a lifetime income of $65,740 beginning at age 65. AIG’s deferred income annuity pays $69,070 to a man who buys at 60 and starts income at 65 from the same $1 million purchase amount. According to Due Diligence Works, there are about a dozen fixed indexed annuities with GLWB riders that will produce a guaranteed lifetime withdrawal at age 65 of at least 7% of the purchase amount if bought at age 60 and untouched for five years.
As with the SPIAs, the DIAs have the same drawbacks compared to the indexed products: lack of liquidity – the accumulated asset “ceases to be” after purchase, and the lack of anything to leave to heirs without diluting the income amount with period certain or death benefit features. Further, in their purest life-only form, the DIA in some cases may never even pay a dime to the annuitants if there is a death prior to the planned income start date.
To summarize, mortality pooling is a powerful concept, and it is the power behind the appeal of income annuities, whether immediate or deferred. But like many interest-sensitive financial products today, income annuity payouts have been drastically reduced over the last decade given the decline of interest rates. There’s only so much income lift that mortality pooling can provide. In contrast, indexed annuities with GLWB features, if purchased in one’s 60s, can produce similar or perhaps better cash flow than life-only income annuities, with none of the tradeoffs. This is because while anyone buying an indexed annuity with a GLWB pays a fee for the lifetime withdrawal benefit, many of those purchasers never actually use the benefit. They pay for something they don’t use – meaning they help subsidize the payments of those who choose to exercise the feature. In this sense, there is something of a behavioral credit providing the income lift in these products, compared to the mortality credits powering income annuities.
There will be a time when interest rates move back up, and income annuities unequivocally provide the most cash flow of any annuity category. But as interest rates remain low, take a look at fixed indexed annuities with a GLWB feature for clients in their 60s wanting income now or within five years. Clients get all the cash flow appeal of an income annuity, with none of the sacrifices.